Tips and traps of the transitional cap

For investors, advisers and super funds alike, the changes introduced into Parliament in December 2006 represented the biggest, and possibly the most positive shift in saving for retirement since the introduction of compulsory Superannuation Guarantee contributions.

The Tax Laws Amendment (Simplified Superannuation) Bill 2006 implements the Government’s 2006 Federal Budget proposals, as revised in Treasury’s “Outcomes of Consultation” paper released in September 2006.

Key changes in new legislation

- Removal of tax on superannuation lump sum withdrawals and income payments for those aged 60 and over. The emphasis of super regulation is shifting from the end benefits stage to the contributions stage.

- Introduction of annual contribution limits or caps and tax penalties on contributions made in excess of these new limits. Where once there was one end figure (the Reasonable Benefit Limit) to consider, investors will now need more than ever to manage and plan their annual contributions.

- A $1 million transitional contribution cap on undeducted contributions made between May 10, 2006, and June 30, 2007.

Most of the measures will apply from July 1, 2007. However, the annual contribution caps and $1 million transitional contribution cap could have an immediate impact on the contributions strategies your clients put in place during the current year.

What is the transitional contribution cap?

Prior to May 10, 2006, there was no limit on the level of undeducted contributions a person could make to superannuation.

Since the new standard contribution caps ($50,000 deductible and $150,000 undeducted) do not commence until July 1, 2007, a measure was necessary to protect the integrity of the system in the interim period. For this reason, a $1 million contribution cap applies from May 10, 2006, until June 30, 2007, to all undeducted contributions.

The legislation refers to undeducted contributions as ‘non-concessional’ contributions. This is how we will refer to them from here on.

Tax consequences of breaching the transitional cap

Contributions that are made in excess of the non-concessional transitional cap will be taxed at the highest marginal tax rate (46.5 per cent) — a significant disincentive for contributions already subject to tax at marginal rates. Funds will report the amount of non-concessional contributions they receive to the Australian Taxation Office (ATO). The ATO will then make an assessment on the information provided and present the individual with a tax liability.

However, recognising that the full details of the excess contribution penalties were not released until the legislation was introduced in December, the Government has provided an option for those who may have breached the cap unintentionally.

Releasing excess non-concessional contributions made before December 7, 2006

Instead of incurring excess contributions tax, excess non-concessional contributions can be released without penalty by applying to the ATO for a transitional release authority (TRA). Critically, this only applies to excess contributions made on or after May 10, 2006, and before December 7, 2006.

The process for implementing a transitional release is as follows.

- Client applies for a TRA by June 30, 2007. While the details of the application process are not yet complete, eligible clients can now register their interest by phoning the ATO on 1800 012 238. In public statements, the ATO has mentioned it will not begin issuing release authorities until after the legislation has received Royal Assent.

- The ATO assesses the client’s application and issues a TRA specifying the amount of contributions able to be released. Where a client withdraws more than is authorised under a TRA, this amount will be included in their assessable income for the year.

- The client must present a TRA to a superannuation provider within 21 days of the date of the authority. Penalties apply if this is not done.

- Super funds are required to pay the requested amount within 30 days of receiving the TRA from the member.

- Amounts withdrawn from super in accordance with the TRA will reduce the client’s non-concessional contributions for the year (May 10, 2006-June 30, 2007). If a TRA is not actioned, the contributions will continue to be included in the calculation of the client’s non-concessional contributions for the year.

Relief for excess non-concessional contributions made from December 7, 2006 — June 30, 2007

For excess non-concessional contributions made from December 7, 2006, to June 30, 2007, a less generous process applies than for contributions made prior to this date. This process by no means assures clients they will escape an excess contributions tax liability. Clients need to carefully plan any large contributions they make between December 7, 2006, and June 30, 2007.

What is the process?

Clients who have made excess non-concessional contributions between December 7, 2006, and June 30, 2007, may apply to the ATO for a written determination that all or part of their contributions be either disregarded or allocated to another financial year. While the exact form of the application has not yet been finalised, the application must generally be made within 60 days of receiving an excess contributions tax assessment (not expected until funds have reported contribution information).

This discretion may also be used for excess contributions made in future financial years.

Such ATO determinations will not be made without serious consideration and will take into account:

- whether ‘special circumstances’ apply to make it unjust, unreasonable or inappropriate to impose the excess contributions tax liability;

- whether the contributions would be allocated more appropriately in another financial year; and

- whether it was reasonably foreseeable that a particular contribution would have been an excess contribution when it was made.

In contrast, where a client argues an excess non-concessional contribution should be reallocated to a previous year in which an unused contribution cap entitlement exists, the ATO will not exercise discretion to reallocate the contribution.

