Decisions regarding pensions and the assets supporting them can have significant capital gains tax implications, writes Tim Miller.
The taxation of SMSFs can be a complex area, including when they are paying pensions.
There are varying tax requirements and results for a fund, dependent on whether it has segregated and/or non-segregated pension assets. These results can be affected when a member needs to transfer out of their SMSF.
Below we examine the issues associated with calculating exempt pension income and the possible effects of electing to transfer assets supporting an SMSF pension.
We also highlight the different impact the death of a member may have on any superannuation death benefit.
Will CGT apply?
SMSFs’ member/trustee circumstances change and occasionally the end result is that a fund needs to be wound up or a member’s benefit transferred to another complying superannuation fund.
In these situations the question often asked is whether the assets supporting the pension can be transferred to a new fund and, if so, is there any capital gains tax (CGT) to pay on the transfer if the member has been receiving a pension?
Fund-to-fund asset transfers are possible, however, CGT may be payable.
There are a few issues that should be highlighted with trustees/members prior to any transfer:
- pensions must be commuted before they can be rolled over,
- commuting a pension creates an accumulation interest, and
- CGT applies on the sale/transfer of assets from an accumulation interest.
The only way to ensure CGT will not apply is to sell segregated pension assets prior to commuting a pension.
The resulting cash can then be rolled over to a new fund and assets purchased at the new trustees’ discretion.
When does CGT relief apply?
CGT applies when a fund disposes of an asset, unless a CGT exemption or CGT rollover relief exists.
For an SMSF there is predominantly one CGT exemption and one CGT rollover relief available.
A fund with segregated pension assets is exempt from CGT, that is, any capital gain or capital loss made on a segregated pension asset is disregarded.
Rollover relief is provided where assets of one small superannuation fund (including SMSFs and small Australian Prudential Regulation Authority funds) are transferred to another small superannuation fund due to a marriage breakdown. In this situation the capital gains position of the asset is transferred to the new fund.
Rolling a pension interest from one fund to another, excluding marriage breakdown, does not satisfy any CGT relief provision.
There may be very good reasons why trustees wish to transfer assets from an SMSF, but unless they satisfy one of the above options there is a possibility any rollover amount will be reduced to allow for any tax liability arising from selling assets.
A fund obtains significant tax advantages associated with the payment of a pension, however, those benefits only apply while a pension is being paid. Once a pension is stopped, or commuted, the tax benefits are reduced.
This is a key to deciding whether assets should be transferred or sold prior to rolling over a member’s interest.
Exempt current pension income deduction
An exempt current pension income (ECPI) deduction is available for a fund that meets its annual minimum pension payment requirements.
The deduction is calculated based on whether a fund has segregated pension assets or unsegregated pension assets.
One of the key factors of the ECPI deduction is capital gains and losses are disregarded if a fund has segregated pension assets.
This will often lead to the assumption that if a fund has segregated pension assets and transfers those assets to another fund, any gains or losses as a result of the transfer will be disregarded for tax purposes.
An asset is not a segregated pension asset if there is no pension to pay. Once a pension is commuted to roll over a member’s interest, a fund’s liability to pay a pension ceases in this instance as the commutation happens prior to the assets being transferred.
Segregated pension assets
A fund has segregated assets if the trustees identify specific assets for the sole purpose of supporting a pension.
A fund that commences paying a pension with all of its assets will in effect adopt the segregated method.
However, a fund that is exclusively paying a pension may adopt the unsegregated asset method, requiring the fund to obtain an annual actuarial certificate, if the fund gives rise to an accumulation interest during the year.
Segregated assets that are transferred after a pension ceases, via commutation, are considered fully taxable as they are no longer pension assets.
Any gains arising in this situation can only be offset by any carried forward losses created prior to the pension commencing or attributable to the transfer after the pension ceases.
As segregated pension assets are disregarded for CGT purposes if sold while a pension is being paid, the most tax-effective action trustees can take, if their assets have unrealised capital gains, is to sell those assets prior to commuting a pension and rolling the cash proceeds over.
Unsegregated pension assets
Assets not specifically identified to support a pension are considered unsegregated current pension assets.
The unsegregated method allows a fund to claim the ECPI deduction based on the proportion of a fund’s average pension liabilities divided by its average superannuation liability.
