The impact of the Government's superannuation changes on SMSFs

Assuming the Government's proposed changes to superannuation become law, they are likely to have a significant impact on certain super fund members. DBA Lawyers' Daniel Butler and Tina Conitsiotis examine what the fallout from the changes will be. 

On 5 April 2013 the Labor Government announced a number changes to superannuation. The main change is the proposed new tax on pension earnings that exceed $100,000 per member per financial year.

Assuming the proposed changes ever become law (and this also assumes the Labor Government is re-elected in September 2013 with the requisite majority), the changes are likely to have a significant impact on certain super fund members.

This article discusses the practical implications of these proposals, with a focus on SMSFs.

How does it work?

Under the proposed changes, earnings on assets supporting pensions that exceed $100,000 per member per financial year will be taxed at 15 per cent.

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Earnings below this threshold will remain tax free. This change is anticipated to have effect from 1 July 2014. Importantly, the $100,000 threshold is proposed to:

• apply in respect of each member (and not the fund as a whole);
• be an annual limit reflective of taxable income as determined under existing tax rules; and
• be indexed to CPI in $10,000 increments.

Example A

Consider Mum and Dad, who each have $2,000,000 in their SMSF (ie, $4,000,000 in total split 50/50). Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode'. What are the implications if the SMSF generates a 5 per cent return and a 10 per cent return?

• Tax payable if the SMSF generates a 5 per cent return
  • $200,000 of total pension earnings have been generated in the fund (ie, $4,000,000 x 5% = $200,000).
  • Remembering that the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore — under the proposed new laws — the SMSF tax liability is nil.
• Tax payable if the SMSF generates a 10 per cent return
  • $400,000 of total pension earnings have been generated in the fund (ie, $4,000,000 x 10% = $400,000).
  • There is a 15 per cent tax on earnings exceeding $100,000 for each member.
  • Therefore — under the proposed new laws — the SMSF tax liability is $30,000 (ie, (($200,000 - $100,000) x 15%) x 2).

Example B

Now consider the same facts as above, but Dad has $3,000,000 and Mum has $1,000,000 in their SMSF (ie, $4,000,000 in total split 75/25).

Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode'. What are the implications if the SMSF generates a 5 per cent return and a 10 per cent return?

• Tax payable if the SMSF generates a 5 per cent return
  • Of the $200,000 of total pension earnings, $150,000 relates to Dad and $50,000 to Mum.
  • Thus, (($150,000 - $100,000) x 15%) = $7,500 is the SMSF tax liability in respect of Dad. As Mum is well under the threshold no tax is paid in respect of her.
• Tax payable if the SMSF generates a 10 per cent return
  • Of the $400,000 of total pension earnings $300,000 relates to Dad and $100,000 to Mum.
  • Thus, (($300,000 - $100,000) x 15%) = $30,000 is the SMSF tax liability in respect of Dad. As Mum is still under the threshold no tax is paid in respect of her.

The above examples highlight the different outcomes that may result depending on numerous factors such as the total amount in the fund, the rate of return on investments and the split between members in the fund.

Note that, under intense media pressure, the Prime Minister, Julia Gillard, made a commitment to the electorate well prior to the 5 April 2013 announcement that there would be no extra tax payable on members aged 60 or older.

Interestingly, the proposal is to levy the new pension tax on the super fund trustees.

Practical implications

Arbitrage opportunities

The new pension tax might create arbitrage opportunities whereby investing outside of the super environment may prove more tax efficient for certain members.

This is especially so, as over recent years, the concession in super have attracted many people contributing most of their investable assets previously held outside of super into the super environment to take advantage of the pension exemption (both within and outside the super fund) when someone attains 60 years and draws a pension.

Example C

Consider retirees, Mum and Dad who have a joint total of $5,000,000 in their SMSF. Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode'. We will assume that Mum and Dad have an equal balance (ie, the fund is split 50/50 between them).

