TechHub

Beware of the effect of ECPI on deductions


Article was first published in selfmanagedsuper magazine issue 038

One of the significant benefits of starting a retirement phase pension is the tax free status of the income associated with the pension, referred to as exempt current pension income or ECPI. Whilst the rules for how an SMSF can calculate and claim ECPI have changed from the 2021-22 income year, where an SMSF has ECPI it needs to be aware of the affect a claim for ECPI may have on fund income tax deductions.

When deductions must be apportioned

Where an SMSF claims ECPI, expenses which it incurs in deriving ECPI are not deductible. Many fund expenses will be incurred in deriving both assessable and exempt income and consequently must be apportioned, so that only that portion that relates to the derivation of assessable income is claimed as an income tax deduction.

Some fund expenses, particularly those that have specific income tax provisions, can be claimed in full, despite a portion of the fund’s income being treated as exempt. The ATO sets out in their taxation ruling TR 93/17 the income tax deductions available to superannuation funds, including the methods to apportion expenses between deductible and non-deductible, where the fund has derived exempt income.

ECPI will also have an effect on any brought forward tax loss. A brought forward tax loss must be first reduced by net ECPI before being applied against fund assessable income.

Which expenses to apportion?

Expenses which are claimed under the general deduction section 8-1 are required to be apportioned. Where there is a specific provision in the Tax Act, reference must be made to the specific provision to ascertain if there is a requirement to apportion the specific deduction where the fund derives exempt income.

Deductible fund expenses can be categorised as follows in relation to whether they need to be apportioned where the fund derives exempt income:

Apportioned Not apportioned
s.8-1 general expensesS.25-5 tax related expenses
Div 40 capital allowance (depreciation)S.295-460 insurance premiums
Div 43 deduction for capital worksS.295-470 future service liability deduction
S.70B (1936 Act) loss on traditional securities (also refer ATO ID 2014/16)

Common SMSF expenses can be classified as follows:

S.8-1 general expensesS.25-5 tax related expenses
Accounting & administration feesTax agent fee
Audit feesActuarial fee for ECPI tax certificate
Bank chargesATO SMSF levy
Investment costs & management feesTax advice fee
Cost to amend SMSF trust deed (updating)
ASIC annual return fee
Legal fees (complying with income tax obligations)

Approach to apportioning

When claiming general expenses (under section 8-1 ITAA 1997) that have been incurred partly in gaining assessable income and partly in gaining exempt income, for example, when a SMSF has a member or members with both retirement phase interests and non-retirement phase interests, you can again refer to TR 93/17 for guidance on apportioning expenses.

Paragraph 7 of TR 93/17 states that:

The correct method for apportioning expenditure between assessable income and non-assessable income depends on the particular circumstances of the case. If there is a single outlay in respect of a thing or service, only part of which is used for gaining or producing assessable income, then the following principles apply:

  1. if a distinct and severable part of the thing or service is devoted to gaining or producing assessable income and part is not, the expenditure can be apportioned according to the ratio of those parts; and
  2. if an outlay serves both objects indifferently, another method must be used to apportion the expenditure which gives a fair and reasonable assessment of the extent to which it relates to assessable income.

In relation to expenditure of an indifferent nature, the ruling provides two apportionment methods.

1. Apportionment for expenses incurred in deriving investment income only:

Expenditure x (assessable investment income/total investment income).

From a practical perspective, this is commonly referred to as the actuarial method and effectively apportions the total expense by first deducting the actuary’s ECPI% from 100% and applying the resultant to the total amount of the deductible expenditure. For example, the ECPI% is 70% and the fund incurred total investment expenses of $200. The portion of the total deductible expense that can be claimed is $60, being 30% (100% minus 70%) of $200.

2. The income ratio method for apportionment of expenses that are general in nature:

Expense amount x (assessable income/total income)

Assessable income, for the purpose of the above formulae, includes all contributions to the fund (assessable and non-assessable) and rollovers (refer paragraph 9 & 9A of TR 93/17).

Example

The following example demonstrates that simply utilising the Actuary ECPI percentage to claim such general expenses will result in an under claimed tax deduction.

A fund was notified by the Actuary of ECPI % of 70% and has:

  • $3,000 of investment expenses;
  • $5,000 of general expenses;
  • $17,100 of assessable contributions;
  • $200,000 of non-concessional contributions;
  • $1,239,000 rollover into the fund;
  • $11,494 of assessable interest income

Claim for ECPI will be $8,046 (70% of $11,494)

Claim for investment expenses will be $900 applying the actuarial method: {(100% – 70%) x $3,000}

Claim for general expenses will be $4,973, using the income ratio method:

{$5,000 x (($11,494 + $17,100 + $200,000 + $1,239,000) – $8,046)}

                                ($11,494 + $17,100 + $200,000 +$1,239,000)

If you applied the actuarial method to the $5,000 of general expenses, the deduction would be only $1,500. An underclaim of expenses may not concern the ATO, but the SMSF client may not be too pleased. Obviously, where an SMSF does not have any non-assessable contributions or rollovers in an income year, the effective deductible portion applicable to expenses claimed under the general deduction 8-1 provision will be the same under both the actuarial and income ratio method.

