Following the major changes to superannuation legislation in 2007, the attraction of reserves in SMSFs diminished. Industry innovation and a response to further legislation and regulatory interpretation has, however, seen somewhat of a resurgence in the use of reserves in SMSFs.
SMSFs and reserves
For practical purposes, a reserve can effectively be considered to be another member account within an SMSF.
Like a member’s accumulation account, it will hold a balance and generally share in a portion of income and expenses of the fund.
SMSFs trustees are permitted, under the Superannuation Industry (Supervision) (SIS) Act, to hold funds in one or more reserves, provided that:
• the trust deed of the fund does not prohibit the use of reserves (SIS Act section 115), and
• the trustee has a strategy to deal with the reserves (section 52B(2)(g)).
Amounts allocated from fund reserves may be counted towards the contributions caps that apply to individual fund members – this will be considered in more detail below.
It is important to note that if the fund maintains any reserves, the trustee is required to formulate and give effect to a strategy for their prudential management.
The strategy for fund reserves must be consistent with the SMSF’s investment strategy and its capacity to discharge its liabilities (whether actual or contingent) as and when they fall due.
Adding to reserves
Generally, SMSF reserves can be increased in four ways:
• contributions allocated to a contributions reserve,
• returns from fund investments being credited to a reserve,
• returns on investments already held in reserves, or
• proceeds of insurance policies being paid to a reserve.
Note: the proportion of income and capital gains attributed by an SMSF to reserve accounts will be subject to tax at normal rates, even if all other income of the fund is exempt from tax under the exempt current pension income provisions.
The ATO, in a recent private binding ruling (1012758141685), provided guidance on two questions raised in respect of reserves, namely:
• Can the trustee of an SMSF pay an amount from a reserve directly to a member of the fund in satisfaction of the required minimum pension payment? and
• Are the amounts allocated from the reserve to a member of an SMSF treated as concessional contributions?
In response, the ATO advised:
“No, an amount cannot be allocated from the reserve to the member’s pension account, nor can it be paid directly from the reserve to the member in satisfaction of the minimum account-based pension requirements.
“No, provided the allocation does not exceed 5 per cent of the value of the member’s interest in the SMSF at the time of allocation.”
Other ATO guidance, in the form of Taxation Determination (TD) 2013/22 and Interpretative Decision (ID) 2015/21 and ID 2015/22, will be covered below.
Types of SMSF reserves
A number of different types of reserving arrangements that could potentially arise in SMSFs are discussed briefly below.
Generally, contributions that are paid to a fund in respect of a member must be allocated by the trustee to the member’s account by the 28th day of the month following receipt by the fund.
Until allocated, the contributions may be held in a reserve. This is particularly relevant when contributions are received by the SMSF in the month of June, but are intended to be for the next financial year (that is, July).
The contributions may be held in a reserve and allocated by the trustee to the member’s account before 28 July.
Incidentally, the ATO does not use the word ‘reserve’ in describing this scenario, instead using the term ‘unallocated contributions account’.
However, as the SIS Act refers to ‘reserves’ and the provisions contained in SMSF trust deeds tend to flow from that, we suggest it is better practice to consider the account as a reserve and prepare documentation accordingly.
That is particularly relevant when considering that any objections to an assessment the ATO may issue for excess contributions will require production of the appropriate documentation to support the objection.
To potentially remove the need for the ATO to issue excess concessional contribution assessments, and then consider an objection to the assessment, it has released a form, “Request to adjust concessional contributions”, so as to identify the fact contributions made in one year are to be allocated in the following year.
Despite that positive action, Topdocs recommends documents detailing the decision to allocate the contribution in the following year and to establish a contributions reserve be prepared and retained as part of the fund documentation.
An anti-detriment reserve is established to fund the ‘increased amount’ that may be paid to certain dependants of a deceased member, as an increase to the lump sum superannuation death benefits, under the anti-detriment provisions.
This type of reserve has had its popularity curtailed following the 2007 legislative changes.
The reason for that fall in popularity is because payments from the reserve, generally being of significant amounts, will most likely be included in the excess contribution caps and, potentially, incur penalty tax.
Investment reserves, sometimes also referred to as income equalisation or smoothing reserves, are reserves used for the purpose of determining the allocation of investment earnings to member accounts.
In practice, this generally involves the fund allocating a certain amount of annual earnings (in years of relatively high investment returns) to an investment reserve account to be accessed in future years of lower investment returns.
Example – investment reserve
Jane and Bob have an SMSF in which, during a particular financial year, the fund achieved an investment return of 15 per cent.
Their trust deed provides for the ‘smoothing’ of returns to limit the probability of a negative return being declared in any financial year.
Rather than crediting the entire 15 per cent return to their individual member accounts in that year, the trustee decided (in accordance with the fund’s trust deed and reserving strategy) to credit 12 per cent to member accounts and allocate the remaining 3 per cent to the fund’s ‘investment reserve account’.
In the following financial year, the fund achieved an investment return of 8 per cent. The trustee decided to credit 10 per cent to member accounts, effectively drawing 2 per cent of the previous year’s 3 per cent allocation, thereby ‘smoothing’ the return for those two years.
Insurance reserves, defined benefit reserves and forfeited reserves, plus the allocation of reserves, will be published next week in part 2.