Mum and Dad transfer $1,000,000 into a family trust (‘FT'). Both the SMSF and the FT generate a return of 5 per cent. The associated taxation implications are as follows:

• Tax payable on the income generated from the FT
  • The FT generates earnings of $50,000 (ie, $1,000,000 x 5%). Assume this income is split equally between Mum and Dad.
  • The tax-free threshold is $18,200 for FY2013. However, no tax is payable on the taxable income of up to $20,542 for FY2013, instead of the usual tax-free $18,200 threshold due to the low income tax offset (‘LITO'), which applies for taxpayers earning $37,000 or less. Assume the LITO applies in respect of both Mum and Dad.
  • Thus, assuming Mum and Dad derive no other taxable income for FY2013, they will each pay tax of $847 or $1,694 combined.
  • (The above ignores the Seniors and Pensions Tax Offset that can result in an eligible single person on $32,279 of rebate income without paying tax, or each partner of a couple on $28,794. We have also ignored the Medicare levy.)
• Tax payable at the SMSF level
  • The SMSF generates earnings of $200,000 (ie, $4,000,000 x 5%). Assume these earnings are allocated equally between Mum and Dad.
  • Remembering that the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore — under the proposed new laws — the SMSF tax liability is: nil.
• Total tax payable: $1,694

Now consider the implications if Mum and Dad did not transfer the $1,000,000 into their FT.

• Tax payable at the SMSF level
  • The SMSF generates earnings of $250,000 (ie, $5,000,000 x 5%). Assume these earnings are allocated equally between Mum and Dad.
  • There is a 15 per cent tax on earnings exceeding $100,000 for each member.
  • Therefore — under the proposed new laws — the SMSF tax liability is $7,500 (ie, (($125,000 - $100,000) x 15%) x 2).
• Total tax payable: $7,500
• Thus, $5,806 is saved by investing $1,000,000 via the FT.

As you can see from the above example, people will be tempted to move assets outside of super to minimise their tax.

This arbitrage opportunity is likely to see a significant shift of assets away from super, thereby undermining the amount that will be raised from this new tax.

Accumulation phase — more attractive?

In light of the proposed pension tax, the natural inclination for some might be to move away from pensions.

The reason for this being that once pension earnings reach the $100,000 threshold, the tax treatment of a member holding an accumulation versus a pension interest inside super will broadly be the same.

That is, both will be taxed at a maximum 15 per cent at the fund level (with a 10 per cent rate applicable to capital gains on assets held for more than 12 months).

However, there can still be significant advantages to maintaining a pension.

Growth generated by a fund in pension phase will accrue in proportion to the tax-free and taxable components of the member's interest, as at the date of the pension's commencement.

This is contrary to an interest in accumulation, where all growth will from part of the taxable component.

Accordingly, one way to maximise the tax-free component of an interest is to keep it in pension phase. This might be a worthwhile strategy, despite the proposed new pension tax.

Example D

Consider a member aged 62 with $4,000,000 in his SMSF. The member is receiving a pension and the SMSF is fully in ‘pension mode'. Half of the interest is comprised of the tax-free component and the other half is comprised of the taxable component. The SMSF generates a return of 5 per cent.

What are the implications if the member remains fully in pension mode? What if the member commuted half his interest into accumulation?

• Implications if 100 per cent pension mode
  • The SMSF generates earnings of $200,000 (ie, $4,000,000 x 5%).
  • Growth will accrue in proportion to the current tax free and taxable components of the pension (ie, 50:50). Therefore, the tax free component of the member will be $2,100,000 (ie, ).
  • Under the proposed laws, tax will be payable on earnings exceeding $100,000. Therefore, tax of $15,000 is payable at the SMSF level (ie, ($200,000 — $100,000) x 15%).
  • A pension payment of $126,000 is made to the member (ie, ($4,000,000 + $200,000) x 3%). As the member has attained age 60, the tax payable in his hands is nil.
  • The total tax liability is therefore $15,000 (all at the SMSF level).
• Implications if 50 per cent pension mode and 50 per cent accumulation mode
  • The SMSF generates earnings of $200,000 (ie, $4,000,000 x 5%). Assume these earnings are split equally between the pension and accumulation interests.
  • Growth in respect of the accumulation interest will form part of the taxable component. Therefore, the tax-free component of the member's accumulation interest remains at $1,000,000. However, the taxable component increases to $1,100,000. Therefore, the tax-free component of the member's interest has been diluted to 47 per cent.
  • Growth in respect of the pension interest will accrue in proportion to the current tax-free and taxable components of the pension (ie, 50:50). Therefore, the taxable component of the pension will be $1,050,000 and the tax-free component will be $1,050,000.
  • Under the proposed laws, tax will be payable on pension earnings exceeding $100,000. Therefore, tax payable at the SMSF level is nil (ie, ($100,000 — $100,000) x 15%).
  • A pension payment of $33,000 is made to the member (ie, ($2,000,000 + $100,000) x 3%). As the member is over 60 years old, the tax payable in his hands is nil.
  • Tax of $15,000 is however payable in respect of the $100,000 earnings derived in accumulation mode.
  • The total tax liability is therefore remains at $15,000 (the same as 100 per cent pension — see above).

