A pooled superannuation trust (PST) is a unit trust in which only assets of superannuation funds, approved deposit funds and other PSTs can be invested.
SMSFs are therefore eligible to invest in a PST and a prominent public offer profit for member fund recently introduced a PST product encouraging investment from SMSFs.
However, for an SMSF with interests in retirement phase looking to invest in a PST there are important considerations to think about with respect to how the fund claims exempt current pension income (ECPI).
Taxation of an investment in a PST
A PST is a tax-paid investment vehicle where the responsibility for the tax liability falls on the Trustee. This means, for example, that a declared unit price would incorporate a provision for income tax including an allowance for tax owing on investment income and capital gains, and tax credits (e.g. imputation credits).
For this reason, a PST will differentiate assets to be accumulation units or pension units. For example, investment earnings and capital gains on pension units would be tax exempt and this would be reflected in the daily unit price.
When the SMSF makes an investment in a PST they will be allocated accumulation and/or pension units and some PSTs may only offer one type.
What type of units the SMSF should purchase is a key consideration and it is generally up to the SMSF trustee to make the correct decision with respect to what type of units they are investing in.
Falcon Super Fund has two members who are both in accumulation phase. The total value of assets in the SMSF is $500,000 at 30 June 2019.
Last year the SMSF earned $20,000 in income, this was assessable and taxed at 15% as it was earned on assets supporting non-retirement phase interests.
If at 1 July 2019 the SMSF invested $100,000 in a PST then it would be sensible to assume the SMSF should elect for that investment to be in accumulation units so that the taxation of the assets now inside the PST is consistent with how income on those assets would otherwise be taxed in the SMSF.
As a tax-paid investment vehicle the SMSF will not be assessed on any income earned while invested in the PST and any gains or losses realised on the disposal of units are exempt for tax purposes.
Consider at 30 June 2019 the SMSF’s units in the PST were valued at $107,000. The unit price has already allowed for taxation on earnings and no earnings in relation to this investment are included in the assessable income of the SMSF when completing their annual return.
The SMSF will report at Section H item 15a D of the 2019 SMSF Annual Return the value of their PST investment at 30 June 2019:
If the trustees decide to sell their PST investment at 1 July 2019 for $107,000 then as capital gains or losses on the investments in the PST have already been allowed for in the unit price there will be no capital gain or loss for the SMSF to report in their annual return.
Where the fund is solely in non-retirement phase over the duration of their investment in the PST this is quite simple. However, if the SMSF has a retirement phase interest things become more complicated.
Investing in a PST when the SMSF has a retirement phase interest
When an SMSF has a retirement phase interest, e.g. an account-based pension, the fund may be eligible to claim ECPI for income earned on assets supporting that retirement phase interest. The fund could be using the segregated or/and unsegregated (proportionate) method to claim ECPI depending on the circumstances of the fund.
If a fund is solely in retirement phase over an entire year all earnings will be exempt from tax. The fund will generally use the segregated method to claim ECPI unless the fund had disregarded small fund assets in which case it will use the proportionate method.
In this instance the SMSF would need to elect for their PST investment to be in pension units so the taxation of earnings on the invested assets is consistent with the tax treatment of earnings in the SMSF. Again, no earnings or capital gains/losses in respect to the investment would be reported in the SMSF.
If an SMSF had an investment in a PST and was fully in accumulation phase, then decided to commence a retirement phase income stream during a financial year, I expect the ATO would want to see the tax treatment of earnings in the PST to be consistent with how earnings on those assets would otherwise have been taxed in the SMSF. Complications would similarly arise if a fund fully in retirement phase created a new accumulation interest. Aligning the tax treatment in this circumstance is not simple.
Investing in a PST when the SMSF has accumulation and retirement phase interests
Additional steps need to be taken to avoid taxation complications where an SMSF has both accumulation and retirement phase interests when investing in a PST.
