By Jared Lynch
There have been big changes announced recently for SMSF pensions. This article explores some of the key changes and discovers that those hardest hit by the $100,000 limit on the pension income tax exemption may well be those left behind after the death of an SMSF pensioner, as well as SMSFs that realise assets. There has also been some positive news and pleasant surprises.
$100,000 limit on pension income tax exemption
To the extent SMSF income is derived by assets supporting a pension, that income is exempt from income tax. Currently, there is no limit on this exemption. However, it has recently been announced that this will change. More specifically, the Hon Bill Shorten MP has stated:
From 1 July 2014, earnings on assets supporting income streams will be tax free up to $100,000 a year for each individual.
Earnings above $100,000 will be taxed at the same concessional rate of 15 per cent that applies to earnings in the accumulation phase.
It has been announced that this will only affect a relatively small number of people:
For superannuation assets earning a rate of return of 5 per cent, this reform will only affect individuals with more than $2 million in assets supporting an income stream.
Treasury estimates that around 16,000 individuals will be affected by this measure
However, in practice, we suspect that this change will end up affecting many more. For example, consider a married couple, Eric and Natalie. Each has $1˝ million in an SMSF (ie, $3 million in total between the two of them). If the assets earn a rate of return of 5%, then consistent with the government announcement, neither will be affected. However, there are two common scenarios where they will be affected.
Scenario 1 — SMSFs realising assets
The first scenario where Eric and Natalie are affected is where their SMSF realises capital gains. Assume the SMSF has real estate that was purchased for $1 million and is now worth $1.6 million. As Eric and Natalie age, the yield on the real estate is not enough to meet their minimum pension payments and so they liquidate the real estate in order to be able to pay the pensions. Assuming that the capital gain is a discount capital gain and that there are no capital losses, this gives rise to a net capital gain of $400,000 (ie, [$1.6 million – $1 million] x [2/3]). This net capital gain forms part of the fund's assessable income. This is in addition to any other income that the fund might have, such as the 'normal' 5% yield of $150,000 (ie, 5% x $3 million). Accordingly, total SMSF assessable income will be $550,000 (ie, $400,000 + $150,000). If Eric and Natalie's benefits are split equally, two lots of $100,000 of the $550,000 are exempt. However, that still leaves $350,000 of assessable income.
Assuming there are no deductions, offsets, etc, then the SMSF will probably have a tax liability of $52,500 (ie, $350,000 x 15%).
Scenario 2 — Death of a spouse
The second scenario is death.
Assume Natalie dies and her benefits in the SMSF commence to be paid to Eric by way of a pension. We suspect that this will mean that all pension income of the SMSF is attributable to Eric. However, the SMSF now has an annual tax bill of $7,500 (ie, ([$1.5 million + $1.5 million] x 5% – $100,000) x 15%).
Therefore, the change can be seen to operate as a de facto death tax.
Extension of pension exemption
Draft tax ruling TR 2011/D3 was very controversial because it stated that a pension — and therefore the pension exemption — ceases instantly upon a pensioner's death, unless the pension is automatically reversionary. This meant that when an SMSF member died, the pension exemption may well stop and therefore if an asset carrying a large unrealised capital gain is liquidated or transferred to a dependant or the deceased's estate, a large capital gain (and thus large income tax liability) might arise for the SMSF.
However, in October 2012, the Mid-Year Economic and Fiscal Outlook announced:
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 was greeted very positively as it was seen as taking the 'sting' out of TR 2011/D3.
The legislation to implement this was registered on Monday 3 June in Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013 (Cth).
However, the $100,000 cap on the pension exemption means that the extension of the pension exemption might not be a perfect solution.
Consider Elizabeth. Her SMSF owns assets with an unrealised capital gain of $600,000. She is the only member of the SMSF and the SMSF uses all its assets to pay her a pension. Originally, TR 2011/D3 had concerned Elizabeth because upon her death, she had thought it would mean that the pension exemption would cease, and a $600,000 capital gain would arise for the SMSF if the SMSF assets were transferred to her estate. This in turn, could cause a tax liability for the SMSF of about $40,000 (ie, $600,000 x (2/3) x 15%). Naturally, Elizabeth greeted the extension of the pension exemption positively as it meant that the SMSF should pay no income tax in that scenario.