On its face, the second scenario appears to be the more tax efficient. However this is not necessarily the case after taking into consideration the potential value of the tax-free component as discussed below.

In the above example, the member has attained age 60 and therefore receives all benefits tax free. This is regardless of whether his interest is comprised of the tax-free or taxable components.

However, upon his death, his superannuation interest may be payable to, for example, an adult independent child.

In this case, it will be significantly more tax effective for his child to receive benefits that are comprised of the tax-free component.

This is because an adult independent child will generally pay tax at 15 per cent on the taxable component of a lump sum superannuation death benefit.

Before a pension interest is commuted, consideration should therefore be given to the tax implications of doing so at both the fund and recipient level.

This includes a consideration of the consequences of potentially eroding the tax-free component.

As highlighted in the example above, the tax-free component works better in pension mode when asset values are rising.

Who is impacted?

The proposed new pension tax may impact many who hold considerably less than $2,000,000 of pension assets.

The Labor Government estimated that it will only impact 16,000 members who have assets that exceed $2 million.

However, $100,000 in pension earnings can readily be derived from a $300,000 investment in a rental property that doubles in value over a 10 year period.

In this case, the net rental yield on such a rental property is typically very low, eg, 3 per cent or thereabouts, and many only hold on to such properties for their long-term potential capital gain.

So when, say, an SMSF disposes with such a property and generates a $300,000 capital gain, after allowing for the 1/3rd CGT discount to a super fund, the discounted $200,000 gain less $100,000 threshold now leaves $100,000 x 15% resulting in $15,000 tax payable.

As discussed, after a low net rental income, the pensioner is now hit with a $15,000 new pension tax, which gives no averaging for the 10 years over which such gain accrued.

If the capital gain was notionally reflected in each financial year, then no extra tax would be payable.

Thus, the proposal is likely catch many more, many who have a modest level of assets —many more than the 16,000 estimate.

Deductibility of expenses

The trustee of a superannuation fund can broadly deduct expenses to the extent that they are incurred in gaining or producing assessable income.

As the law currently stands, income generated from assets used to support a pension will constitute exempt income and therefore any associated expenses are generally not deductible to the extent that exempt income is derived as a proportion of total (assessable and exempt income).

The proposed new pension tax will alter the above position.

Under the proposed rules, pension income that exceeds $100,000 per member per financial year will be assessable income in the hands of the fund.

It follows that any expenses incurred in producing income that exceeds the $100,000 threshold will be deductible.

The new $100,000 pension tax will therefore add another layer of complexity to the deductibility of expenses. At this stage it is not certain as to how the deductibility of such expenses will be apportioned.

CGT implications

There has been some speculation within the industry regarding the impact of the proposed changes on the ability of a fund to carry forward capital losses.

Will such losses be available to offset capital gains made while the fund is in pension mode?

Based on the way the current law is operates, it is likely that the proposed new pension tax will not adversely impact on the ability of a fund to carry forward existing capital losses, provided the fund is using the unsegregated pension asset method.

If a fund merely holds segregated pension assets, then its capital losses are lost forever; similarly any capital gains realised on segregated pension assets are disregarded.

It is important to remember that if a fund is wholly in pension mode, then the ATO considers the fund to have adopted a segregated asset method.