Typically, in an SMSF where there is both a retirement and accumulation interest no specific assets are set aside to support a specific interest, the fund is what we call unsegregated. This means the assets earn income and change in value over the year, and at year end the earnings and any capital gains and losses are attributed to each interest on a fair and reasonable basis to determine the balance of each interest for the new financial year.
Further, for an unsegregated fund the proportion of the fund in taxable accumulation phase vs tax free retirement phase does not just change once a year at year end, it changes during the year as transactions occur. For example, if pension payments are taken or contributions received this will change the proportion of the fund that is in pension vs accumulation, sometimes quite considerably.
The proportion of the fund’s income that can be claimed as exempt from tax must be calculated and certified by an actuary. The calculation determines the average liabilities in retirement phase as a proportion of the average total superannuation liabilities over the income year. The calculation must take into account all the fund’s superannuation liabilities (unless assets are specifically segregated to support a portion of the liabilities, in which case these are excluded – we’ll consider this shortly).
For an SMSF with units in a PST, the actuarial exempt income proportion would be calculated based on the fund’s total superannuation liabilities including those backed by the PST units. However, the exempt income proportion is only applied to the SMSF’s ordinary income, which excludes income taxed in the PST.
This will skew the SMSF’s tax calculation, providing a different tax outcome depending on whether the PST units are retirement or non-retirement phase.
Advantage SMSF has two members, Joe with $1,000,000 in accumulation phase and Jane with $1,000,000 in an account-based pension at 1 July 2018.
Their fund owns units in a PST with a value of $500,000. During the 2018-19 income year the fund earned a total of $100,000 of income, of which $30,000 related to the PST.
For simplicity, let’s assume that the member liabilities remain unchanged during the year.
Exempt income proportion = Average retirement phase liabilities / Average total superannuation liabilities
= $1,000,000 / $2,000,000
ECPI = 50% x Ordinary income
= 50% x Total income – PST income
= 50% x ($100,000 - $30,000)
= 50% x $70,000
The fund’s remaining $35,000 of ordinary income would be assessable and taxed at 15% in the fund.
How the $30,000 of income that was earned on the PST unit is taxed will depend on whether the SMSF held non-retirement or retirement phase units. Assuming they are retirement phase units then the $30,000 of income would have been exempt from tax in the PST.
Overall, $65,000 or 65% of the fund’s total income has been exempt from tax in 2018-19, when only 50% of its liabilities are in the retirement phase.
There doesn’t appear to be a mechanism to ‘true-up’ the tax an SMSF pays overall so by holding units in PSTs there is the potential that different tax outcomes may arise.
If we wanted to ensure the tax treatment of earnings taxed in the SMSF and those taxed in the PST is consistent (i.e. reflective of the accumulation and retirement phase interests in the SMSF) we would need the PST investment to have a number of units in pension and accumulation for the year corresponding to the final actuarial exempt income proportion. However, we don’t know the actuarial exempt income proportion until year-end, meaning this is not possible in practice
Sunrise SMSF has two members, Peter with $500,000 in accumulation phase and Shelly with $500,000 in an account-based pension at 1 July 2019 and is not segregated. The trustee purchased $250,000 worth of accumulation units and $250,000 worth of pension units in a PST at 1 July 2019 in line with the current proportion of accumulation to pension assets.
During 2019-20 Peter makes a contribution of $100,000 on 2 July and Shelly takes pension payments of $5,000 on the 15th of each month. Over the year $20,000 in assessable income was received.
At year-end the fund obtains an actuarial certificate, which certifies that 43.925% of income can be claimed as exempt current pension income. This says that on average around 44% of fund assets were supporting retirement phase liabilities over the year. However, the fund is effectively receiving a 50% tax exemption on income earned on their PST investment, a higher proportion of exempt income due to not rebalancing the PST investment over the year.
