Decision time for SMSFs on proposed super changes
If proposed super changes are enacted many SMSFs may need to reconsider which method they use for claiming exempt current pension income.
At the May budget the federal government announced a proposal to introduce a $1.6 million cap on the amount of super that can be transferred to the pension phase, effective 1 July 2017. While this still needs to be passed as law, if it is enacted many SMSFs will need to reconsider whether to use the ‘segregated method’ for claiming exempt current pension income (ECPI) rather than the more commonly used ‘unsegregated method’. It’s worth understanding the pros and cons of both methods and the impact of this change on your SMSF.
This approach pools the SMSF’s assets, with the income from these assets proportionately allocated between member pension accounts and accumulation accounts. The portion allocated to the pension accounts can be claimed as exempt from fund 15% income tax. Tax rules require the SMSF to obtain a Tax Certificate from an actuary, who will advise the percentage of the fund’s assessable income that is tax exempt.
As an example, consider an SMSF with $1 million in funds split equally between two members at the start of the income year, 1 July 2015. On 1 January 2016, one of the members, who has retired, commences a pension. So half the fund is in pension mode from 1 January 2016.
Under the unsegregated method, the ECPI percentage issued by the actuary would be 25%, as 50% of the fund was in pension mode for half of the income year. This ECPI percentage of 25% is applied for the entire income year, not just the period in which the pension was in place. Consequently, 25% of income earned in the first half of the income year (July to December) will be exempt from fund 15% income tax, even though the fund was not paying a pension during this period. Conversely, only 25% of the fund’s income derived during the second half of the income year (January to June) is exempt from fund income tax, even though 50% of the fund is in pension mode.
This method does not require a certificate from an actuary, but the SMSF must be able to track income from assets that have been allocated to fund pensions. For this method, the value of the fund assets that have been segregated to fund pensions cannot be more than the total value of those pensions.
Taking the unsegregated example above, had the trustees segregated fund assets to the value of the pension, then all income, including any capital gains on disposal, would be exempt from fund 15% income tax. So, if one of those segregated assets was a property, upon sale, all the capital gain would be exempt from fund 15% income tax. This compares to the unsegregated method, where only 25% of the gain would have been exempt. Consequently, the future investment plans of SMSF trustees will have a bearing on the method the fund selects.
Many SMSF trustees are aware of the effect of the $1.6 million proposed cap on how ECPI is claimed. Many are asking whether they can select the fund assets that come under the pension.
They want to ensure:
- High-income producing and growth assets are pension assets so that any increase in asset values would result in a higher pension value that would not be restricted by the $1.6 million cap.
- Assets with low cost bases and substantial unrealised capital gains would also be segregated to the pension side of the SMSF to maximise the amount of capital gain on disposal that would be exempt from fund 15% income tax.
SMSF trustees need to ensure their accountant or administrator is proficient in using the segregated method:
- No longer will it be acceptable for SMSF accountants or administrators to apply the unsegregated method as a default.
- SMSF accountants and administrators need to have a discussion with SMSF trustees about the two methods for the SMSF claiming ECPI and let the SMSF trustees decide which is best to use, taking into consideration any costs in adopting the more onerous segregated method.
- Fund assets need more active management from an income tax perspective.
- Administration of SMSFs with both pension and accumulation members needs to be done more regularly than annually.
- SMSF that implement the segregated method must decide on whether there will be two separate bank accounts, that is, one for the pension members and one for the accumulation members or only one physical bank account, which would require on-going monitoring.
Other factors to consider:
- It must be clear to which side of the fund assets belong. This can be done as part of the title registration of the asset or by trustee minutes/resolutions.
- Lumpy assets, for example real property, can be a problem for the segregated method where the value of the asset is more than the value of the pension accounts. You cannot partially segregate an asset to the pension accounts. For example, if an SMSF has a real property asset with a market value of $1 million, but the pension account only totals $700,000, the fund cannot segregate 7/10ths of the property to the pension account. In this situation the unsegregated method may be the only option to claim ECPI.
- The segregated method can only be implemented on a prospective basis. A concern is that the method used to claim ECPI may be retrospective, for example where it is discovered that an asset with a significant capital gain was disposed of during the year and the segregated basis provides a more favourable tax result for the fund. While there may be appropriately dated minutes of trustee meetings or resolutions purporting to segregate the asset as a pension asset prior to its disposal, the ATO may request evidence to substantiate the alleged date of the minute/resolution.
- The choice of method the SMSF can use to claim ECPI can be changed from year to year.
Segregating fund assets and tracking income
When using the segregated method, while there is no requirement for a Tax Certificate from an actuary, you will be required to identify those fund assets that have been segregated as pension assets and track the income from those segregated pension assets to claim them as exempt from 15% fund income tax.
This could require specialised SMSF administration software that can implement the segregated method and make the correct claim for ECPI.