New pension rules - a call to action

The Government’s tax reform agenda continues to make all of our lives difficult. Take the new capital gains tax (CGT) rules for example.

The Government’s tax reform agenda continues to make all of our lives difficult. Take the new capital gains tax (CGT) rules for example. The tax treatment for family trusts is different to unit trusts is different to collective investment vehicles is different to super funds is different to individuals is different to life insurance companies is different to…. It is virtually impossible for financial planners to keep up with the daily changes. In fact, many planners are probably spending more time discussing the taxation merits of a specific investment with a client than the real issue of investment criteria. For a government hell bent on making things simpler, can things really get more complex?

What’s more, the Treasurer has recently let it be known that his next target for simplification is going to be superannuation. If we are to take the recent pension taxation rules as a guide, then we are all in trouble.

The new pension rules, to commence on 1 July 2000, change the taxation status of super funds running pensions and are the most complex that we have ever seen.

More importantly the new pension rules aren’t limited to taxation. They may require trustees of a self managed super fund paying a pension to change the fund’s existing trust deed and accounting systems by 1 July 2000.

Current pension rules

The existing pension tax rules are very favourable for self managed super fund clients. In particular, where the trustee of a super fund earns income or capital gains on assets held to fund a member’s pension, there is no tax payable (pursuant to Section 282B of the Income Tax Assessment Act 1936).

Consider the following simple example: the Jones super fund.

John Jones set up a self managed super fund in June 1995 with super benefits rolled over from his employer super fund. John is now retired, aged 60 and is a widower. His current benefits in the Jones super fund amount to $367,050. John has been living off cash sitting in his fund over the past five years.

He has depleted all the cash reserves in the fund. The only assets of the fund are 15,000 National Australia Bank shares. The shares were acquired in June 1995 at $12.20. On 5 May 2000 these shares were worth $24.47.

Hearing of the new rules, John decided to commence a pension before the new rules start on 1 July 2000. Once the pension is commenced, any capital gain realised in respect of the disposal of the NAB shares is tax-free. In that regard, let’s say that John commenced the pension on 5 May. On 10 June, he sold 5,000 of the fund’s NAB shares for $25.50. The capital gain on the disposal of these shares is 5,000 shares x ($25.50 - $12.20) = $66,500. However, under the current rules, the trustee of the fund does not pay any tax on the disposal of the shares. Furthermore, any interest or dividend income the trustee earns in respect of the fund’s pension assets will be also tax-free.

Beating the new rules

One way of beating the new rules is to commence a pension before July 1. The proposed section 273K of the Income Tax Assessment Act provides that when assets are transferred to meet current pension liabilities, the new pension rules do not apply where the trustee of a super fund (including a self managed super fund):

? has a liability to pay a current pension to a member pre-1 July 2000, and

? the liability is to be met from the fund’s segregated current pension assets post 30 June 2000.

This is a significant concession for clients with an existing self managed super fund paying a pension. It is also a call to action for financial planners with existing client self managed super funds able to commence a pension pre 1 July 2000.

Let’s go back to the Jones super fund. As the fund commenced a pension on 5 May, the trustee is to be protected from the new rules. As a result, if the trustee of the fund sells 5,000 more NAB shares on 1 September 2000 for $27.00 the capital gain of 5,000 x ($27.00 - $12.20) = $74,000 is tax free.

The new rules

Under the new rules, the tax exemption disappears for pensions commenced in a fund after 30 June, 2000. When the trustee of the fund commences the pension, this will trigger a disposal for capital gains tax purposes.

However, the capital gain will not be brought to account to tax until the asset is actually disposed of by the trustee of the fund. Furthermore, the capital gain is to be determined as the lower of the capital gain at the time of the commencement of the pension or the time when the asset is disposed.

Turning back to the Jones super fund. Let’s say that John waited until 1 July 2000 to start his pension. At the time of commencing the pension, the fund’s NAB shares were trading at $25. On 1 September, 2000 the trustee sells 5,000 NAB shares for $27.

The capital gain realised by the trustee of the fund in respect of the disposal of the NAB shares is the lower of:

? CGT at commencement — [5,000 x ($25 - $12.20)] x 2/3 = $42,666

? CGT at disposal - [5,000 x ($27 - $12.20)] x 2/3 = $49,333

The end result is that the trustee registers a capital gain of $42,666 in respect of the disposal of the 5,000 NAB shares. Tax payable at the super fund rate of 15 pre cent on these shares is $6,399.90. As can be seen for clients with accumulation assets pregnant with capital gains, a delay in commencing a pension post 30 June 2000 could prove costly.

Proposed section 273D(2) of the Income Tax Assessment Act provides that where a pension begins to be paid out of a complying super fund on or after 1 July 2000, the trustee of the fund must transfer assets to the fund’s segregated current pension assets. For existing pension funds, section 273A(4) provides that the trustee of a super fund should segregate current pension assets by no later than 30 September 2000. This later segregation, however, will be deemed to have occurred for pension tax purposes on 1 July 2000.

With this segregation of pension assets idea in mind, financial planners must turn to their trust deeds to assess whether the deed can cope with the pressures of the new pension rules. At a bare minimum, the trust deed must contain clauses that allow the trustee of the fund to segregate current pension assets as well as establish and maintain pension and miscellaneous reserve accounts. From our review of more than 100 different self managed super funds over the past year, only a small fraction of these deeds have the capacity to cope with the new rules.

As a final point, due consideration must be given to the accounting and administration systems used by trustee clients. Many of these do not allow member pension accounts to be segregated nor for reserve accounts to be established and maintained. Without these basics, a manual override of the existing system may be necessary to cope with the new rules. This procedure can be time intensive, costly and dangerous from a compliance point of view. It goes without saying that financial planners with self managed super funds paying a current pension, need to assess the trust deeds, accounting and administration systems of their clients by no later than 30 June 2000 to determine if they are compliant with the new pension rules.

Grant Abbott is a director of the Strategist Group. The Strategist Group, in conjunction with Money Management, is holding a one day seminar on “Pensions and Tax Reform — A Financial Planner’s Perspective” in various capital cities around Australia in June 2000. For further details contact Kerry Johnstone on 02 9955 2955.