SMSFs and anti-detriment payments

MLC senior technical consultant Mike Mitchell outlines some of the challenges faced by SMSFs wishing to make anti-detriment payments.

An anti-detriment payment is an additional amount included in a lump sum death benefit paid to eligible beneficiaries.

The payment is broadly designed to restore the deceased's death benefit to what it would have been if a 'contributions tax' (of up to 15 per cent) had not be paid on the taxable contributions.

It essentially refunds the tax paid on super contributions made by (or on behalf of) the member during their period of fund membership. It may also, potentially, reimburse the earnings lost due to the tax payments.

In order to make the payment, the super fund must have sufficient cash or capital to pay the anti-detriment amount to the beneficiary.

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The amount is not directly refunded by the Australian Taxation Office (ATO).

Instead, the super fund is able to claim a tax deduction, which reduces the fund's assessable income and potentially provides a tax saving equivalent to the anti-detriment amount.

There is no legal requirement for super funds to make anti-detriment payments, and SMSFs are often not able to make these payments due to funding issues. 

Issues to consider

Key issues that SMSF trustees must consider include whether the fund will have sufficient money to pay the anti-detriment amount and whether it can fully utilise the tax deduction.

The trustees need liquidity in the fund to make the additional payment.

Having done this, the SMSF is entitled to a tax deduction to recoup the anti-detriment payment, which may need to be utilised over several years.

Funding the payment

Anti-detriment payments cannot be taken from other members' accounts. The superannuation fund must therefore have sufficient capital available to fund the increased death benefit.

Two approaches are using unallocated reserves and purchasing insurance cover.

Reserves

Reserves can be maintained in a fund unless the trust deed prohibits them and can only be populated with investment earnings.

Funds undertaking reserving are required to have a documented reserving strategy, which is consistent with the fund's investment strategy.

It may take time to accumulate sufficient funds in a reserve from investment earnings to enable the SMSF to make an anti-detriment payment. 

The ATO has expressed the view that an anti-detriment payment cannot be made directly from a reserve to a beneficiary.

The amount must be allocated to the member's account. Allocations from a reserve in excess of 5 per cent of the member's interest are counted against the concessional contribution cap.

In most cases, the 5 per cent threshold will be breached and may result in excess contributions tax.

This means it is difficult for most SMSFs to use a reserve as a means of paying an anti-detriment amount without other unfavourable consequences.

However, the benefits of creating a large tax deduction may outweigh the cost of any excess contributions tax payable.

Insurance

Another approach is for the trustee to hold an insurance policy over the life of the members, which is not linked to any members' account.

The trust deed must also provide the trustees with the discretion to use the proceeds to make an anti-detriment payment and not automatically direct the payment to a reserve, which creates the problems outlined above. 

Trustee discretion is required because, traditionally, if a life insurance policy is linked to a member, the proceeds are allocated to the deceased member's account when they are received by the fund and cannot be used to pay an anti-detriment amount.

However, the downside to providing the trustees with discretion is that the premiums for the insurance policy will not be deductible to the fund. 

Premiums are only deductible where a death benefit will be paid and the anti-detriment amount is strictly not part of the death benefit.

The loss of the tax deduction may be a concern to some trustees if they are given discretion to decide what to do with the insurance money.

Funding required

If the SMSF trustees would like to be able to fund anti-detriment payments, they will need to ensure the fund holds (or accumulates) a sufficient reserve or takes out an appropriate level of insurance cover.

However, if the formula method is used to calculate the anti-detriment payment, it is based on the taxable component which changes over time due to contributions, withdrawals and investment earnings.

This makes it difficult to determine the appropriate amount to hold in a reserve or the suitable level of cover to take out.

Also, the anti-detriment payment is an 'all or nothing' provision, as it's not possible to pay only a part of the anti-detriment amount the beneficiary is entitled to receive. 

Tax deduction

The tax deduction the fund claims is determined by dividing the anti-detriment payment by 15 per cent.

This can result in a significant amount and consideration must be given to whether the SMSF can utilise the deduction and how long it will take.

For example, a fund that makes an ant-detriment payment of $60,000 will be entitled to a tax deduction of $400,000.

In general terms, if the deduction exceeds the fund's assessable income, a tax loss arises which can be carried forward to offset against assessable income in future financial years.

Generally, anti-detriment payments are fully deductible in the year the amount is paid, even where the fund has derived exempt income due to a pension being paid up to the date of the member's death.

In future years, the carried-forward tax loss is reduced firstly by any exempt income (eg, income derived from assets supporting a pension).

This erodes the value of the deduction.

After this carried-forward tax loss is reduced by exempt income, any remaining loss can be offset against assessable income (ie, income from assets held in the accumulation phase).

This means that the SMSF may not get the full value of the tax deduction if any members are in pension phase.

This may be managed if those members are rolled into another superannuation fund and only accumulation phase members remain in the SMSF.

However, assets may need to be sold to facilitate the rollover, which may be difficult if the SMSF holds large, illiquid assets such as property.

SMSF members should discuss the taxation consequences with their tax advisers to understand the implications for their fund prior to implementing the strategy.

Also, while emphasis is often put on the significant tax deduction that may be claimed, the ability for the fund to use the deduction must be considered.

Regulator's view

At this time there is no clear guidance from the ATO (the regulator of SMSFs) on these strategies.

One possible argument is that holding insurance which is not linked to a specific member's account, and therefore not intended to be paid as a death benefit, is contrary to the sole-purpose test.

Super funds that breach the sole-purpose test run the risk of becoming non-compliant.

The ATO is aware of the above strategies being used by SMSFs. At this stage it has only publicly addressed the issue concerning non-deductibility of the insurance premiums, but not the sole-purpose test implications.

Trustees should ensure they obtain legal and tax advice prior to implementing these strategies.

This includes understanding the risks if the ATO provides an unfavourable view, and the ability to unwind or modify the strategy if the view of the ATO is unfavourable.

Mike Mitchell is a senior technical consultant at MLC Technical Services.