However, the $100,000 cap on the pension exemption may change this. Upon death, only the first $100,000 of income is exempt. This might mean that Elizabeth's death might result in her SMSF having to pay income tax of $45,000 (ie, [$600,000 x (2/3) – $100,000] x 15%).
Grandfathering and anti-detriment deductions
Certain grandfathering provisions have been announced in respect of the $100,000 cap on the pension exemption. The most important grandfathering provision is that assets acquired before the announcement of the cap on 5 April 2013, are exempt from the cap until mid 2024.
However, for SMSFs for whom this grandfathering does not apply — and for all SMSFs from mid 2024 — the scenarios outlined in this article might causes concern.
Such SMSFs might consider the role of anti-detriment deductions in this situation.
A pleasant surprise
An amount that supports a pension is always to be treated as a separate superannuation interest for income tax purposes (see reg 307-200.05 of the Income Tax Assessment Regulations 1997 (Cth)). Some people might have gone to effort to ensure that — by using pensions — they had multiple interests in their SMSFs.
Under the original exposure draft of Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013 (Cth), although the pension exemption would continue past death, the pension itself would not and thus any separate interests would all instantly mix together upon death.
However, the finalised version of the legislation contained a pleasant surprise. Namely, interests are effectively kept separate after death. See the new reg 307-125.02 of the Income Tax Assessment Regulations 1997 (Cth).
Failure to meet minimum pension standards
The tax exempt status of current pension income for SMSFs is dependent on trustees ensuring that the minimum pension standards in the Superannuation Industry (Supervision) Regulations 1994 (Cth) are met.
If the minimum pension standards have not been met, the ATO considers that a pension ceases for income tax purposes. Furthermore, the ATO considers that the trustee has not been paying a pension at any time during that financial year. This can have a severe impact on SMSFs where, for example, a pension minimum has not been paid due to an inadvertent mistake or factors beyond the control of the trustee. In these cases a minor discrepancy can result in the pension ceasing and any sums paid during the year being treated as lump sum payments. This may require significant administrative effort and cost, including the recalculation of pension minimums or the revaluation of assets that will support the new pension.
The ATO announced via its website in January 2013 that the above regulations would not be rigidly applied. The Commissioner's general powers of administration ('GPA') may be exercised in cases where the failure to meet the minimum pension standards was due to either an honest mistake made by the trustee resulting in a small underpayment of the minimum payment amount, or matters outside the control of the trustee.
Furthermore, in certain circumstances the trustee is able to self assess their entitlement to the exercise of the GPA. In order to be able to do so, all of the following conditions must be satisfied:
- · failure to meet the minimum pension requirements was an honest mistake or was outside the control of the trustees;
- · the underpayment is only small (that is, it does not exceed one-twelfth of the minimum annual pension payment);
- · the entitlement to the pension exemption would have continued but for the trustee failing to pay the minimum payment amount;
- · upon the trustee becoming aware that the minimum payment amount was not met for an income year, the trustee makes a catch-up payment as soon as practicable in the following income year; or treats a payment made in the current income year, as being made in that prior income year (ie, an intended prior year payment);
- · had the trustee made the catch-up payment in the prior income year, the minimum pension standards would have been met; and
- · the trustee treats the catch-up payment, for all other purposes, as if it were made in the prior income year.
In all other cases the trustee will need to write to the ATO and outline why they did not meet the minimum pension requirements. The ATO will then consider whether the exercise of the GPA is warranted.
Significant changes have been announced in respect of SMSF pensions. This article explored some key changes and identified that the introduction of the $100,000 pension exemption limit might end up most affecting SMSFs upon a pensioner's death and when an asset is sold or transferred. This article also outlined some positive news for SMSF trustees.
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.