With the release of draft legislation by Treasury on 21 May 2021 for the previous Budget proposal to provide choice to superannuation trustees when determining the fund’s claim for exempt current pension income (ECPI) and to remove a redundant requirement to obtain an actuarial certificate when claiming ECPI for certain funds, it’s time to take a closer look at the implications of the proposed measures, both from a technical and practical application perspective.
What the draft legislation says
The draft legislation, on the face of it, implements the two proposed measures from the 2019 Budget announcement, being:
- To allow superannuation trustees to choose their preferred method of calculating ECPI when they have member interests in both accumulation and retirement phases at one time, but only retirement phase interests at another time, during an income year; and
- To remove the requirement for superannuation trustees to obtain an actuarial certificate when calculating ECPI, where all members of the fund are fully in retirement phase for all of the income year.
In relation to the first proposed change to ECPI, the Explanatory Memorandum (EM) states that “these amendments provide superannuation trustees with greater choice in how they calculate exempt current pension income and minimise the complexity and cost in a fund’s reporting”. An initial review could lead the reader to such a view, however, upon closer look there is potential for the new legislation to make the calculation of ECPI more complex than it already is. It may, however, provide trustees with opportunities for increasing their ECPI claims and hence reducing their tax burden.
Of the second proposed change, the EM states that it “..will reduce costs and remove unnecessary red tape for affected funds”. The draft legislation appears to achieve exactly that by exempting such funds from the disregarded small fund assets (DSFA) rules and permitting them to use the segregated method to calculate ECPI.
When the new ECPI rules will apply
Both proposed measures are to apply from the first day of the quarter after the day the passed legislation received Royal Assent. However, they both also state that the relevant amendments will apply to the 2021-22 income year and later income years. Given that we are unlikely to see the legislation passed before 1 July 2021, that means they are likely to apply retrospectively. It also leaves precious little time for actuaries and SMSF accounting platforms to make the necessary changes needed to accommodate the new rules.
Funds affected by these new measures
Self-managed superannuation funds (SMSFs) affected by these two proposed measures are:
1. Providing trustees with a choice when claiming ECPI:
SMSFs claiming ECPI that:
- have a period(s) (not being the whole income year) where the SMSF consists wholly of retirement phase pensions, other than defined benefit pensions; and
- do not have DSFA the same income year.
SMSFs with DSFA will continue to be required to use the proportionate method to claim ECPI for an income year, unless they are a fund for which the second proposed measure applies.
2. Removing the redundant actuarial certificate requirement:
SMSFs claiming ECPI that:
- consists wholly of retirement phase pensions, other than defined benefit pensions, for the entire income year; and
- has DSFA for the same income year.
Providing trustees with a choice when claiming ECPI
It was expected that the proposed change would provide affected SMSF trustees with a choice of applying either:
- the current approach to claiming ECPI where the segregated method must be used for periods in the income year that wholly consist of retirement phase pensions, not being defined benefit pensions; or
- the pre 2017-18 approach to claiming ECPI where the proportionate method is used to claim ECPI for the entire income year, despite the fund having periods that wholly consist of retirement phase pensions, not being defined benefit pensions.
Utilising Accurium’s actuarial certificate data for financial year 2018-19, our research has identified:
- 11% of funds which applied for an actuarial certificate had periods of deemed segregation;
- Of those funds which had a period of deemed segregation, 89% had only one deemed period, and 11% had more than one deemed period during the year;
- We estimate only 3% of all SMSFs in 2018-19 claimed ECPI and used both the segregated and proportionate methods due to having deemed or elected segregation.
A closer look at the draft legislation reveals that:
- An SMSF trustee is required to make a choice as to whether an asset of the fund is or is not a segregated current pension asset during a period, being less than a whole year, where the SMSF consists wholly of retirement phase pensions, not being defined benefit pensions.
There appears to be no default position, that is, the fund assets during a period where the SMSF consists wholly of retirement phase pensions are treated as segregated current pension assets, unless the trustee chooses not to treat them as such. The SMSF will be required to make a choice, either for an asset to be segregated or not.
- A choice will have to be made on an asset by asset basis.
An asset will include individual tax parcels, for example where there have been multiple acquisitions of the same listed share. This could mean quite a number of choices that will be required to be made by an SMSF trustee for assets to be or not to be treated as a segregated current pension asset during period consisting wholly of retirement phase pensions, other than defined benefit pensions.
