A variety of superannuation reserves have been used for a significant period of time. This second instalment of a two-part feature sees Grant Abbott examine how they work and the value they can add to SMSFs.
In the previous edition of selfmanagedsuper, we looked at the history and definition of reserves and examined why using them in an SMSF was a sound strategy. We finished part one of the feature with a case study to challenge accountants and SMSF advisers to formulate an appropriate allocation strategy from an investment reserve.
We will begin part two with a reminder of the case study facts.
1. Case study
The Jones SMSF was established in 1998. Since then the financial planner and accountant of the fund have been allocating 20 per cent of its earnings to an investment reserve created upon inception. Following a review of the fund’s trust deed, last upgraded in 1998, you find that the trustee of the fund can maintain an investment fluctuation reserve only.
A separate investment strategy for the reserve has been completed by the fund’s financial planner, investing in an Australian shares exchange-traded fund and for the year ended 30 June 2015, the fund’s audited accounts show an investment reserve of $130,000.
The fund has two members, Sam and Pat Jones, both aged 56, with Sam in receipt of a transition-to-retirement income stream (TRIS) valued at $400,000 with a tax-free/taxable proportion of 60 per cent/40 per cent. Sam also has a lump sum accumulation account with $120,000 that is all taxable. Sam has his own business and will continue to contribute to the fund whenever possible. Pat is retired and has an account-based pension of $350,000 (50 per cent tax free/50 per cent taxable), although no pension documentation has ever been drawn up. The fund runs a pooled investment strategy for all superannuation interests, with an allocation of 70 per cent to Australian equities and 30 per cent to cash.
Let’s look at the case study in light of the key compliance and strategy components of any SMSF reserve.
2. The importance of the trust deed
As noted previously, SMSF reserves can be used for a wide variety of purposes. Some reserves can be very tax effective, thereby increasing the long-term capital and strategic value of the SMSF. For example, on the death of a member, an anti-detriment benefit payment out of the fund’s anti-detriment reserve to the deceased member’s spouse, child or legal estate, if in accordance with section 295-485 of the Income Tax Assessment Act (ITAA) 1997, may result in a significant tax deduction to the trustee of the fund – one that can be carried forward for use by younger members of the fund.
Strategy note: Reserves work well for multi-generational SMSFs. Two-member funds that pass from dad to mum and then are wound up may benefit from reserves throughout their life, but the expense and watchfulness required in terms of monitoring allocations may not be cost effective.
As noted by the Australian Prudential Regulation Authority (APRA), there is no definition of reserves in the Superannuation Industry (Supervision) (SIS) Act 1993 and very little guidance on how the trustee of a fund is to operate and maintain a reserve. As such, it is the fund’s trust deed and ancillary documentation that will provide the platform for successful implementation and use of reserves.
It is important to know section 55(1) of the SIS Act 1993 provides that a person, which would include a trustee, the fund’s advisers and auditor, must not breach the governing rules of the fund.
Therefore, if a fund does not have specific reserving powers or narrow reserving powers limited to a general reserve, then the broader opportunities afforded by SMSF reserving strategies cannot be used. This is certainly found in the case study with the simple income equalisation reserve – a common reserve in the 1990s, but very limiting in today’s strategy climate if that is all the fund has in its deed.
ii. Review of the fund’s deed for reserves
Before considering any reserve strategies for a client, the trust deed of an SMSF must be reviewed and more often than not will need to be updated to a modern SMSF trust deed with reserving rules that:
- allow the creation of a reserve,
- specifically allow a reserve type such as an anti-detriment, pension, investment, funeral or insurance reserve,
- enables the trustee of a fund to provide a purpose and rules around a reserve,
- provides for a means of allocating to a reserve, and
- details when amounts may be allocated from a reserve to a member’s superannuation account, another reserve or a member’s beneficiaries.
By way of an example, consider the specific reserving rule required by APRA (contained in the SMSF Strategies and NowInfinity trust deeds): “The trustee may establish one or more reserve accounts for the fund, which may include amongst others an investment reserve, anti-detriment reserve, a contributions reserve, a pensions reserve, an income stream reserve and a funeral reserve. Any reserve account may be for the benefit of current, past and future members, their dependants, legal estate or the trustee.”
When reviewing any SMSF trust deed, ensure that apart from the other terms and conditions covering investment strategies, many of the terms dealing with allocations to and allocations from the reserves created under the deed are included.
Case study review: trust deed to be updated
The fund’s trust deed was last updated in 1998, which is a serious compliance breach for the trustees of the fund. Quite apart from a need to upgrade the deed to cater for pension and anti-detriment reserves in the fund, the trustee is currently offering a TRIS that did not come into law until 2005 and also an account-based pension that did not come into law until 2007. Both of these income streams would be breaching the existing governing rules of the fund and thus would not be allowed under its current deed.
As an aside, it would be surprising that the fund’s auditor had not picked up on the old deed as the review of the fund’s deed is an important part of the SMSF audit process and auditor licensing. The trustee of the fund will need to seek the auditor’s advice on the matter of an old deed.
In addition, there needs to be a process in place for a review of all past transactions, implementations and member benefits to ensure they have not breached the governing rules of the fund.Once this review is completed, the next step is to complete a deed of ratification, with the trustee ratifying the various transactions, notwithstanding that they were not specifically allowed by the governing rules of the fund at the time of completion of the transaction. This is not perfect and there is a risk the fund’s accountant, administrator and auditor are at risk for compensation under section 55(1) of the SIS Act 1993, which prevents any person breaching the governing rules of the fund.
