The long-awaited legislative change to determine the debit value upon commutation for market linked and life expectancy pensions that are capped defined benefit income streams (CDBIS), passed parliament in June 2020 and applies retrospectively from 1 July 2017.
What was the problem?
From 1 July 2017 when a retirement phase income stream is commuted the member must report a transfer balance debit in respect to the commutation.
For a CDBIS, unlike an account-based pension (ABP), the commutation value is not simply the market value of the assets supporting the income stream at the time of the commutation. For a market linked pension or life expectancy pension that is a CDBIS in an SMSF the law as at 1 July 2017 identified the debit value upon commutation to be the special value calculated just prior to the commutation. The special value is calculated as the term remaining (rounded up) x annualised payment.
However, the ATO interpretation of the legislation is that upon full commutation the member has no entitlement to a future payment. Therefore, the annualised payment used in the formula would be $0, resulting in a nil debit value. If a member was to fully commute with a debit value of $0 there would be no reduction in their transfer balance account (TBA). When a new complying income stream is commenced a TBA credit equal to the purchase price and hence the income stream would effectively be double counted against the member’s transfer balance cap (TBC).
The ATO recognised that this was not the intent of the law and have been applying a common sense approach where they would not take compliance action where an impacted pension was commuted and the member either reported nothing, or a value other than ‘nil’, as the TBA debit.
Implementing the new rules
In June 2020 law was passed which fixed the nil debit issue and prescribed a new formula for determining the debit value upon commutation. The new formula is quite different to the prior special value method and still does not relate to the value of assets supporting the income stream. Therefore, it is likely that anyone who has reported a debit for the commutation of an impacted income stream since 1 July 2017 has reported a value different to what would be determined under this new formula.
The ATO has said in its latest guidance on the new rules, released 31 August, that funds will be required to review any information already reported to them. Pleasingly, they have acknowledged that reporting will not need to be reviewed for a member who is now deceased, or for SMSFs that have already been wound up.
The ATO does not expect any retrospective reporting to commence until November 2020, with an intent to provide additional guidance before the end of November in respect to when they expect the reporting review to be completed by.
What is the new formula for calculating the TBC debit?
The new formula for calculating the debit value for a CDBIS market linked or life expectancy income stream which is fully commuted on or after 1 July 2017 is as follows:
The amount of the original transfer balance credit in respect of the income stream less the sum of the following amounts:
- the amount of any transfer balance debits (other than a payment split)
- the total amount of superannuation income stream benefits the person was entitled to receive before the start of the financial year the commutation takes place
- the greater of
- the sum of the superannuation income stream benefits paid during the financial year the commutation takes place
- the minimum amount required to be paid under regulations 1.07B and 1.07C of SISR or regulation 1.08 of the Retirement Savings Account Regulations 1997 during the financial year the commutation takes
The ATO has clarified the following in respect to this formula:
- It is only debits arising when an income stream is divided (a payment split) that are disregarded when calculating the value of the debit. Debits arising from a payment split are reported to them by the individual
- The ‘total amount of superannuation income stream benefits the person was entitled to receive before the start of the financial year the commutation takes place’ is the sum of the actual pension payments made between 1 July 2017 and 30 June of the year prior to that in which the commutation occurs, provided that the payments are made in accordance with the requisite standards
- For market linked income streams the minimum amount required to be paid in the year of commutation can be the minimum payment based on 90% of the annual payment determined based on the pension factors, and should be pro-rated for commutations that occurs part way through a year, in accordance with Schedule 6 of the superannuation Industry (Supervision) Regulations 1994 (SISR).
Issues and case study
A common scenario for SMSFs impacted by these new rules may be those funds who commuted a CDBIS at 1 July 2017 in order to reset the terms of the income stream and have the income stream no longer be treated as a CDBIS.
The potential good news is that for market linked pensions generally there will not be a material discrepancy between what the fund may have reported as the TBC debit and the new formula.
Just prior to 1 July 2017 the special value credit reported to the ATO would have been the term remaining at 1 July 2017 multiplied by the annualised pension payment to be taken in 2017-18.
At 1 July 2017 if the income stream was fully commuted, then based on the legislation at the time, typically the debit would have been assumed to be the same as the initial TBA credit reported for the income stream as at 30 June 2017.
If we see how this compares to the TBC debit that would need to be reported under the new rules then it would be the original special value of the income stream less the minimum pension payment for 2017-18. Fortunately, the difference will be negligible because the minimum payment for an income stream commuted on 1 July 2017 would be pro-rated to 1/365 of the annual payment for 2017-18.
