Definition of segregated pension assets
An asset, or pool of assets, is a segregated pension asset for tax purposes if it is solely supporting retirement phase liabilities at a time in a financial year.
Where a self-managed super fund (SMSF) contains segregated pension assets, the income earned on those assets will be claimed as exempt current pension income (ECPI) using the segregated method.
Income Tax Assessment Act (ITAA) 1997 Section 295.385 defines segregated current pension assets. It says a fund’s assets will be segregated current pension assets if (among other things) they are ‘invested, held in reserve or otherwise dealt with at that time solely to enable the fund to discharge all or part of its liabilities (contingent or not), as they become due, in respect of superannuation income stream benefits that are RP superannuation income stream benefits of the fund at that time’1 .
Assets which are not segregated pension assets at a time in a financial year may still be eligible to claim ECPI, but will require an actuarial certificate and will claim ECPI by multiplying the actuarial exempt income proportion determined using the proportionate method (also known as the unsegregated method) by the income earned on assets which were not segregated pension assets. The calculation of the actuarial exempt income proportion using the proportionate meth-od, as defined in ITAA 1997 Section 295.390, will exclude any segregated pension assets. The exempt income proportion under the proportionate method is based on the average value of superannuation liabilities and does not include liabilities for which segregated current pension assets or segregated non-current assets are held.
Segregated non-current assets
An asset, or pool of assets, is said to be segregated non-current assets if the assets are sole-ly supporting non-retirement phase liabilities and the fund obtains an actuarial certificate under ITAA 1997 Section 295.395.
Assets which are solely supporting accumulation interests in an SMSF are by default not segregated non-current assets. For example a fund which does not yet have a member in retirement phase. Earnings on accumulation assets are taxable, and in years where the fund has periods where it is solely in accumulation phase and periods where there is also a retirement phase interest will use the proportionate method to claim ECPI.
Segregated non-current assets will occur where assets are documented as part of the fund’s investment strategy to be set aside to solely support accumulation phase interests, and the fund obtains an actuarial certificate. This is not common in an SMSF. If a fund does have segregated non-current assets these will be excluded from the actuarial exempt income proportion calculation under the proportionate method and earnings on the segregated assets will be entirely taxable.
How an SMSF can have segregated pension assets
A fund can meet the definition of segregated pension assets in two ways:
- Deemed segregation
- Elected segregation
Deemed segregation occurs at any time all assets of the fund are supporting retirement phase superannuation income stream benefits e.g. account-based pensions or transition to retirement pensions in retirement phase. A fund’s assets may have multiple periods of deemed segregation if members commence pensions or/and receive contributions in an income year meaning the fund moves into and out of solely being in retirement phase. Whether the fund has deemed segregation is a matter of fact based on the asset structure of the fund and transactions in the year and cannot be adjusted in arrears.
Elected segregation occurs where assets are documented as part of the fund’s investment strategy to be set aside to solely support retirement phase interests. This may occur for example where a member wishes for a particular asset’s income and expenses to be solely attributable to their retirement phase in the fund, and where they also want the fund to claim ECPI based on the elected segregation.
An asset which is elected to be segregated cannot exceed the value of the retirement phase interests to which it is attributed at any time, and the fund will need to ensure that the liquidity requirements of the retirement phase income streams are considered if segregating lumpy illiquid assets. Income earned on the segregated asset is claimed as ECPI and general expenses are not deductible. When a segregated asset is sold gains or losses are disregarded under the segregated method. In many cases a fund may also maintain a separate bank account or track notional sub-accounts in order to maintain the segregation where the asset is earning income e.g. rent on a commercial property.
Elected segregation is not common in an SMSF however deemed segregation may occur once the SMSF has a member who moves into retirement phase.
An exception to the definitions above is that assets which meet the definition of disregarded small fund assets cannot be segregated pension assets.
Disregarded small fund assets
A fund will have ‘disregarded small fund assets’ in a financial year, as defined in ITAA 1997 Section 295.387, and be ineligible to have segregated pension assets, if:
1. the SMSF has a retirement phase account at any time during the financial year in question; and
2. on 30 June just before the start of the financial year, a member of the fund had a total superannuation balance that exceeds $1.6 million and they also had a retirement phase income stream (this looks across all superannuation accounts of the member not just those in the SMSF).
If these two conditions are met the fund will have ‘disregarded small fund assets’ and will be unable to use the segregated method, either elected or deemed, to claim ECPI in that financial year. This test is done each financial year to determine how the fund must claim ECPI. A fund with disregarded small fund assets will not have any segregated pension assets and will claim ECPI using the proportionate method.
A quirk of this new rule is that it means we can have a situation where an SMSF may have only retirement-phase accounts but not be eligible to use the segregated method to claim ECPI.