Periods of mixed interest + period of deemed segregation

For an SMSF that claims ECPI under both the segregated and proportionate method in the same income year, this presents a challenge when apportioning expenses for the purpose of claiming as an income tax deduction. This would apply where the SMSF does not have disregarded small fund assets and does not make the choice for assets held during a period of deemed segregation not to be treated as segregated current pension assets.

When apportioning expenses (those expenses that must be apportioned) the basic principle to apply is that any method used is fair and reasonable. The following approaches to apportioning expenses, where an SMSF claims ECPI under both methods, can be considered:

Expense relates to asset during period not deemed segregated (an investment expense):

  • Expense x (100% – ECPI%) – the actuarial method

Expense relates to asset solely to deemed segregated period (investment expense):

  • Expense not deductible

Expense relates to asset during both unsegregated & deemed segregated periods (investment expense):

  • Expense x (100% – ECPI%) – this is actually not appropriate as only applies to unsegregated period. Actuarial providers may include on the actuarial ECPI certificate an expense percentage that can be used to apportion expenses that relate to assets (investment expenses) for periods when the asset was deemed segregated and other periods the asset was an unsegregated asset.

Expense not related to particular asset or income type (general expense):

  • Income ratio method from TR 93/17

Example

The Friendly Family Super Fund is an SMSF. It starts the 2021-22 income year with two members, one in retirement phase and the other not. The non-retirement phase member commences a retirement phase pension on all of their benefits in the SMSF in October 2021. Consequently, from that time the SMSF consists wholly of retirement phase interests. However, at the start of February 2022, the fund admits four members who rollover their benefits into the SMSF. These benefits remain in accumulation – non-retirement phase interests.

This and fund income, can be represented as follows:

The SMSF does not have disregarded small fund assets and has not made the choice to treat assets held during the period of deemed segregation not as segregated current pension assets. Consequently, it will claim ECPI using both the segregated and proportionate method for the 2021-22 income year. The fund has acquired the relevant actuarial certificate to cover the periods of unsegrgeated assets, which includes an ECPI percentage of 71.07% and a deductible percentage to apply to expenses that can’t be attributed to solely producing assessable or exempt income of 22.048%.

In additon to the assessable income for each period, as outlined above, the fund has received during 2021-22 total assessable contributions of $6,500 and total rollovers of $956,800.

The fund has incurred expenses of which some relate to income earned from investments and some relate to the fund as a whole. Let’s consider how those expenses are apportioned:

Depreciation of $15,650: related to income from investment assets + covers entire income year:

  • Deductible per Division 40 ITAA 1997 → requires apportionment where derived exempt income;
  • Relates to fund asset, being the rental property;
  • Covers both periods of unsegregated assets + deemed segregation (the entire income year).

Use actuarial provided deductible portion of 22.048% that has been calculated taking into consideration the whole income year.

  • $15,650 x 22.048% = $3,450

If ECPI percentage of 71.07% was used to apportion the expense, this would result in an amount of $4,528 being claimed, which is greater than the above amount of $3,450. This would be an incorrect (over) claim for depreciation as the 71.07% only applies to the unsegregated periods and does not take into account the period of deemed segregation. When the period of deemed segregation is taken into consideration, this increases the ECPI percentage and conversely decreases the deductible proportion of the expense.

Accounting fees of $2,320: Not related to any income from fund assets + covers entire income year.

Apply income ratio method:

$2,320 x [($6,500 + 0 + $956,800 + $153,345) – $122,5951]
                          ($6,500 + $0 + $956,800 + $153,345)

= $2,065

Rental property expenses of $1,200: related to income from investments + covers deemed segregated period only.

Deductible portion = $0 → incurred during period of deemed segregated → all incurred in earning exempt income → non-deductible.

Rental property expenses of $2,600: related to income from investments + covers both unsegregated periods.

Deductible portion → apply actuarial method using ECPI% that applied for that period

$2,600 x (100% – 71.07%) = $752

Rental property expenses of $2,950: relates to income from investments + covers entire income year.

Deductible portion → apply actuarial provided deductible portion of $22.048%

$2,950 x 22.048% = $650

Review and understand your SMSF admin platform

It is the responsibility of the preparer to determine whether this proportion is fair and reasonable for each relevant fund expense. This will include understanding how the SMSF admin platform treats expenses when an SMSF has ECPI, how expense accounts should be set up in the platform to ensure apportioning is only applied to those expenses where it is required, and where apportionment is required, the relevant apportioning approach is applied.

1. ECPI claim = [(($47,054 + $59,237) x 71.07%) + $47,054] = $122,595

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