Retirees who commuted a life expectancy pension may need to check their pension documents to determine if there will be a material discrepancy between what the fund reported as the TBC debit and the debit under the new rules. The pension documentation for life expectancy pensions should set out the frequency of pension payments during the year. For example, they may require the fund to pay the pension monthly on the last day of each month. In which case, if the pension was commuted on 1 July 2017 there would have been no requirement to make any payments in the 2017-18 year prior to the commutation. If this is the case, then under the new rules the TBA debit will be equal to special value that was credited just prior to 1 July 2017.
Case study – Market linked pension commuted at 1 July 2017
For example, consider a CDBIS market linked pension (MLP) with an annual payment for 2017-18 of $100,000, assets supporting the income stream valued at $832,000, and a term remaining of 10 years at 1 July 2017, which was commuted in full:
- Original TBA special value credit = 10 x 100,000 = $1,000,000
- TBA debit reported using special value at 1 July 2017 = 10 x 100,000 = $1,000,000
- TBA debit using new formula at 1 July 2017 = 1,000,000 – (100,000 x 1/365) = 1,000,000 – 273.97 = $999,726.03
- TBC credit at 1 July 2017 when commenced new MLP = $832,000
If the member receiving this income stream had used the original methodology when they commuted their MLP on 1 July 2017 then their TBA at the end of day 1 July 2017 would have been $832,000. If they had other account-based pensions they may have retained up to $768,000 in account-based pensions and still remained inside the TBC of $1,600,000.
If we now review the transfer balance account reports and identify the TBA debit upon commutation on 1 July should have been $999,726.03, then the member may have created an excess transfer balance of $273.97 at 1 July 2017, potentially subject to excess transfer balance cap tax.
Case study: Market linked pension commuted at 1 September 2020
If we assume instead that the member above did not commute their income stream at 1 July 2017, but retained $600,000 in ABPs to utilise their full TBC.
- They kept the CDBIS MLP for a couple of years and commuted it on 30 Aug 2019 to commence a new MLP in order to extend the term of the pension.
- In 2017-18 and 2018-19 pension payments of $100,000 and $125,000 respectively were paid from the income stream.
At 30 Aug 2019 the income stream had a term remaining (rounded up) of 8 years, an account balance of $780,000 and annual payment of $115,000 selected based on it being allowable within the MLP payment upper and lower limit for 2019-20. A pension payment of $10,000 had been paid in July and August.
Upon full commutation the member was not sure what was an appropriate TBA debit, but estimated based on the original special value methodology it might be around 8 x 115,000 = $920,000, providing more than enough space under their TBC to commence a new MLP with account balance of $780,000 and so actioned the commutation and new pension commencement.
However, at June 2020 the new formula for calculating the TBA debit was made law, retrospectively applying from 1 July 2017. Under this new formula the TBA debit at 30 Aug 2019 should have been only $755,000.
1,000,000 – 100,000 – 125,000 – max(115,000 x 61/366, 20,000)
1,000,000 – 225,000 – 20,000
This means their TBA at 30 August 2019 would be 1,600,000 – 755,000 +780,000 = 1,625,000, an excess of $25,000! The member may be required to commute $25,000 (or more if notional earnings are applied) from their account-based pensions to remove this excess transfer balance.
Luckily this member has some commutable income streams (ABPs) that could be utilised to reduce their TBA below the TBC.
It is also possible that the action of commuting a CDBIS market linked or life expectancy income stream to purchase a new complying pension that is not a CDBIS could similarly create an excess transfer balance. This is more likely for pensions with very high payments, and assets supporting the income stream around the $1.6million TBC. This could occur if the revised TBA debit value is lower than the purchase price of the new non-commutable complying pension, such that the member has created an excess transfer balance that they cannot remove. If the member had anticipated this outcome they would likely have not commuted the income stream.
We are at this stage unclear whether the ATO will retrospectively tax excess amounts raised as a result of revised TBA debit calculations for these income streams, or if they will provide any kind of materiality measure to the assessment. It would not seem fair to penalise retirees who made decisions based on their understanding of the law at the time, or in the period where we had no clarity on what the debit value should be. Hopefully the ATO applies a forward looking approach in the review and re-reporting guide to be released in November, and potentially an amnesty to those retirees who have a resulting excess position in a non-commutable income stream.