Allocating from an unallocated reserve to a member in an SMSF: which member account can the allocation be made to?

The ATO’s view on the use of reserves in an SMSF is outlined in their Regulator’s Bulletin, SMSFRB 2018/1 ‘The use of reserves by self-managed superannuation funds’, which was published on 15 March 2018.

On the whole, the contents of this Bulletin contained few surprises. However, there was one view stated in the Appendix at item 52 which presented a change in the ATO’s previously known view on allocations from a reserve:

  • An allocation cannot be made from the reserve to an existing account-based pension.

At Accurium we deal with a number of SMSFs who have unallocated reserves due to the cessation of the liability to pay an old defined benefit income stream. This can arise on the expiry of a life expectancy pension, or death of the final pensioner for a lifetime pension. With the pension liability ceased, the assets form an unallocated reserve in the fund. This unallocated reserve does not belong to a member account and cannot simply be paid out of the fund.

In order to reduce these reserves over time it is common for the less than 5% rule (under Reg 291-25.01 of ITAR 1997) to be utilised which allows for a trustee to allocate less than 5% of the value of each member’s total interest in the fund to an account for each. Prior to the publication of SMSFRB 2018/1 an allocation of monies from a reserve could be made directly to an account-based income stream.

For example, consider an SMSF which has two retiree members, one member with a non-reversionary lifetime complying defined benefit income stream, and a second member with an account-based income stream. If the member with the lifetime income stream passes away, the remaining assets that were supporting the defined benefit income stream will now remain an unallocated reserve in the fund. This cannot be paid as a superannuation death benefit without first allocating to a member interest. However, the trustee can use the reserve allocations rules to allocate up to just below 5% (noting if the allocation is 5% or more, then this concessional cap exemption will not apply) of the remaining member’s interest from the reserve to the account-based pension each year.

Prior to the release of this ATO Regulator’s Bulletin, the advice we had received from the ATO was that allocating from the reserve directly to a pension account in this way was acceptable. We understand that many clients have implemented the less than 5% rule in this way, and have seen SMSFs with very large balances implementing this strategy pass an audit by the ATO.

So what had changed?

We contacted the ATO for clarification on the view presented in the Bulletin that an allocation cannot be made from a reserve to an existing account-based income stream.

The Regulator’s Bulletin states that:
This strategy would attempt to gain a tax advantage by allocating capital into the retirement phase without triggering a transfer balance credit to the member, thereby having a greater amount of earnings being exempt current pension income.

In a response to our enquiry the ATO recognised there has been no change to the legislation around reserves, however, they noted that the integrity measures underpinning the transfer balance cap have meant they have used the Bulletin to identify how they will be applying their compliance approach to allocations from a reserve from 1 July 2017. 

Allocating amounts from a reserve directly to an income stream would circumvent the  transfer balance cap rules and this revised ATO view and requirement to first allocate to a member’s accumulation account eliminates this outcome. Any new retirement phase pension interest commenced with that accumulation balance will raise an associated transfer balance cap credit for the member.

How the ATO will apply this new approach

The ATO has confirmed to us that it will not be applying compliance resources to review allocations from reserves prior to 1 July 2017. So, for SMSFs that have allocated amounts from reserve directly to a pension interest, based on industry practice in 2016-17 or prior income years and the introduction of the transfer balance cap, there should be no compliance or income tax issue. 

Since 1 July 2017, the ATO expects to see allocations from reserves to be added to an accumulation interest of an member. You cannot allocate from a reserve directly to a member’s pension account. Where a member has pension interests and an accumulation interest then the total allocation from the reserve (up to just less than 5% of the member’s total interests) will need to be allocated to the member’s accumulation interest.

Implications of this new view

This change creates an additional administrative step for funds solely in pension phase with an unallocated reserve. The SMSF trustees may need to create a new accumulation interest for a member in order to receive an allocation from such a reserve. 

Also, where a member has an existing accumulation interest, the allocation from reserve will mix with the existing account and is likely to change the tax components. Consideration should be given to tax planning of income streams. For example, in some instances it may be preferable to maintain multiple pension accounts in order to retain favourable tax for particular beneficiaries.

Should you have any questions about defined benefit income streams and the use of reserves you can call us on 1800 203 123.

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