In the second tranche of the super reforms, the Government announced as part of its integrity measures for self-managed super funds to explicitly prohibit the use of asset segregation as a method for determining a fund’s tax exemption for an income year where the member was in receipt of an income stream and just before the start of the income year and has a total superannuation balance that is in excess of $1.6 million.
This measure will introduce a new section 295-387 into the ITAA 1997 which outlines that such assets will be known as disregarded small fund assets at all time in an income year if the fund is covered by subsection (2) for the income year.
Subsection (2) will specifically state that a complying super fund will be covered for an income year if:
- the fund is a SMSF or Small APRA Fund (SAF) at any time during the income year;
- at any time during the year there is at least one interest in the fund in the retirement phase; and
- just before the start of the income year:
- a person has a total superannuation balance that exceeds $1.6m;
- the person is a retirement phase recipient of a superannuation income stream; and
- at any time of the year that person has a superannuation interest in the fund.
Importantly, it is noted within the explanatory memorandum that it will not be necessary for a person with an interest in the small fund to be receiving an income stream from that fund.
Tax vs. SIS decisions
The rationale for the Government to introduce this concept of disregarded small fund assets was due to concerns that SMSFs will look to ‘cycle’ assets between accumulation and retirement phase interests in order to reduce the impact of tax on income and capital gains. It is important to note that whilst the fund may not be eligible to apply for tax exemption under s.295-385 of the ITAA 1997, it will still be eligible to operate separate investment strategies for a specific member or class of members. This is because the covenants within section 52B of the SISA specifically provide for an SMSF to have an investment strategy where:
- the directions relate to the strategy to be followed by the trustee in relation to the investment of a particular asset or assets of the fund; and
- the direction are given in circumstances prescribed by regulations
This is an important distinction to understand, because whilst the fund is eligible to set aside specific assets to a member and/or their superannuation interests, where the assets are disregarded small fund assets they will be required to take a proportionate approach for tax purposes as to the income generated for the financial year by assets supporting the payment of income streams. Given the ongoing benefits in this instance of the proportioning rule for amounts moving into retirement phase, the decisions around segregation for SIS purposes in my view remains an important one.
100% pension phase actuarial certificates now required?
Upon my initial reading of this legislation and the explanatory memorandum, it appears that these new laws will have broader application that how segregation currently applies. With subsection 295-387 of the ITAA 1997 prohibiting the use of the segregation method for pension members with balances greater than $1.6m, it is the current view of the Australian Taxation Office (ATO) that segregation (subsection 295-385 of ITAA 1997) applies to arrangements where 100% of the fund is supporting the payment of income streams – even where the assets are ‘pooled’ between members (e.g. Mum & Dad).
I have included an extract of this information from the ATO website below:
Where all SMSF fund members are receiving a pension and the combined account balances of these pensions is equal to the market value of the fund’s total assets, in effect all assets of the fund will meet the requirement of being ‘segregated’ as they have the sole purpose of paying super income stream benefits. In this situation the ATO will accept that the SMSF is not required to identify individual assets as being dedicated to funding a super income stream benefit.
What this new subsection tends to suggest is that fund’s that are 100% in retirement phase that have a member with a super balance in excess of $1.6m, will no longer be eligible to receive tax exemption under s.295-385 of the ITAA 1997 – the segregated method. Therefore, that fund will be required to use the proportional method and obtain an actuarial tax certificate to be provided with a 100% tax exemption for the income year. This is because the fund the assets of the fund will be covered by subsection 295-387 of the ITAA 1997 as disregarded small fund assets.
Let’s take a look an example to further understand
Gavin and Sally are trustees and members of a SMSF. Both members have retired and currently drawing Account Based Pensions. Gavin’s balance is $1.5m and Sally $600k. The entire balance of the SMSF is supporting the payment of income streams, so regardless of whether the assets of the fund are pooled for Gavin and Sally, the Commissioner determines that the fund has segregated current pension assets and therefore can apply tax exemption under s.295-385 of the ITAA 1997 (i.e. no actuarial certificate is required as all fund income and expenses are disregarded).
As at 30 June 2018, Gavin’s total superannuation balance (pension) has grown to $1.65m. As a result the fund will now have disregarded small fund assets and no longer be eligible to claim tax exemption under the segregated method. Therefore, the trustees will need to apply for an actuarial tax certificate under s.295-390 of the ITAA 1997 and have an actuary determine that the fund has 100% tax exemption.
It seems somewhat bizarre that trustees may find themselves in this position, but it is clear that Treasury weren’t too happy with the ideas being put forward within the SMSF industry to counteract the $1.6m transfer balance cap. We will watch with interest how this proposed legislation will progress as it enters Parliament in the next few weeks in readiness for a 1 July 2017 start date.