- The timing of when the choice is to be made is not clear, but the logical conclusion appears to be that it will be made in arrears.
The draft legislation states that the fund “may choose to treat an asset of the fund as being, or no being, a segregated current pension asset of the fund at a particular time in an income year…”. The question is when is the “particular time”?
Where an SMSF uses the proportionate method to claim ECPI, this is applied on a retrospective basis. That is, after the relevant income year, the SMSF trustees obtain the relevant actuarial certificate and apply the exempt income proportion to the fund’s eligible income and claim as exempt.
Where the fund elects to segregate assets and claim ECPI under the segregated method, such segregation must be done on a prospective basis. However, when a fund moves into a period where all its assets are supporting retirement phase interests it is not a deliberate choice of the trustees. It is a consequence of member actions such as commencing an income stream or meeting a condition of release. Under the current rules, assets are deemed to be segregated current pension assets. ECPI is claimed under the segregated method for income in this period retrospectively based on whether assets were deemed to be segregated or not.
Although it is not explicitly stated in the legislation, the logical conclusion of giving trustees the choice between these two retrospective methods is that this choice can be made retrospectively. This fundamentally changes the process for claiming ECPI. Trustees are no longer doing a mechanical calculation based on the established strategy or circumstances of the fund. They will have a range of options available to them for how they do this calculation and can choose the one that gives them the best tax outcome.
For example, consider an SMSF with a period where it consists wholly of retirement phase pensions, not being defined benefit pensions and has no DSFA for that income year. During the period the SMSF disposes of two assets, one for a capital gain and the other for a capital loss. The SMSF trustee makes the choice, retrospectively, to treat the asset that gave rise to a capital gain as a segregated current pension asset, but not to treat the asset that gave rise to a capital loss as a segregated current pension asset. Consequently, the gain from the segregated current pension asset is disregarded and not subject to tax. The capital loss from the asset not treated as a segregated current pension asset can be offset against other assessable capital gains or carried forward to a later income year under the proportionate method. The trustees get to pick the best outcome on an asset by asset basis. For even the simplest of funds caught under these proposed rule changes there are likely to be a range of different options for how ECPI can be claimed.
It is possible that the legislation will be clarified to ensure that decisions regarding which ECPI methods to use should be made in advance. However, this is likely to give rise to a number of potential issues. Firstly, such a policy would be very difficult to enforce. Secondly, it would present the dilemma of trustees being unaware of when a period where the fund consists wholly of retirement phase pensions is about to commence so that the relevant choice can be made for assets that the fund holds at that time. Further, the trustees would have to make a similar choice for any assets acquired during the period, where the fund consists wholly of retirement phase pensions. As there appears to be no default position of an asset’s status during such a period, is it not clear what happens where the trustee has not made the prospective choice.
Removing a redundant actuarial certificate requirement
The super reforms applying from 1 July 2017 introduced ‘disregarded small fund assets’ (DSFA) to ensure members impacted by the transfer balance cap could not use partial segregation to realise capital gains 100% tax free. However, SMSFs that consists wholly of retirement phase pensions, other than defined benefit pensions, can have DSFA if member balances grow above $1.6m, and due to having DSFA they cannot use the segregated method to claim ECPI. Consequently, they must use the proportionate method to claim ECPI which requires an actuarial certificate even though the actuarial exempt income proportion is 100%.
Under the proposed measure, these affected SMSFs will be permitted to use the segregated method to claim ECPI and consequently will not be required to obtain an actuarial certificate. This is achieved by excluding a fund from the DSFA rules where its assets would otherwise have been segregated current pension assets at all times during the income year. This measure saves the affected SMSF the cost of an actuarial certificate.
Where to from here?
The consultation period on the proposals is open until 18 June 2021. During this time interested parties can make submissions to Treasury about the draft legislation. Hopefully, the final version of the legislation will clarify the procedure for trustees making the choice of the effective ECPI method that is applied.
If the changes go ahead unaltered, they will provide SMSF trustees, their advisers and accountants with the opportunity to analyse the different ECPI choices available to them to determine the best tax outcome for their members and clients. While this is likely to add complexity and administrative cost, SMSF practitioners who are across the changes will be able to help their clients lower their tax bills.