ATO turns up the heat on fund reserves

In a recent superannuation surcharge ruling, the commissioner of taxation opened a Pandora’s box when he talked of using reserves in a self managed superannuation fund (SMSF).

In a recent superannuation surcharge ruling, the commissioner of taxation opened a Pandora’s box when he talked of using reserves in a self managed superannuation fund (SMSF). In general, SMSF strategies have never considered the use of reserves. However looking at the commissioner’s ruling (SCR 1999/1), it appears that the use of reserves enables advisers to:

? manage their clients RBLs;

? smooth investment returns;

? potentially defer the super surcharge;

? make the concept of an inter-generational fund a reality

What is a reserve?

Section 115 of the Superannuation Industry Supervision Act (SIS Act) enables the trustee of a super fund to maintain reserves in an accumulation fund provided the trust deed of the fund allows the creation of a reserve. In SCR 1999/1, the commissioner states that a reserve is: “where the net market value of the assets of the fund exceeds the total of member’s account balances.”

Importantly, reserves are sourced from different areas of a superannuation fund. For example the Commissioner noted that reserves may be sourced from undistributed investment earnings; unallocated employer contributions; and forgone or forfeited benefits.

However, we would also add the following to the list:

? the release of pension reserves from a fund for the benefit of accumulation members;

? a transfer of reserves;

? the retention of insurance proceeds;

? benefits which may be forgone in the event of death or retirement where the member’s current benefits exceed their pre-determined limit.

Typically reserves have been used by employer funds, industry funds and life insurance companies to smooth investment returns. Although the smoothing of investment returns is almost an industry standard (except in SMSFs), we also have witnessed reserves used for the following purposes, all of which are legitimate and in some cases canvassed in SCR 1999/1:

? Advisory fees;

? Taxes in the fund;

? Life insurance premiums;

? Death and disability payments;

? Ensuring members are guaranteed a minimum benefit.

Trust deeds and reserves

The key to establishing a reserve is the trust deed. Section 115 of the SIS Act allows the trustee of an accumulation super fund to establish a reserve provided “the rules of the fund do not prohibit reserves.”

Surprisingly most trust deeds do not allow the trustee to create a reserve at all, or if a reserve can be created, it is limited to events of bankruptcy and where a member is mentally incapacitated. As a result, trustees that employ a deed with a limited reserving capacity are unable to use the reserving strategies laid down in SCR 1999/1.

More importantly if they attempted to implement a reserving strategy in contravention of their deed, they would be in breach of the sole purpose test thereby rendering the fund non-complying. Accordingly, we strongly suggest you take the time to review your trust deeds and determine what type of reserves may be established by the trustee.

At the very least the trust deed that you are using should have an ability for the trustee of the fund to create an investment reserve, contribution reserve, miscellaneous reserve, pensions reserve and any other reserve that is allowable under the superannuation, taxation and social security laws

Investment reserves

Under SCR 1999/1, an investment reserve is required to be set apart from other reserves in the fund and can only contain undistributed investment earnings. Undistributed investment earnings arise where the trustee sets a crediting rate for member accounts such that the net income of the fund is not distributed to all members. The use of the investment reserve can be for the purpose of smoothing of investment returns, paying expenses, taxes and the like or other purpose detailed above.

Importantly, the commissioner’s ruling notes that where an allocation is made from an investment reserve to the members who created that reserve, and the allocation is on a proportional basis, then no part of the allocation will be a surchargeable contribution. However where an amount is allocated, perhaps to one member over the other members that created the reserve, then that allocation will be a surchargeable contribution in the hands of the member. This does not mean that it will be subject to the surcharge for it is to be tested against the member’s surcharge threshold.

Grant Abbott is the founder and co-director of Grant Abbott Consultants.