This average is subject to the applicable period the fund is in pension, usually a financial year. In the instance where a fund closes down part way through a year, the calculation is done for the period to closure.
Unsegregated pension ECPI calculation (assets transferred at 1 January)
Simon has an SMSF that has been paying him an account-based pension for a number of years.
He is the sole member of the fund and decides to transfer his pension to another fund rather than retain trustee responsibility of his SMSF as he gets older.
The assets are transferred on 1 January and the pension is commuted at 31 December.
In simplistic terms, the actuary will calculate the percentage of exempt income using a formula similar to this, but in reality their calculation is more advanced:
Average pension liability/average superannuation liability x pension days/days in period
Average pension liability = $900,000 (fund was 100% in pension mode)
Average superannuation liability = $900,000
Pension days = 184 (days until commutation)
Total days = 185
$900,000/$900,000 x 184/185
= 99.5% exempt current pension income deduction
Segregated versus unsegregated pension assets
The unsegregated method is likely to produce a better tax result over the segregated method when a fund elects to transfer assets, particularly if all assets are successfully transferred in a very small time frame.
All income received after the pension is commuted, or likewise prior to a pension commencing, will be taxable if the segregated method is selected.
What would be the tax implications on Simon’s fund if he elected to segregate his assets based on the parameters in the above example? The average liability of $900,000 was based on an opening account balance of $800,000 and a closing balance of $1 million. Simon expects to roll over $1 million to a new fund. The $200,000 growth represents a capital gain on the assets sold to roll over the benefits. The fund has held the assets for longer than 12 months.
The possible outcomes available to Simon are as follows:
$200,000 taxable income less ECPI deduction of $199,000 (99.5% of $200,000) = $1000 at 10% = $100 tax, which results in $999,900 being rolled over.
Segregated method – assets sold prior to rollover (prior to commutation)
All capital gains are disregarded, there is no tax liability and the entire $1 million is available to be rolled over.
The entire gain is taxable as the sale of the assets via the transfer occurs after the pension has been commuted. As the assets have been held for more than 12 months, the applicable calculation is $200,000 at 10% = $20,000 tax. So Simon can only roll over $980,000.
Unsegregated method – assets transferred (or sold prior to rollover)
If Simon elects to use the unsegregated method and transfers all assets on the one day, the tax result would be as follows:
Based on these calculations it is likely to be in Simon’s best interest to seek a tax exemption certificate from an actuary or, alternatively, to sell the assets prior to closing the pension.
If there is no compelling reason to transfer assets to another fund, it may make greater tax sense to sell assets and transfer cash.
SMSF trustees need to determine whether any associated tax liability is outweighed by the need to retain a specific asset before making a decision to roll over to another fund.
Death of a member
The above situation is clearly the result of a choice made by the members of a fund not to continue with their SMSF.
Trustees, however, also need to consider the scenario where they are limited by choice, such as when a member dies. Death is the only condition of release that has a compulsory cashing requirement associated with it.
When a member has tax dependants, such as a spouse or a child under the age of 18, the trustees have the opportunity to retain the member’s benefit within an SMSF to pay a pension to the dependant.
If there is no such dependant, then there is no alternative but to pay the member’s benefit out in the form of a lump sum.
The Australian Taxation Office has indicated a fund’s liability to pay a pension ceases the day a member dies, unless there is a contract in place to pay a reversionary pension.
Prior to 1 July 2012 this meant if a fund had unrealised capital gains and a pension member died, tax was payable on those gains as a result of the need to pay out the death benefit.
This could only be offset by carried forward realised losses.
Minimising tax on death after 1 July 2012
As the timing of one’s death is not always apparent, it made planning for this moment quite difficult.
Members and trustees needed to consider taking precautionary action to minimise the tax impact of death, such as resetting cost bases.
Thankfully regulations were introduced, effective from 1 July 2012, that ensure the exempt current pension income deduction continues until the death benefit is paid as long as that payment is made as soon as practicable.
When moving assets out of an SMSF, pension trustees/members need to be aware of the potential tax consequences associated with the transaction. While we have relief when a member dies, this doesn’t apply when we make a choice to commute our pension. As stated above, there are opportunities available to minimise the CGT liability for SMSFs and trustees should seek advice to ensure they have covered all bases to investigate these opportunities.