This will result in a loss of any carry-forward capital losses. Thus, for capital losses to continue to be carried forward some accumulation balance is required.

Increase costs and complexity

The proposed new pension tax is likely to add substantial complexity and costs to the superannuation industry, especially those funds that have members who are likely to be covered by the new regime.

Flowing from this, if the new pension tax is ever implemented, it is likely that trustees will need to implement costly and complex new processes and develop new computer systems, programs and paperwork to cater for the new tax.

This is unfortunate as many large funds, eg, industry super funds, may have to incur substantial costs for a few, if any, members, who may be hit by the new tax.

Unfortunately, the cost of putting these processes in place is likely to flow through to all fund members and give rise to a significant increase in costs.

Perhaps the simpler option would have been to tax the relevant member in their personal tax return, as opposed to at the fund level.

However, this may mean the Prime Minister may have to back down from a promise! Needless to say that if the Government is re-elected and can get the new pension tax passed as law, the super industry is likely to want to lobby Government to come to its senses and implement a more streamlined and efficient system.

Allocation of income

Naturally, the most tax-effective position for clients following the proposed changes will be to hold a pension interest with earnings below $100,000.

To fit within these circumstances, advisers may be inclined to more carefully assess how earnings within a fund are allocated and they may also see merit in implementing reserving strategies to smooth out fluctuations in earnings to members.

Typically earnings are allocated in a manner that is fair and reasonable as between all of the members of the fund (assuming there are no separate investment strategies for each member).

Broadly, ‘fair and reasonable' generally means in proportion to member balances. In some circumstances, however, trustees may be able to distribute in a more flexible manner if their governing rules allow.

One situation where this may be worth considering is when another member is below their $100,000 threshold and can obtain a greater allocation of earnings.

Grandfathering

Under the proposed changes, grandfathering rules will apply to capital gains tax (‘CGT') assets acquired before 1 July 2014. A summary of these rules is as follows:

• for assets that were purchased before 5 April 2013, the reform will only apply to capital gains that accrue after 1 July 2024;
• for assets that are purchased between the period of 5 April 2013 to 30 June 2014, individuals will have the choice of applying the reform to the entire capital gain or only that part of the gain that accrues after 1 July 2014; and
• for assets that are purchased from 1 July 2014, the reform will apply to the entire capital gain.

If the new pension tax becomes law, this grandfathering gives rise to further issues. There are some funds that regularly turn over assets while in pension mode to step up the cost base of assets for CGT purposes.

However, this will not be as popular with funds holding pre-5 April 2013 assets, given they have a ‘privileged' CGT status until mid-2024 when future gains will then come under the CGT regime.

The question then to ask is what method will future capital gains be tracked on pre-5 April 2013 assets?

Will funds require an independent qualified valuer's opinion to ‘lock in' the cost base of those assets to calculate any future capital gain accrued after mid-2024 when the asset is finally disposed of, or will any gain be deemed to accrue over the ownership of the asset based on the pre- and -post mid-2024 holding periods, in a similar manner to how a capital gain is tracked on a main residence that is used for income production?

As you can see, there is additional tracking of asset value and systems required to prepare funds for the new tax.

Multiple funds

There are many members who have more than one super fund.

Where a member is caught by the new pension tax and has multiple funds, an interesting question is which fund pays the tax?

Can the member choose, or do you have to pro-rate the tax, based on how the proportion of each fund balance equates to a proportion of the whole.

As discussed above, substantial extra costs and processes will be associated with the proposed new pension tax.

Conclusions

The proposed new pension tax is likely to significantly impact super fund members if this proposal ever finalised as law.

Members who realise capital gains may be caught in this tax net as well as those producing more than the $100,000 threshold.

New planning opportunities will emerge and the new tax is likely to result in several new trends, such as more assets being withdrawn from super and a move away from pension to accumulation mode.

However, it will take some time to determine how solid these trends will become if the new law is passed.

In addition, other planning measures are likely to develop which are designed to minimise the impact of this new tax.

By Daniel Butler, director, and Tina Conitsiotis, lawyer, DBA Lawyers.