Example one: ATO may reallocate excess contributions

A client aged 40 has an annual salary sacrifice agreement with their employer for $100,000. The employer mistakenly makes the contribution for one financial year on July 1 of the next year, resulting in two annual contributions in the same year.

Example two: ATO may consider it not reasonably foreseeable that contribution would be in excess

A client authorises an overseas superannuation transfer, but exchange rate movements before the transfer mean the client exceeds the relevant contribution cap.

Example 3: ATO will not exercise discretion — past years’ unused entitlements cannot be brought forward

A client aged 63 makes a $750,000 non-concessional contribution in the 2009-10 financial year. After receiving an excess non-concessional contributions assessment, the client applies to the ATO to re-allocate the excess $300,000 ($450,000 would qualify under the averaging provisions) to earlier financial years.

Tips and traps for investors wishing to take advantage of $1 million transitional cap

Tip one: sale of property

A popular strategy that has emerged since May 10, 2006, is to invest the proceeds of the sale of a residential or investment property into super. The aim is to use the $1 million transitional cap to convert taxable income in retirement to tax free income.

Tip two: borrowing against investment assets

In a similar vein, borrowing against existing investment assets and using the proceeds to make a super contribution can be an effective alternative. This will particularly be the case if taxes and costs associated with the sale of such an asset are prohibitive.

Tip three: small business clients may contribute $2 million

A tip for clients who qualify for the small business Capital Gains Tax (CGT) concessions may be to consider delaying the sale of small business assets until after June 30, 2007. This will provide those clients with the opportunity to take advantage of the $1 million non-concessional cap this financial year and still have the ability to use the $1 million lifetime CGT cap in the next financial year. Essentially, this gives these clients a chance to contribute $2 million over two financial years.

Tip four: clients turning 65 or 75

The age of a client is important in implementing a $1 million contribution strategy, as those aged 65 and over who do not meet the work test and those aged 75 and over generally cannot contribute to superannuation. However, further transitional measures provide some relief for those turning 65 or 75 and may allow them to make large contributions before July 1, 2007.

- Clients aged 64 between May 10, 2006, and September 5, 2006, will be able to contribute up to June 30, 2007, without having to meet the work test even if they turn 65.

- Clients aged 74 between May 10, 2006, and September 5, 2006, will be able to contribute up to June 30, 2007, even if they turn 75, provided they meet the work test.

The work test in this context is being gainfully employed for at least 40 hours in no more than 30 consecutive days.

Tip five: defined benefit members

Some defined benefit members may ensure a higher final multiple of salary if voluntary after-tax contributions are made to a defined benefit scheme.

For these members, it may be worth incurring the excess contributions tax to ensure the higher retirement benefit. Whether this is appropriate will depend on the client’s particular circumstances.

For most clients, a $1 million transitional contribution strategy represents a one-off contribution made in addition to other contributions they would ordinarily make during the year or made on their behalf as part of their employment arrangements. A critical factor in implementing this strategy is to also take account of these other contributions to ensure the $1 million cap is not inadvertently breached.

It’s worth remembering that it is only excess non-concessional contributions made before December 7, 2006, that can be released under a TRA.

Trap one: employer contributions in excess of age-based deduction limits

Clients need to be careful of the level of any Superannuation Guarantee, salary sacrifice or other employer contributions made during the year (in addition to their $1 million non-concessional contribution).

Employers are still subject to age-based deduction limits (ABDL) in 2006-07. Employers can generally exceed the age-based limits if they wish to provide extra superannuation support for an employee, although no deduction will be available. Where they do, however, these extra employer contributions will count towards the employee’s $1 million non-concessional cap for 2006-07. And so it follows that where $1 million has already been contributed, an excess contributions tax liability will arise.

Trap two: regular after-tax contributions arrangements

Clients who have already made a $1 million contribution should also be aware that future after-tax contributions would also count towards the cap. This means existing after-tax contribution arrangements need to be considered. The decision to cease these arrangements will come down to the particular circumstances. For example, for contributions made as part of an arrangement prior to December 7, they can be reversed by a TRA.

Trap three: deductible personal contributions

Like ABDLs for employer contributions, the existing rules for self-employed persons will continue to exist. While deductible contributions are not subject to the transitional cap for 2006-07, only 75 per cent of any contribution over $5,000 is deductible. The extra 25 per cent uplift is non-deductible and treated as an undeducted or non-concessional contribution in the fund.

For example, in order to claim the full deduction of $105,113 in 2006-07, a 55-year-old is required to make a contribution of at least $138,484. Therefore, if a client has already made such a contribution but intends to take advantage of the full $1 million limit, they would be wise to consider reducing the subsequent non-concessional contribution equal to the amount of the gross up.

So, in the example above, the client should contribute $966,629 instead of the full $1 million so as not to exceed the cap.

Harvey Russell is a technical services manager at Colonial First State.