Once the above is completed, the next step is to immediately upgrade the fund’s trust deed. From a family law and estate planning perspective, it is important no member, dependant of a member, deceased member, the member’s legal personal representative or a deceased member’s legal estate has any right or entitlement to a reserve account unless so authorised under the rules of the fund.
3. How is a reserve created?
Section 115(1) of the SIS Act 1993 enables the trustee of an SMSF to establish one or more reserve accounts for the fund, provided the governing rules do not prevent the creation of a reserve.
From a practical and importantly an accounting perspective, a reserve account is where the trustee has set aside surplus assets of the fund into an account not directly for the benefit of a member. A classic case in point is the creation of a contributions reserve, whereby an employer transfers an amount to a superannuation fund for the general benefit of its employees with no specific allocation to a later point in time. This is an important strategy for the purposes of deferring concessional contribution caps as:
- The making of the contribution to the fund will generally be deductible to the employer in the year of income in which the contribution is made (section 290-60 of the ITAA 1997).
- The contribution will be treated as a taxable contribution to the trustee of the fund and thus form part of the fund’s assessable income in the year in which the contribution is made (section 295-160 of the ITAA 1997).
- The contribution, if made directly into a member’s account, will be treated as a concessional contribution at the time of crediting to the member’s account and will be tested against their concessional contributions caps.
- If the contribution is allocated to a contributions reserve, then it will not form part of the member’s concessional contributions until such time as it is allocated from the reserve, which needs to be completed in a certain time frame pursuant to SIS regulation 7.08.
The ATO National Tax Liaison Group analysed a contributions reserve in respect of non-concessional contributions made on behalf of a member, that is, contributions made by the member themselves into a reserve for a later allocation. The following discussion is an important analysis of contributions reserving for both concessional and non-concessional contributions. Please note, this discussion was five years ago, however, still holds today.
ATO view on contributions reserves
Where a non-concessional contribution is allocated to a member’s account in a later financial year than the year the contribution was made, it will count towards the member’s non-concessional contributions cap for the financial year during which it is allocated to the member’s account. The non-concessional contribution does not need to be paid into a reserve, but may be paid into an account, such as a suspense account set up for recording contributions prior to allocation to fund members.
- The amount of a person’s non-concessional contributions for a financial year is determined under section 292-90 of the ITAA 1997.
- Sub-section 292-90(2) of the ITAA 1997 provides that a contribution is a non-concessional contribution if it is made in the financial year to a complying superannuation plan ‘in respect of you’ and it is not included in the assessable income of the superannuation provider. Paragraph 292-90(2)(c) of the ITAA 1997 excludes certain contributions from non-concessional contributions. None of the exclusions apply in this case.
- Paragraph 292-90(4)(a) of the ITAA 1997 also includes in non-concessional contributions an amount allocated by the superannuation provider to a member in accordance with the conditions specified in regulation 292-90.01 of the Income Tax Assessment Regulations (ITAR) 1997.
- Apart from a number of exceptions, an amount will be allocated by the superannuation provider in accordance with regulation 292-90.01 of the ITAR 1997 where it is allocated under division 7.2 of the SIS Regulations and is not an assessable contribution under sub-division 295-C of the ITAA 1997. None of the exceptions in regulation 292-90.01 apply in this case.
- In relation to an accumulation interest, sub-regulation 7.08(2) of division 7.2 of the SIS Regulations requires a trustee to allocate the contribution to a member of the fund within 28 days after the end of the month in which the trustee received the contribution. (Where it is not reasonably practicable to allocate the contribution within 28 days after the end of the month, a longer period that is reasonable in the circumstances is permitted for the allocation of the contribution).
- The operation of these provisions results in all non-concessional contributions being counted towards the cap twice: once under sub-section 292-90(2) of the ITAA 1997 when the contribution is made, and once under paragraph 292-90(4)(a) of the ITAA 1997 when the contribution is allocated to the member’s account. This issue also arises with concessional contributions as section 292-25 of the ITAA 1997 interacts in the same way with sub-regulation 292-25.01(2) of the ITAR 1997.
- To avoid this double counting of non-concessional contributions, the tax office will interpret the specific provision paragraph 292-90(4)(a) of the ITAA 1997 as applying rather than the general provision (sub-section 292-90(2) of the ITAA 1997). The tax office believes this interpretive approach is necessary because to give sub-section 292-90(2) precedence over paragraph 292-90(4)(a) would make paragraph 292-90(4)(a) nugatory.
- Therefore, where a member of a superannuation fund makes a non-concessional contribution to the fund in a financial year and that contribution is allocated to the member’s account in the following financial year (but within 28 days of the end of the month that the contribution was received by the trustee), the contribution will count towards the member’s cap for the financial year that it is allocated to the member’s account. The contribution will not count towards the member’s cap for the financial year that the contribution was made.
- The tax office is aware this approach leaves some scope for manipulation of the excess contributions caps. Therefore the commissioner applies sub-regulation 292-90.01(2) of the ITAR 1997 only to amounts allocated within 28 days of the end of the month that the contribution is received.
- The ATO has previously raised concerns with the operation of this provision with Treasury.