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The viability of reserves in an SMSF: part 2

Part 1 of this two-part article considered some reserves that may be used by trustees of SMSFs and some guidance on the use of reserves. Part 2 continues the consideration of the range of reserves and looks at rules regarding payment out of the reserves.

Insurance reserve

The purpose of an insurance reserve is to pay premiums on insurance covering the life and/or disability of one or more members of an SMSF, and to receive the proceeds of a policy in the event of a claim.

The ATO has stated that, in its view, the proceeds of an insurance policy should be added to the account from which the premiums were paid, “notwithstanding that it is not possible to say that the member will have an interest in the policy, it being owned by the trustee” (ATO National Tax Liaison Group superannuation technical sub-group, September 2009).

Usually, insurance premiums are paid from the accumulation account of the member on whose life the cover is held and, in the event of a claim, the proceeds are paid to the member’s account and, in many instances, paid out of the fund.

In instances where it is preferable for the insurance proceeds to remain in the SMSF, ensuring the proceeds of any claim are directed to an insurance reserve will enable the funds to remain within the SMSF.

As the funds held in the reserve do not belong to a particular member, the trustee is not required to pay that money as member benefits and can apply them for other purposes, such as clearing a loan under a limited recourse borrowing arrangement.

Example – insurance reserve

Danny is considering the purchase of a property by his SMSF under a limited recourse borrowing arrangement.

As Danny is the sole member of his SMSF and, following his death, his benefits will need to be paid to his adult children, he realises the SMSF will be in a vulnerable position with a ‘lumpy asset’ and possibly a large amount of debt.

To avoid the need for a fire sale of the property, Danny has his SMSF take out insurance cover on his life.

Rather than paying the premiums from his member account, Danny decides to create an insurance reserve in his SMSF, from which the premiums will be paid.

The trust deed permits the trustee to operate one or more reserves.

If Danny passes away:
• in accordance with the ATO position, the proceeds of the life policy will be added to the insurance reserve,
• Danny’s benefit in the SMSF will need to be paid out to his dependants or to his estate,
• the cash from the insurance proceeds can be used to pay the benefit,
• the property can remain in the SMSF, avoiding the need for an urgent sale of the property,
• if they wish, the adult children can become members of the SMSF, and
• if so, the value of the insurance reserve can be gradually transferred to the members over time.

Note: There are limitations on the types of insurance an SMSF may hold, and the purpose for which the cover is held.

Defined benefit reserve

Defined benefit reserves, also known as solvency reserves, can arise for SMSFs if established as defined benefit funds prior to 12 May 2004:
• to support the payment of fixed-term or lifetime pensions, and/or
• to support the funding of traditional defined benefit arrangements.

In its Interpretative Decision (ID) 2015/22, the ATO considered the scenario of funds supporting:
• a defined benefit pension being applied to commence a market-linked pension, and
• a pension reserve being applied to commence an account-based pension.

It determined the amount allocated from the pension reserve (that is, to the account-based pension) would be included under the member’s concessional contributions cap.

Forfeited benefit reserve

Forfeited benefit reserves hold amounts forfeited to the fund from member accounts.

Note: Due to the vesting requirements under the Superannuation Industry (Supervision) (SIS) Act, the use and existence of a forfeited benefit reserve would be very rare.

Allocation of reserves

Amounts held in reserves will generally be dealt with (that is, allocated) in accordance with the provisions of the fund’s trust deed.

Generally, the funds allocated from a reserve will be measured, with other contributions, against a recipient’s concessional contributions cap. This will be considered further below.

Where reserves exist and there are no remaining members, the reserves will be dealt with according to the ‘wind-up’ provisions contained in the fund’s trust deed.

Concessional contributions cap

In certain circumstances, amounts allocated to an SMSF member from fund reserves may be counted against the concessional contributions cap. However, this will not generally occur if:
• the amount is less than 5 per cent of the value of the member’s interest in the fund and is allocated in a fair and reasonable manner for:
– every member of the fund, or
– every member within a class of members who get the reserve allocation,
• the amount is used solely to discharge a current pension liability at that time and allocated to:
– satisfy an existing pension liability within the fund,
– commence a new pension (on commutation and rollover of an existing pension), or
– pay a superannuation death benefit.

Note: The above appears to contradict the answers contained in the private binding ruling mentioned in part 1.

However, the exception mentioned above relates to the funding of defined benefit pensions, for example, when the actuary calculates a shortfall in meeting the solvency requirements and directs the trustee to transfer funds from a solvency reserve to rectify the position.

The ATO, in Taxation Determination 2013/22, rules that the amount of a contribution made to a super fund in a particular year (year 1) and allocated to a member the following year (year 2) will be counted against the member’s contributions cap in year 2.

Also, in ID 2015/21, the ATO covered the issue of payments from a self-insurance reserve and whether such payments were measured against the recipient’s concessional contributions cap, and determined that they would be measured against that cap.

Reserving within funds

Managing of reserves is an important operational aspect of SMSFs.

Where reserving within an SMSF is used, careful attention is required in relation to the trust deed provisions:
• ensuring the trust deed does not prohibit (or, preferably in our view, actually permits) the use of reserves,
• governing the types of reserves permitted, and
• when and how the reserves will be created, managed and used.

It is also important to consider the overall consequences of having a reserving policy, with regard to the members’ stated needs and objectives for the fund.

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