The ATO’s interpretation of the new rules means legacy pensions may be double counted for transfer balance cap purposes.
When an SMSF member partially or fully commutes an income stream they are required to calculate and report the debit value that will apply to their transfer balance account (TBA). The purpose of this debit value is to increase the member’s remaining transfer balance cap (TBC) by the value of the income stream that has been transferred out of retirement phase.
This becomes important where a member wants to restructure an income stream or transfer it to another provider. For example, an SMSF trustees might commute an existing account-based pension at 1 July and re-commence a new income stream in order to move contributions made in the previous year into retirement phase, while maintaining only one pension interest instead of two.
Another reason we see commutations in an SMSF is where a member is re-structuring their legacy pensions including lifetime, life-expectancy and market-linked income streams. These are non-commutable income streams meaning that upon commutation the balances cannot be left in accumulation phase, but must be used to commence another complying income stream. This is generally a new market-linked income stream in the SMSF or a complying annuity with a life company. Where the pension commenced prior to 1 July 2018 it will be a capped defined benefit (DB) income streams for the purposes of the TBC.
The debit a member of an SMSF receives against their TBA upon commutation for capped DB income streams is defined in Income Tax Assessment Act (ITAA) 1994 section 294.145. For a lifetime income stream it is the original transfer balance credit that arose at 1 July 2017 less debits that have occurred since that time (apart from payment splits). For a market-linked or life expectancy income streams the debit value is the special value of the income stream at the time of commutation.
Issue with commutation debit value for market-linked or life-expectancy income streams
The ATO has confirmed with Accurium that its interpretation of the legislation defining the special value of capped DB income streams means that in certain cases the TBA debit on commutation will be $0.
This issue impacts market-linked and life-expectancy income streams on full commutation and is caused by the requirement to re-calculate the special value at the commutation date. The special value at commutation is the annual entitlement multiplied by term remaining rounded up at that time.
To work out the annual entitlement ITAA section 294.135 provides a method to annualise the ‘first superannuation income stream benefit you are entitled to receive from the income stream just after that time’.
You might think that this means we look at the next income stream payment the trustee would have paid:
- for a market-linked income stream the first payment in the next year, because the trustee needs to make a full annual payment prior to commutation, and
- for a life expectancy income stream it would be the next payment due.
However, we understand that the ATO’s interpretation is that because the income stream will be commuted in full, the member has no entitlement to any future income stream benefit and so the annual entitlement is $0. Consequently the special value on commutation is also $0.
Why this is a problem
A special value of $0 effectively means the member will have their income stream double counted under the TBC when the member is re-structuring these legacy income streams. The member does not receive a debit value equal to the ‘value’ of the income stream; instead there is a $0 debit value. This means the member’s transfer balance account is not reduced in line with the value of the income stream that has been transferred out of retirement phase. However when the member re-commences a new income stream or annuity this will raise a credit against their TBA equal to the market value of the assets supporting the new income stream (the purchase price).
The ATO has indicated that a fix to this issue requires a change in the legislation by Treasury.
The ATO’s interpretation means that, to avoid this double counting issue, some retirees will not be able to re-structure their legacy income streams to adjust terms such as reversionary beneficiaries or term of payment. It could also prevent them moving their income streams to a new provider or winding up the SMSF. If the income stream has a market value which would cause a member’s TBA to exceed their TBC if it was restructured then the member’s hands are tied. Implementing the re-structure would mean raising an excess transfer balance because the new income stream would not be a capped DB income stream.
We encourage professionals dealing with trustees who have market-linked or life-expectancy income streams to talk with the ATO about the implications on the member’s TBA prior to making decisions in relation to these income streams and obtaining a private binding ruling where appropriate.
Example: commuting a market-linked income stream
75-year-old John is the sole member of his SMSF and his only interest in the fund is a market-lined pension with a balance of $0.5million. With a remaining term of 8 years on his pension, his annual pension payments are around $70,000. John also has a non-commutable public sector defined benefit pension meaning that his total TBA at 1 July 2017 for both pensions was $1.4m.
John is finding it more difficult to manage his SMSF and is looking to wind it up. Market-linked pensions are non-commutable except to commence a new complying income stream so the only option available is to transfer his income stream to a retail provider. The TBA credit on commencing the new income stream will be the value of the assets used to commence the pension at that date, i.e. the rollover from John’s SMSF of $0.5million.
Unfortunately, under the ATO’s interpretation there is no debit against John’s TBA when his market-linked pension is commuted. Rolling over his market-linked pension to a new provider would therefore result in an increase in his TBA of $0.5m, giving him an excess transfer balance of $0.3m. As the market-linked pension is non-commutable John cannot make a commutation to bring his balance under the cap and will have to pay penalties on this excess for the remainder of the term of his pension. He has the unenviable choice of either continuing to run his SMSF, despite the difficulties, or paying penalties on any new pension he starts.
We understand that industry participants are working on submissions to Treasury. If you have clients impacted by this we recommend you discuss it with your professional body.
In the meantime, if you are considering making changes to a complying income stream, or have done so already, we recommend you talk with the ATO as they are aware of this issue.