The ATO has recently outlined its concerns with the use of reserves in SMSFs, making it clear it expects them to use reserves only in limited circumstances and for legitimate purposes, as set out in section 115 of the Superannuation Industry (Supervision) Act 1993.
The use of reserves is likely to attract the ATO’s attention for compliance with the sole purpose test and the general anti-avoidance provisions in tax law. Where reserves are maintained, it is important that:
- they comply with the legislative requirements to have a clearly articulated purpose,
- the trustee has formulated and given effect to an investment strategy for the management of reserves, and
- the strategy is regularly reviewed.
In the first edition of its new public advice and guidance product, “SMSF Regulator’s Bulletin” (SMSFRB 2018/1), issued on 15 March, the ATO says it is also concerned reserves may be used to circumvent total super balance and transfer balance cap restrictions introduced from 1 July 2017. This may allow a member to make non-concessional contributions, access the concessional contributions five-year bring forward or potentially increase the SMSF’s exempt current pension income.
Although the ATO has indicated it will not apply compliance resources to the use of reserves prior to 1 July 2017, it will scrutinise the growth or establishment of reserves post 1 July 2017.
In large Australian Prudential Regulation Authority (APRA)-regulated funds, the use of reserves is often necessary to manage the application of expenses between current and future members. There are also regulatory requirements for large funds to consider and implement the use of risk mitigation reserves for contingent events. In SMSFs, however, the small membership generally negates the requirements for reserves to be maintained.
Outlined below are the ATO’s views on the use of particular reserves.
Large funds may use an administration reserve to fund future administration and operational expenses over a changing future membership base. The cost of changing the computerised administration systems to implement the 1 July 2017 changes in a large fund may have been hundreds of thousands of dollars. Where such a fund has thousands of members join and leave each month, the cost is required to be fairly spread over current and future members.
As the membership of an SMSF is not expected to fluctuate over time, the ATO expects administration and operational expenses to be allocated to members as they arise.
Accordingly, the tax office does not expect to see SMSFs operating administration reserves.
Large funds may use an investment reserve to smooth the impact of market fluctuations over time. This is particularly relevant for funds that have investment options that are pools of underlying investments rather than members investing directly.
Again, as the membership of an SMSF is not expected to fluctuate over time, the ATO expects investment returns to be allocated to members as they are earned. Accordingly, it does not expect to see SMSFs operating investment reserves.
Operational risk reserves
Operational risk reserves are legally required to be considered by APRA-regulated funds to meet their operational risk financial requirement (ORFR) target amount. These amounts cover the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events.
SMSFs are not required to meet ORFR target amounts. In addition, given the mutuality between SMSF members and trustees, SMSF trustees are well poised to manage operational risks on behalf of members.
Life expectancy, lifetime and flexi complying pensions may have required the establishment of one or more reserve accounts to enable the trustee to satisfy their liability to pay complying pensions. As these types of pensions have not been able to commence in an SMSF since 1 January 2006, there should be no new pension reserves established. However, many pension reserves continue to grow due to investment performance exceeding historic actuarial assumptions and their management continues to create issues.
Pension reserves cannot be used to support an account-based pension.
All SMSFs have been prohibited from self-insuring since at least 1 July 2016, thus the ATO’s view is self-insurance reserves are not permitted.
The tax office also affirms its previous views that SMSFs cannot hold an insurance policy in a reserve which may then become available for distribution to fund members. Insurance policies may only be held to form part of a benefit payment in respect of the insured member.
The ability to pay an anti-detriment payment has ceased for members who die after 1 July 2017, thus the ATO does not expect the establishment of any new anti-detriment reserves in SMSFs. However, it is acknowledged some SMSFs may have established anti-detriment reserves and these reserves will need to be maintained. The tax office expects any such reserves will be progressively distributed to members.
Distribution from reserves
The distribution of an amount from a reserve to a member account is counted towards the member’s concessional contributions cap unless the allocation is less than 5 per cent of the member’s total interest in the fund and is allocated on a fair and reasonable basis.
The ATO has also stated an allocation from a reserve account cannot be made to an account-based pension.
Historically, many complying pensions have ceased, however, amounts have remained in the complying pension reserve account. These reserves have often been allocated to account-based pensions the member may have in the SMSF.
The ATO’s view in SMSFRB 2018/1 is that such allocations would circumvent the introduction of the transfer balance cap from 1 July 2017. This represents a change that SMSF trustees need to be aware of.
A distribution from reserves could, however, be made to an accumulation account and then transferred to a new account-based pension if the member has remaining transfer balance cap space.
SMSFs that establish or maintain reserves need to be mindful of the views expressed by the ATO in the first edition of the “SMSF Regulator’s Bulletin” and ensure they comply or obtain specialist advice in respect of their particular SMSF.