With a significant amount of wealth having been built up by the baby boomer generation, we will begin to see an intergenerational transfer of these assets down to ‘GenX’. Over time, superannuation has become a focal point for the baby boomers as governments started encouraging funding their own retirement and placed less emphasis on the age pension.
When we talk about wealth transfer within a superannuation environment, the changes to the definition of dependents from 1 July 2007 effectively knocked out the ability to retain money inside an SMSF an pay an income stream to a son or daughter, regardless of their tax dependent status. Nowadays a benefit to a beneficiary who is not a tax dependent must simply be paid out.
But, this doesn’t mean that the existing SMSF becomes dead and buried with those members…
A strategy adopted somewhat across various superannuation funds is the use of the anti-detriment provisions contained within section 295-485 of the Income Tax Assessment Act (ITAA) 1997. I say this is somewhat used, there are only some industry and retail super funds that actually claim this tax benefit for their members. However, this benefit which is calculated on the death of a member becomes a tax deduction for the super fund, the spoils of this deduction is passed across the members of the fund. Within an SMSF environment, this strategy becomes far more powerful as the tax benefit actually passes down to the next generation for the future benefit of family members to the SMSF.
So, what are the anti-detriment provisions?
The anti-detriment provisions came into effect in 1988 when the then Hawke Labour Government made significant changes to super funds, introducing taxation on earnings, contributions and CGT. As a result of these changes, a compensation tax rate was introduced on the then post June 1983 taxed component, which is now part of the taxable component of a superannuation interest. It was a statement by Treasurer Paul Keating at the time that the Labour Government wouldn’t introduce a ‘death tax’ and as a result this mechanism provided a means to compensate the introduction of contributions tax in respect of death… and from this statement, the anti-detriment deduction was born!! It was supposed to provide for a refund of tax paid by a fund since 1988.
How does it work?
As mentioned above, section 295-485 provides a tax deduction for an increased amount paid as a death benefit. The SMSF can deduct an amount if it:
- pays a lump sum to the estate or to a spouse or child of the deceased at the time of death or payment; and
- increases the lump sum amount, or does not reduce the lump sum by an amount (being the tax saving) so that the amount of the lump sum is the amount that the fund could have paid if there was no contributions tax.
There are a few ways in which an SMSF can fund this additional anti-detriment amount. The most common approach is through the creation of reserves within the SMSF. Reserves will typically be built up from investment earnings over time to allow for the additional payment to be made in the event of a member’s death. Alternatively, insurance may be used to fund this additional payment, contributions by other members (subject to certain requirements) or tax provisions within the Fund.
Note: The ATO has recently formed a view on anti-detriment payment amounts from fund reserves and their treatment against the concessional contribution cap. Refer to the NTLG Superannuation Technical Sub Group minutes from their 16 June 2009 meeting for further details.
Why use anti-detriment?
The anti-detriment rules have broad application across all super funds, however as stated earlier, no all funds apply it and the benefits in a larger fund don’t benefit the deceased’s family members.
One of the significant benefits of using this strategy is for future CGT on sale of assets when benefits need to be paid to non-dependent beneficiaries. ATO ID 2004/688 outlines that where a pension recipient dies and there are no longer any beneficiaries that can receive an income stream, the tax exempt status of a fund ceases. Therefore, CGT at 10% (1/3rd discount applies where asset held > 12 months) will apply. The use of the anti-detriment tax deduction could effectively wipe out any potential CGT issues.
Another consideration to run an anti-detriment reserve is for clients who may have an inability to run recontribution strategies with their existing benefits. This may be due to age of the member or an inability to recontribute due to the type of fund assets (e.g. property).
When we talk about intergenerational SMSFs, the ability for the fund to leave behind a ‘legacy’ for future fund members sets an SMSF apart from other funds. The calculation can provide the next generation with an SMSF with significant tax losses that effectively means that future taxable contributions and fund earnings (inc. CGT) will not be subject to tax!!
How to calculate?
To determine the amount of an anti-detriment payment, there are three methods that can be applied to calculate the tax saving. These include:
- The audit method – you will need to have actual tax records of all contributions tax actually deducted
- EM Method – this is a calculation outlined in the ‘explanatory memorandum’ to section 295-485
- ATO ID 2007/219 method – an alternative method accepted by the ATO to calculate the amount
I won’t bore you with the formula details for the methods above, let’s simply have a look at the benefits in a couple of case studies… the first example will look at how the tax deduction applies, and the second example will demonstrate the power of the anti-detriment amount when CGT applies to assets on payments made to an estate or non-dependent adult children.
Jim (51) passed away on 1 September 2008 (D.O.B – 01/12/1957). He commenced work on 1 October 1977. He had benefits inside his SMSF of $800,000. It was decided that a lump sum amount is to be paid to his spouse.
Using the EM method, the anti-detriment tax saving equals $69,793, which provides the SMSF with a tax deduction of $465,287. The ATO ID method provides a higher tax saving amount of $109,293, which provides a tax deduction of $728,621. The tax deduction can be used to offset contributions, earnings or CGT within the fund both in the year of payment an future financial years (no timeframe).
Don is 75 years of age (D.O.B 01/08/1933) and has retired from employment at age 65. His wife has passed away and he now has his adult children as the sole beneficiaries of his estate which includes a direction through a death benefit nomination form to transfer his super in-specie to the estate when he dies (he has $2m of property in fund, with a cost base of $750k). His fund is made up entirely of taxable component.
In the event of Don passing away, the fund needs to deal with the capital gain of $1.25m on the property. As there are no further dependants, the pension benefit would convert back to accumulation phase and be subject to tax at 10%. This would mean a $125,000 CGT bill for the fund!! but where does the cash come from??
If an anti-detriment reserve was created over time whereby $279,221 of Don’s $2 million sat in a reserve (member benefit would then have been $1,720,778), this additional payment would have provided a tax deduction of $1,861,474 and completely wiped out the capital gain (and then left a further $600k of tax benefits from his kids within the fund).
Note: Using Reserves to fund an anti-detriment amount will have its earning subject to tax at 15%.
Does it all sound too good to be true? What are the problems or issues?
Well, to be honest there’s not a lot of downside… from an adviser perspective, there is a need to understand the different methods of determining the amount, the need to operate and manage reserves within the SMSF (including separate investment strategy), and the need to consider how benefits will be paid out of the fund.
Will the ATO scrutinise these transactions? more than likely ‘yes’, however their role is to ensure that the law applies as it should. With appropriate documentation evidencing the payment of the anti-detriment amount, there should be no issues with the ATO wanting a closer look.
The use of the anti-detriment within SMSFs is a fantastic strategy that all strategic advisers in SMSFs need to understand. For SMSF trustees, it is important that they have an understanding and appreciation of the merits of running reserves for the potential long term benefits that they will provide their children.