While the new rules for pension fund tax exemptions (exempt current pension income or ECPI) have now been in place for over 12 months, the first few 2017/18 income tax returns are now being prepared and lodged. As always, real client cases illustrate best that the new world is very different from the old.
In fact, as we deal with these live cases ourselves, more weird and wonderful scenarios are emerging.
This article explains just a few.
To recap, from 2017/18 onwards, SMSFs providing retirement-phase pensions are divided into two camps:
Camp 1: Funds that are no longer allowed to be classified as segregated. These funds can only claim ECPI if they have an actuarial certificate to support their claim. This is true even if:
· they are entirely in pension phase all year, or
· they are entirely in pension phase for just part of the year.
Camp 2: Funds that are allowed to be classified as segregated. These funds must claim their ECPI as follows:
· for any periods when the fund is 100 per cent providing retirement-phase pensions, using the segregated method (where the fund claims all investment income during that time as ECPI, even if it is only for part of the year), and
· for any other periods during the year, using the traditional actuarial certificate method. The certificate will provide a single percentage, which will be applied to all taxable investment income received at any time other than when the fund is 100 per cent providing retirement-phase pensions.
The challenge for these funds is the need to divide up a single year into multiple different periods and use different methods to claim the relevant tax exemption for different periods.
Deciding whether an SMSF falls into camp 1 or 2 depends on the answer to a single question:
At the previous 30 June (so 30 June 2017 for 2017/18 returns) did any member of the fund have:
· a total superannuation balance (TSB) (across all funds) of more than $1.6 million, and
· a retirement-phase pension (of any size and in any fund)?
If the fund answers yes to this question, it falls into camp 1. All other funds fall into camp 2.
Quite apart from the challenges of answering this threshold question (how would most SMSF accountants actually know how much an individual client held in an external fund at the previous 30 June?), this new treatment presents some very interesting scenarios and new inconsistencies.
Example 1: new scenarios where actuarial certificates will be required
Funds that fall into camp 1 (cannot segregate) will need an actuarial certificate even if the fund is 100 per cent providing retirement-phase pensions all year. Not surprisingly, the percentage will be 100 per cent.
During 2017/18 this will only affect funds whose members had superannuation balances in other funds or if the SMSF had a special pension, such as a market-linked pension. This is because it was not possible for a fund to be entirely providing a retirement-phase account-based pension throughout all of 2017/18 if the member had more than $1.6 million at 30 June 2017 (by definition, some of this amount would have had to be in accumulation phase).
On 30 June 2018, however, it is likely many $1.6 million pension accounts would have increased slightly – let’s say to $1.7 million. If the SMSF has just one member, no balance in any other fund and their only balance is this $1.7 million retirement-phase pension at 30 June 2018, the fund will fall into camp 1 (unable to segregate).
If no new contributions are made, no new members join and no pension commutations occur in 2018/19, the fund will remain 100 per cent providing retirement-phase pensions all year. Nonetheless, it will require an actuarial certificate to claim its ECPI for that year.
Example 2: different behaviour for pension resets changes whether a fund is in camp 1 or 2
It is common for those with pension accounts and new contributions being made to the fund to periodically reset or refresh the pension. In effect, they stop the pension, combine it with new contributions (an accumulation balance) and restart the pension.
In future this will become less common for those with large balances. This is because they cannot put any more super into pension phase once they hit the $1.6 million threshold. But it is likely to remain common for those with smaller balances.
Consider a fund with a single member, Penny. She started her retirement-phase pension with $1.5 million at 30 June 2017. During 2017/18, it grew to $1.55 million and she also added $100,000 of non-concessional contributions. She therefore had $1.65 million at 30 June 2018.
Historically she has refreshed her pension account at the end of each year to combine it with new contributions. She can do this in June/July 2018 without exceeding her $1.6 million transfer balance cap as follows:
· the initial pension added $1.5 million to her transfer balance account (TBA),
· fully commuting that pension when it is worth $1.55 million will reduce her TBA to -$50,000 ($1.5 million less $1.55 million), and
· restarting the pension with $1.65 million will bring it back up to $1.6 million (-$50,000 + $1.65 million).
How her SMSF’s 2018/19 income tax return is prepared will depend profoundly on how she did this refresh in June/July 2018. Did she:
· stop and restart the pension on 30 June 2018, or
· stop and restart the pension on 1 July 2018, or
· stop the old pension on 30 June 2018 and restart the next day on 1 July 2018?
The third alternative now potentially creates a completely different result to the first two.
If Penny stops and restarts her retirement-phase pension on the same day (either 30 June or 1 July), she will have a retirement-phase pension in place at 30 June 2018. (This satisfies one of the two conditions above). She will also meet the second condition – a TSB of more than $1.6 million. Her SMSF is therefore in camp 1. It cannot claim its ECPI using the segregated method.
If, however, she splits the reset across two financial years (stops the old pension at 30 June 2018 and delays restarting her pension until 1 July 2018), her fund will be in camp 2.
The trustee of Penny’s fund may not care in this case – if she makes no further contributions, her fund will be entirely tax exempt throughout 2018/19 regardless of whether or not it needs an actuarial certificate.
However, what happens if Penny makes a downsizer contribution in 2018/19? Or what happens if she inherits superannuation from her husband and rolls it over into her fund? (Generally this would require her to switch off her own pension, creating a new accumulation account.) In this case, structuring the fund so ECPI can be claimed using the segregated method may change the tax outcomes significantly.
Example 3: very different tax outcomes
Consider a fund that can segregate and has two members (Steve and Simone) with $900,000 each. Steve has been retired for several years and had a retirement-phase pension all year with his full balance.
Simone retired in October 2017 and started her retirement-phase pension with her full balance on 1 November 2017. She made a further contribution on 1 March 2018 of $300,000, which she left in a new accumulation account for the rest of the year.
Ignoring earnings and pension payments, their fund looked broadly as follows during 2017/18:
· 1 July 2017 – 31 October 2017: 50 per cent retirement-phase pensions,
· 1 November 2017 – 28 February 2018: 100 per cent retirement-phase pensions,
· 1 March 2018 – 30 June 2018: around 86 per cent retirement-phase pensions.
Unless balances in other funds change the equation, this fund is allowed to segregate and therefore must claim its ECPI using the segregated method for the period 1 November 2017 to 28 February 2018.
Income earned during the remaining two periods would have a single actuarial percentage (around 69 per cent) applied to determine ECPI.
Consequently, there would be a significant difference in terms of tax consequences between, say, realising a large capital gain in December 2017 versus June 2018.
If, on the other hand, the fund was not allowed to segregate, a single actuarial percentage (around 79 per cent) would apply to all investment income regardless of when it was received during the year.
(Reality check: how could this fund be precluded from segregating? Imagine Steve had a large accumulation balance in another fund that took his TSB over $1.6 million at 30 June 2017.)
Conclusion
These rules are now 12 months old, but lodging 2017/18 SMSF annual returns is likely to reveal a great many scenarios we’ve not even thought of yet where the results are not exactly as expected.
Meg Heffron is head of SMSF technical and education services at Heffron SMSF Solutions.