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The changing landscape of SMSF exempt income claims
In the wake of superannuation reform changes seen over the past year there is one provision that has escaped much of the scrutiny dealt to big ticket items like the transfer balance cap but has the potential to trip up self-managed superannuation fund (SMSF) trustees.
Exempt current pension income (ECPI) is the most valuable tax concession available to SMSFs with members in retirement phase, and the disregarded small fund assets provision removes the ability of some SMSFs to use the segregated method when claiming ECPI.
When a fund has disregarded small fund assets
The disregarded small fund assets provision is set out in Section 295.387 of the Income Tax Assessment Act 1997. An SMSF will have disregarded small fund assets in an income year if:
- on 30 June just before the start of the income year, a member of the fund had a total superannuation balance of over $1.6 million and also has a retirement phase income stream (the retirement phase income stream does not have to be in the SMSF); and
- the fund is paying a retirement phase income stream at some time during the income year in question.
This test is completed each year to determine the method used by the fund to claim ECPI. If an SMSF has disregarded small fund assets the trustee must use the proportionate method to claim ECPI for that income year. This applies to all fund assets and so a fund cannot segregate assets for tax purposes.
This means a trustee does not have the option to treat assets as elected to be segregated to retirement phase pension accounts in order to realise gains tax free. Indeed this was the background to this provision. With the new $1.6 million limit on the amount which can be transferred into retirement phase there was a thought that some trustees may attempt to circumnavigate the tax outcomes of the new transfer balance cap rules by using segregation. By segregating assets to the retirement phase, a trustee would again be able to realise capital gains tax free.
Disregarded small fund assets was introduced to stop this by disallowing the use of segregation for tax purposes, requiring those funds who meet the definition to use the proportionate method to claim ECPI on all assets. A fund with both accumulation and retirement phase accounts due to the transfer balance cap is now required to claim ECPI using the proportionate method and capital gains would not be fully tax exempt.
Administration of disregarded small fund assets
The disregarded small fund assets provision refers to a fixed value of $1.6 million for the test of a member’s total superannuation balance, rather than referring to the transfer balance cap which is indexed with inflation (and so likely to increase over time). This means that more funds may fall into the disregarded small fund assets definition over time.
The disregarded small fund assets provision also introduces additional administration requirements for SMSF trustees and professionals.
In order to complete a tax return for an SMSF, knowledge of each member’s total superannuation assets at the prior 30 June is needed in order to complete the disregarded small fund assets test. This test determines whether a fund is eligible to use the segregated method, which is critical to ensure ECPI is claimed correctly in the annual return. This means finding out new information about other superannuation accounts members may have, including industry, retail or government superannuation funds.
Case study
At 1 July 2017 John and Jane were the two members of an SMSF. John had an account-based pension (ABP) balance of $1,400,000 and Jane had an accumulation balance of $110,000. Jane retired and commenced an ABP on 1 February 2018 with her entire accumulation balance of $125,000 at that date. Pension payments were paid uniformly over the year.
The SMSF earned $80,000 in assessable income over 2017-18.
The fund was a mix of retirement and non-retirement phase from 1 July 2017 to 31 January 2018. From 1 February 2018 to 30 June 2018 the fund was solely in retirement phase.
The SMSF would not have disregarded small fund assets for 2017-18 as John’s total superannuation balance was only $1,400,000.
The fund must claim ECPI in the following way:
- Using the proportionate method from 1 July 2017 to 31 January 2018 as assets were supporting a mix of retirement phase and non-retirement phase accounts
- Using the segregated method from 1 February 2018 to 30 June 2018 as assets were solely supporting retirement phase accounts and deemed to be segregated current pension assets
The trustee needs to break down the income received over the year into these two periods. It is determined that $60,000 of assessable income was earned from 1 July to 31 January and $20,000 of assessable income was earned from 1 February to 30 June. An actuarial certificate is obtained to certify the exempt income proportion for income earned on assets which were not segregated. The exempt income proportion determined by the actuary was 92.6 per cent.
The SMSF trustee will calculate the fund’s ECPI to claim in the annual return as:
ECPI = (actuary’s exempt income proportion x income on assets which were not segregated)
+ income on segregated pension assets
= (92.6% x $60,000) + $20,000
= $75,560
However prior to submitting the annual return it is discovered that at 30 June 2017 John also had an accumulation balance of $250,000 in a retail fund and so his total superannuation balance was actually $1,650,000. The SMSF would then have met the definition of having disregarded small fund assets and would be unable to use the segregated method to claim ECPI in the 2017-18 income year.
Even though the SMSF is entirely in retirement phase from 1 February 2018 to 30 June 2018 the disregarded small fund assets provision disallows the use of the segregated method and the proportionate method must be used over the entire income year.
An amended actuarial certificate is obtained for and the actuary determines the exempt income proportion using the proportionate method for the full income year to be 95.6 per cent.
The trustee updates their calculation of ECPI as follows:
ECP = 95.6% x $80,000
= $76,480.
In this scenario the fund would actually have under-claimed ECPI in the annual return if they did not correctly allow for disregarded small fund assets when completing the annual return.
In practice disregarded small fund assets could lead to a better or worse tax outcome depending on the timing and size of income earned over the year. However remember that the fund does not have a choice, where it has disregarded small fund assets it must use the proportionate method to claim ECPI.
Conclusion
The disregarded small fund assets test must be completed every income year in order to determine how to claim ECPI. The annual return can no longer be completed in isolation but requires knowledge of superannuation accounts for each member outside their SMSF.
The Australian Taxation Office has identified that ECPI is an ongoing area of compliance focus for SMSFs and so it is more important than ever to ensure ECPI is claimed correctly in the annual return, and this means understanding and applying the new disregarded small fund asset provisions.
Melanie Dunn is technical services manager at Accurium.
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Leading industry experts contribute to the Money Management & Super Review website and magazine, providing insight into a wide range of specialised topics within the financial services industry.
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