By Daniel Butler and Bryce Figot
The Federal Government's October 2012 Mid-Year Economic and Fiscal Outlook ('MYEFO') included an important announcement that provided a great boost of confidence to the SMSF industry. Namely, with effect from 1 July 2012, a tax exemption will apply following the death of an SMSF member in receipt of a pension until that pension has been paid out of the fund.
In light of this announcement, this article considers whether it is still important that pensions be made 'auto-reversionary'.
In draft taxation ruling TR 2011/D3 the ATO stated:
A [pension] ceases as soon as the member in receipt of the [pension] dies, unless a dependent beneficiary of the deceased is automatically entitled under the superannuation fund's deed, or the rules of the [pension], to receive [a pension] on the death of the member.
This caused considerable concern. To illustrate, consider an SMSF with one member where that member has been receiving a pension for many years. Due to the pension (income tax) exemption in subdiv 295-F of the Income Tax Assessment Act 1997 (Cth) ('ITAA 1997'), the SMSF probably has not paid any income tax, including capital gains tax ('CGT'), for a number of years. Now assume the member dies. The SMSF assets might be carrying a large, unrealised capital gain. The Superannuation Industry (Supervision) Regulations 1994 (Cth) require the deceased member's benefits be cashed as soon as practicable after death. Accordingly, the assets might either be transferred out of the SMSF in specie or alternatively the assets might be sold and the proceeds used to pay out the death benefit. Either way, the SMSF will have a CGT event. According to the view in TR 2011/D3, there is no longer any pension and thus there is no longer any pension exemption. Accordingly, the CGT event could result in a significant tax bill to the fund.
TR 2011/D3 acknowledged that, with the correct documentation in place, it is possible for the member's pension, upon death, to automatically continue. In this instance the pension exemption continues and no tax bill would arise to the fund. A pension structured like this is often referred to as a pension that automatically reverts, or an auto-reversionary pension ('ARP').
Change announced by the MYEFO
The MYEFO announced that
The Government will amend the law to allow the tax exemption for earnings on assets supporting superannuation pensions to continue following the death of a fund member in the pension phase until the deceased member's benefits have been paid out of the fund. This change will have effect from 1 July 2012. This measure is estimated to have a small but unquantifiable cost to revenue over the forward estimates period.
The superannuation law requires the benefits of a deceased member to be paid out of the fund as soon as practicable following the member's death. The continuation of the earnings tax exemption beyond the death of a member will be subject to this existing requirement.
This change will benefit the beneficiaries of deceased estates by allowing superannuation fund trustees to dispose of pension assets on a tax-free basis to fund the payment of death benefits.
As noted above, the extension of the pension exemption following death will apply from 1 July 2012. However, TR 2011/D3 applies from 1 July 2007. This means that for pensioners who died on or prior to 30 June 2012, unless they had an ARP, the ATO consider the pension exemption ceased on the person's death. We note the ATO view is reflected only in a draft ruling which is not law nor is it a binding ruling. Nevertheless it is consistent with the ATO's view reflected in ATO ID 2004/688 where the pension exemption ceased upon the member's death. Thus, if taxpayers do not follow the ATO's view they may be at risk and should seek expert advice on how to manage such risk.
How to set up an ARP
Most reversionary nominations are mere wishes and are not binding. Thus to effect an ARP a 'locked in' reversionary nomination must exist. Typically, in an SMSF this requires a special deed that facilitates a nomination that binds a trustee's discretion (ie, an effective fetter binds a trustee's discretion based on a specific power in the deed).
Our experience over many years has shown that under most SMSF deeds we have reviewed, the binding death benefit nomination ('BDBN') would prevail over a reversionary nomination. BDBNs are more specific as to death and are binding. A reversionary nomination, on the other hand, is typically discretionary and is effected at the time of commencement of a pension.
Alternatively, the ARP can also be facilitated by a BDBN that directs not just to whom the death benefit is to be paid (eg, to spouse) but also how (eg, as a pension). Naturally, the SMSF deed should also authorise this.
Thus, an ARP typically needs to be 'locked into' the SMSF governing rules to be effective and often this is via a specially drafted SMSF deed with a reversionary nomination and/or by a suitably drafted BDBN.
Are ARPs still required?
The next question is, once the MYEFO extended pension exemption announcement becomes law, will an ARP 'locked in' reversion still be required?
Interestingly, an ARP will, following the proposed change, not be required for the pension exemption to continue beyond a pensioner's death . However, the ATO consider that an ARP was required for pensioners who died on or before 30 June 2012 to ensure the pension exemption continues beyond death.
Therefore strictly speaking there appears to be no need for ARPs after 30 June 2012. However, considering the proportioning rule in s 307-125 of the ITAA 1997, there can be significant advantages in ensuring each pension has a 'locked in' ARP as it provides better protection against adverse tax and succession risks.
Broadly, the proportioning rule results in each benefit reflecting the applicable proportion of tax free and taxable components. In other words, one cannot 'cherry pick' the tax free money; a benefit paid must reflect a proportion of each (tax free and taxable) component.
In an SMSF environment, a member is generally required to have one or more separate pensions to have more than one superannuation interest. This is because, an SMSF member only has one interest unless they have one or more pensions: Income Tax Assessment Regulations 1997 (Cth) regulation 307-200.05. Indeed, a lot of planning has been directed at ensuring the tax free component of each pension has been maximised in recent years and this has generally resulted in members having numerous pensions (aka superannuation interests) in the same SMSF.
In some cases, taxpayers may have certain pensions that are 100% or predominantly tax free and others that are predominantly taxable. In this situation, the death of the pensioner may, given the ATO's views in TR 2011/D3, result in a member ceasing his or her pensions unless an ARP is in place for each pension. If the pension ceases, it reverts back to accumulation mode and if there are several pensions involved, the different pension interests are merged together. This results in mixed taxable and tax free components, which cannot be separated or untangled again. Thus, ensuring ARPs exist in respect of each pension will overcome this risk. Naturally, to achieve an effective ARP requires an appropriate SMSF deed, pension documents or BDBN. These documents are generally available from SMSF lawyers.
Draft regulations recently issued to cover the MYEFO announcement to broadly extend the pension exemption until the time the lump sum if paid if a member dies with a pension at the date of their death which is not an ARP. A new definition of 'superannuation income stream benefit' is proposed to be inserted in reg 995-1.01 of the Income Tax Assessment Regulations 1997 (Cth) to facilitate the continuation of the pension exemption.
It should also be noted that the ATO have recently issued a fact sheet 'SMSFs – starting and stopping a superannuation income stream (pension)' in respect of an SMSF failing to pay the minimum pension amount during a financial year. The ATO may apply its powers of general administration ('GPA') to overcome the strict consequences that would otherwise arise if the minimum pension is not paid in respect of a financial year in view of its analysis in TR 2011/D3 that the pension would otherwise cease. This administrative solution is not applicable to the situation discussed above with respect of not having an ARP on death and we await the finalisation of the ATO's finalisation of the definition of 'superannuation income stream benefit' discussed above so the ATO can then proceed with finalising TR 2011/D3. It is not until these are finalised that we will get certainty on this topic.
The announcement in MYEFO is great news for the SMSF industry and the government should be commended for its foresight and practical approach. However, there are still reasons to ensure a pension is an ARP to protect against adverse tax consequences. Quality SMSF documentation here is a key factor in achieving an effective strategy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.