Segregating investments in a PST
One solution for SMSFs with interests in both retirement and non-retirement phase may be to use segregation. Trustees can elect to segregate certain assets or pools of assets to solely support particular retirement or non-retirement phase liabilities. Segregating assets under s295-385 or s295-395 of the ITAA 1997 allows ordinary income earned on those assets to be entirely tax exempt or entirely taxable.
It is not wholly clear whether this option can be used for PSTs, as they do not produce ordinary income in the fund. However, if they can, then an SMSF holding units in a PST could elect to segregate those units to solely support retirement or non-retirement phase interests. By matching the retirement and non-retirement phase status of the PST units to the respective member interests in the SMSF the trustee can ensure the tax treatment is consistent. As with any segregation strategy, this decision should be documented as part of the fund’s investment strategy.
The value of the PST units is unlikely to exactly match the value of all of the retirement or non-retirement interests, meaning the fund may still have unsegregated assets and be required to use the proportionate method for claiming ECPI for income earned on the fund’s remaining assets. However, the actuary will exclude any segregated assets from the actuarial exempt income proportion calculation so that the value of that asset will not skew the taxation of earnings on the remaining assets.
Dove Super Fund has three members, John in accumulation phase with a balance of $100,000 and Bob and Karen in retirement phase (account-based pensions) with $700,000 and $400,000. The total value of assets in the SMSF is $1,200,000 at 1 July 2019.
On 1 September 2019 the trustees decide they would like to invest $300,000 in a PST. They document that $300,000 of fund assets will be segregated to Karen’s account-based pension.
During 2019-20 John received monthly concessional contributions totaling $25,000 and Bob took a payment of $50,000 on 1 January and Karen took a payment of $24,000 on 28 June. The fund earned $45,000 in income over the year.
At year end the fund obtains an actuarial certificate to determine the exempt income proportion. The actuary excludes the $300,000 segregated pension asset from their calculation and certifies 88.887% of income can be claimed as exempt current pension income. The SMSF does not earn any assessable income on the segregated pension asset so there is no segregated ECPI to claim, instead the income earned on the pension units inside the PST is tax free and reflected in the unit price.
If the PST investment had not been segregated for tax purposes in the SMSF (but pension units were still selected in the PST) then the $300,000 would not be excluded from the actuarial calculation and the exempt income proportion would be 90.525%. This may overstate the exempt income that would be fair and reasonable to claim on fund income.
Note that if the investment is segregated to accumulation phase then the SMSF will require a separate actuarial certificate under Section 290-395 of ITAA 1997 in order to segregate that asset and claim ECPI using the proportionate method on other fund assets.
Issues with segregation:
The potential use of segregation here gives rise to two key issues:1. If an SMSF has disregarded small fund assets then they cannot segregate for tax purposes.
An SMSF has disregarded small fund assets if it has retirement phase interests and at the prior 30 June one of its members had a retirement phase account and a total superannuation balance of over $1.6 million
This impacts many SMSF retirees with larger balances and may mean that, in order to segregate an investment in a PST, the trustees will need to consider options such as having two SMSFs. Having one fund solely in accumulation phase, another in retirement phase, would allow the allow the trustee to select the PST units to match the fund’s interests.
2. The trustee will need to carefully monitor fund liquidity.
If a large portion of a retirement phase interest is an investment in a PST then as that investment is generally not paying a distribution to the SMSF it is not producing income to assist in meeting annual pension payment requirements. As other assets are drawn down the fund may get to a point where there are no liquid assets available, but the pension still has a balance, and therefore a minimum pension requirement, due to the investment in the PST. This situation should be avoided to ensure the fund remains eligible to claim ECPI. Units in the PST may need to be sold in order to generate liquid assets to fund pension payments.
For SMSFs with both retirement and non-retirement phase interests investing in a PST may not be as simple as it appears.
We would welcome guidance from the ATO for SMSFs investing in PSTs and whether using the segregated method is an appropriate strategy to ensure balanced tax treatment.
If segregation is the solution for SMSFs, then funds with larger balances may be locked out of investing in PSTs due to the disregarded small fund assets legislation.