Introduced as part of the superannuation reforms the disregarded small fund assets legislation applies from the 2017-18 income year onwards and removes the ability of some self-managed superannuation funds (SMSF) to use the segregated method for tax purposes.
With a 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.
Disregarded small fund assets was introduced to stop trustees segregating assets to realise gains tax free despite having an accumulation interest due to the transfer balance cap.
A fund with both accumulation and retirement phase accounts due to the transfer balance cap would be required to claim exempt current pension income (ECPI) using the proportionate (unsegregated) method and capital gains would not be fully tax exempt. 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.
When a fund has disregarded small fund assets
The disregarded small fund assets provision is defined in Section 295.387 of ITAA 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 p 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 how the fund must 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 will not have deemed segregation, nor have the option to treat assets as elected to be segregated, for tax purposes. The ATO has been clear that a fund can still segregate for investment purposes, for example electing in the fund’s investment strategy to allocate assets to certain member accounts so that the income from those assets is allocated to that member’s account, instead of allocating income on a proportional basis.
Administration of disregarded small fund assets
The legislation for disregarded small fund assets references a fixed value of $1.6 million for the test of 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.
Further, it is possible for an SMSF to have only retirement-phase accounts in an income year, but not be eligible to use the segregated method to claim ECPI. For example, a member may have a retirement phase incomes stream in their SMSF worth less than $1.6 million, but if the value of their super interests outside the SMSF increases their total superannuation balance above $1.6 million the SMSF would have disregarded small fund assets. This means the fund would need to use the proportionate method, and obtain an actuarial certificate, to claim ECPI in the annual return. The actuary’s certificate would show an exempt income proportion of 100%. This anomaly was raised in a number of submissions to government on the draft legislation; however no changes were made in the final legislation.
In order to complete an SMSF annual return, tax agents will need knowledge of member total super balances
The disregarded small fund assets provision also introduces additional administration requirements for SMSF professionals. In order to complete a tax return for an SMSF, tax agents will first need knowledge of each member’s total superannuation assets at the prior 30 June 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. For professionals who have previously only dealt with the SMSF accounts this means finding out new information about other superannuation accounts members may have, including industry, retail or government superannuation funds.
At 1 July 2017 John was the sole member of an SMSF. He had an account-based pension (ABP) balance of $1,400,000 and an accumulation balance of $110,000. John commenced a second ABP on 1 February 2018 with his entire accumulation balance of $125,000 at that date.
The SMSF earned $80,000 in assessable income over 2017-18.
The fund will be 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 will be solely in retirement phase. The SMSF would not have disregarded small fund assets as John’s total superannuation balance was only $1,510,000.
Based on the ATO view of deemed segregation the fund will claim ECPI using the proportionate method from 1 July 2017 to 31 January 2018 and must use the segregated method to claim ECPI from 1 February 2018 to 30 June 2018. The trustee determines 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. The exempt income proportion as determined by the actuary was 90.0%, which excludes the segregated current pension assets.
Applying the exempt income proportion to the $60,000 of assessable income earned on assets which were not deemed segregated gives exempt income of $54,000. Combined with the segregated pension income of $20,000 this gives a total amount of ECPI of $74,000.
If however we learn that at 1 July 2017 John also had an accumulation balance of $200,000 in a retail fund and so his total superannuation balance was actually $1,710,000. John’s 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 01 February 2018 to 30 June 2018 the proportionate method must be used over the entire income year.
An amended actuarial certificate is applied for and the actuary determines the exempt income proportion using the proportionate method for the full income year to be 95.0%.
Applying this exempt income proportion of 95.0% to the full year assessable income of $80,000 the amount of ECPI the trustee can claim in the annual return is $76,000.
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.
A fund does not have a choice when it has disregarded small fund assets, it must use the proportionate method to claim ECPI.
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.
The ATO have 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.
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 the SMSF. However it is critical that when applying for the fund’s actuarial certificate you have the answer to ‘does the fund have disregarded small fund assets?’ on hand as this is required in order for actuaries to correctly calculate the fund’s exempt income proportion used to claim ECPI.