For example, a sole member SMSF with a retirement phase income stream of less than $1.6 million but where the member also has a superannuation balance outside of the SMSF which brings their total superannuation balance above $1.6 million. This would result in the SMSF being solely in retirement phase for the financial year but will also meet the definition of ‘disregarded small fund assets’ and as such is unable to claim ECPI using the segregated method. This fund would be required to obtain an actuarial certificate and claim ECPI using the proportionate method.
Segregation for tax purposes vs segregation for investment purposes
Where a fund trustee wants to maintain elected segregation for investment purposes but not for tax purposes this is allowed even if the fund has disregarded small fund assets. This is an investment decision of the trustee and should be documented as part of the fund’s investment strategy. For example a trustee might set aside a pool of asset to support a member, or group of members, interests in the fund so that the income and expenses of those assets is solely allocated to those members. Unless the assets also meet the definition of segregated pension assets an actuarial certificate will be required to claim ECPI for tax purposes.
What is required for segregation?
The ATO website on the segregated method states that the trustee needs to consider whether the SMSF’s income stream assets meet the requirement of being ’segregated’ by determining whether:
- the assets are clearly identified as assets dedicated to funding super income stream benefits
- there is a clear relationship established between the relevant assets and the member’s account.
For deemed segregation this is relatively simple. If all accounts in the SMSF are retirement phase income streams on a day and there are no accumulation accounts, reserve accounts or complying defined benefit income streams then the fund has deemed segregation on that day.
The following points, while not exhaustive, may assist in determining the requirements to be met for an asset to be a segregated pension asset using elected segregation.
1. A segregated asset needs to be completely separate
Part of an asset (e.g. part of a property) cannot be a segregated pension asset. The asset, or pool of assets, must be entirely segregated.
For example, consider a two member SMSF where Member One elects segregate an investment property to their account-based pension. The value of a property is less than the value of Member One’s account-based pension and so the property is eligible to be segre-gated to support Member One’s pension. In this scenario the fund would use the segregat-ed method to claim ECPI in respect of the segregated property and claim ECPI under the proportionate method for income earned on all other assets of the fund. The trustee would obtain an actuarial certificate which will state the exempt income proportion that will apply to earnings on all assets of the fund except the segregated property.
Note that it is possible to segregate part of a bank account where notional sub-accounts are maintained in order to track the segregated part of the account. For example if Member One’s property paid rent into the fund’s general bank account the trustee could maintain notional sub-accounts to separately track the income and earnings in the bank account relating to the segregated asset, and those transactions and earnings that do not relate to the segregated asset.
2. Elected segregation needs to be documented
Segregation must be properly documented in the fund investment strategy. In addition, the decision to implement a segregation strategy should be in line with the fund’s investment strategy and member objectives. For example, Jim and Jenny run their own SMSF and as part of their investment strategy review, after taking into account for example, the circumstances of the fund, their liquidity requirements, and each member’s desired investment strategy and objectives, they decide it is appropriate to maintain a segregation strategy. They document that a decision had been made to allocate 10,000 BHP shares to solely support Jim’s account-based pension from 1 July 2018.
The investment strategy of the fund should give consideration to the decisions made regarding segregation and any changes should be appropriately documented.
For example, if Jim and Jenny were primarily invested in term deposits and shares in line with a balanced portfolio, then by segregating 10,000 BHP shares to Jim he might be taking on a riskier investment profile than Jenny. This means that although the fund overall holds balanced assets, Jim holds more growth assets, and Jenny more defensive assets proportionately, and this should to align with the investment strategy documented by the trustees.
3. Cannot segregate purely for tax avoidance
Segregation must be justifiable based on various fund and member considerations. These considerations should not solely be a tax advantage. It is best practice to document and implement segregation strategies in advance and not in arrears. This is even more important in light of the ATO’s focus on transfer balance account reporting and exempt current pension income for 2017-18. For example, segregating a property to a pension on 1 July of the year it is sold for a large capital gain, then removing the segregation in the fund after 30 June when the gains have been received as tax exempt might look suspicious!
Segregation can be complicated and is generally more work. There are greater administration and documentation requirements due to keeping track of separate pools of assets and notional sub accounts for segregated bank accounts.
Many SMSFs are setup because Mum and Dad (and sometimes their children) wish to ‘pool’ their assets and make investment decisions as a family, for these funds segregation may not be part of their investment strategy.
However all income earned on segregated retirement phase assets is exempt income, and in particular capital gains incurred on such assets will be disregarded. Segregation strategies can therefore be attractive from a tax planning perspective.
1Extracted from ITAA 1997 Section 295-385(4)