Co-authored by Daniel Butler, Director, DBA Lawyers
Due to the complexity of the rules and the importance of complying with the law in relation to the pension exemption, we examine the two methods for calculating ECPI in respect of account style pensions (ie, account-based, allocated and market linked pensions) under the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’) in the SMSF environment. A sound understanding of the ECPI method is required to manage and correctly apply the transitional CGT relief provisions in relation to FY2017.
The main ECPI provisions are set out in ss 295-385 and 295‑390 of the ITAA 1997. These provisions provide the foundation for working out how much of the ordinary and statutory income of an SMSF (ie, income other than assessable contributions and non-arm’s length income) is exempt from tax when the fund is paying a pension. (We generally refer to the term pension for simplicity as the correct tax term is superannuation income stream.)
Naturally, it is important to understand both the segregated and the unsegregated methods of calculating ECPI to ensure SMSFs are appropriately treated for tax purposes where one or more pensions are being paid. This understanding is also essential for compliance with the transitional CGT relief provisions. Unless the two ECPI methods are correctly understood and applied, SMSFs may miss out entirely on CGT relief.
From 1 July 2017 a pension must be in retirement phase to obtain an ECPI exemption. A transition to retirement income stream (‘TRIS’) will no longer be entitled to an ECPI exemption from 1 July 2017 as a TRIS will no longer be eligible to be in retirement phase.
We also note that the law and actuarial, industry and ATO practice differs considerably. Thus, careful analysis is required to ensure the correct application of the law is made in each instance.
The unsegregated method is the most commonly used method for determining ECPI. Under this method, no particular SMSF assets have been set aside or identified as supporting pensions paid by the fund, and the fund’s exemption is calculated using the following prescribed formula:
Average value of current pension liabilities
Average value of superannuation liabilities
- the numerator (ie, the top line above) averages the current value of pension liabilities in that financial year (‘FY’) (this does not include liabilities for which segregated current pension assets are held); and
- the denominator (ie, the bottom line above) averages the value of the fund’s current and future superannuation benefit liabilities (this does not include liabilities for which segregated current pension assets or segregated non-current assets are held).
Under the unsegregated method, an actuary must certify the exempt proportion of assessable income of the fund each FY in accordance with the above formula. In applying the formula, the actuary will broadly have regard to, among other things, the average balance, contributions, earnings and the days during a FY that the average balances are held in the fund.
The unsegregated method does not require any special changes to a fund’s accounting system. There is generally an actuarial certificate and possibly some other supporting records such as trustee resolutions consistent with a fund using the unsegregated method.
Some of the reasons for using the unsegregated method include:
- The record keeping requirements associated with this method are generally less onerous than for the segregated method. There may, therefore, be less administration and associated cost savings using this method (rather than the segregated method). Indeed, this is by far the most popular method in practice.
- Capital losses are not lost (as they are under the segregated method).
- The fund may be precluded from applying the segregated method from 1 July 2017 under the new rules (see below for further discussion of this restriction).
The segregated method is where the investments of a fund are allocated between assets that are being used solely to provide pensions (these assets are known as segregated current pension assets) and other assets (such as assets in accumulation phase).
There are broadly two ways that ECPI segregation could apply:
- active or actual segregation whereby certain fund assets are specifically set aside to fund current pension liabilities; or
- deemed or de facto segregation whereby all of the assets of the fund are supporting current pension liabilities.
Active segregation is not that common and a considerable number of SMSFs are segregated as a result of being deemed segregated (ie, 100% of fund assets are funding pension liabilities).
Active segregation depends on appropriate record keeping. For example, it would be best practice to have:
- trustee resolutions recording:
- the specific assets that have been specifically identified as funding the pension liabilities; or
- the specific assets that are not funding pension liabilities, eg, an SMSF may have all of its assets funding a pension apart from certain assets which are not funding a pension. It may be easier to record the non-pension assets (eg, cash in a separate bank account) rather than the pension assets which may be far more comprehensive (eg, a diversified portfolio of investments);
- assuming less than 100% of the fund is segregated — accounting records or computer systems that are set up to track the income/losses, capital gains/losses, tax entitlements and other aspects relating to the assets funding pensions (or as noted just above, the non-pension assets if this is easier); and
- possibly other documentation which evidences segregation including a statement or letter of advice, financial statements, tax returns, a fund’s investment strategy, etc.
As already noted, deemed segregation is possibly the more common form of ECPI segregation and there may not be any records evidencing this type of segregation.
As discussed above, under active segregation, the fund’s accounting system needs to track the income/losses, capital gains/losses, tax entitlements and other aspects relating to the assets funding pensions. More specifically, the accounting system needs to be able to track not only the income/losses, changes in market values of assets, gross and net capital gains and franking offsets, foreign tax credits and other tax attributes of the fund’s segregated assets.
In contrast, under deemed segregation, there is no specific tracking needed as 100% of the fund’s assets are funding pension liabilities at that time.
Some of the reasons for using the segregated method may include:
- Can result in more efficient tax management of the tax exemption provided to income and capital gains from pension assets, eg, an asset likely to give rise to a significant capital gain can be segregated and hence the gain can be realised tax free.
- Allocating investments to a member’s account may assist keeping separation of ‘who owns what’, eg, some couples like to keep financial separation.
- There is no requirement for an actuarial certificate.
Can segregation be for part or does it have to be for an entire FY?
The ATO has confirmed that an SMSF can be segregated for part of a financial year (‘PFY’). The following is a recent extract (with minor edits) from the ATO’s website (reference QC 47029):
Where an SMSF is paying only a pension prescribed by the superannuation regulations, most commonly an account-based pension, including a TRIS from segregated assets, an actuarial certificate is not required. This exemption applies to an SMSF, even where it commences to pay an account-based pension during the year. The only exception is where the SMSF is also paying pensions not prescribed by the regulations, where the fund can still have segregated assets but will be required to get an actuarial certificate.
This change [in ATO view] will be reflected in a soon to be published addendum to TD 2014/7.
However, some may get the impression from other ATO materials that segregation is required for the entire financial year (‘EFY’) if they review this extract of the ATO’s website (reference QC 21546; it is a pity that these two extracts are not linked as not all users will readily come across both webpages in their research):
Where all SMSF fund members are receiving a pension, for the entire year of income and the combined account balances of these pensions is equal to the market value of the fund’s total assets, in effect all assets of the fund will meet the requirement of being ‘segregated’ as they have the sole purpose of paying super income stream benefits. In this situation, the ATO will accept that the SMSF is not required to identify individual assets as being dedicated to funding a super income stream benefit. You will not need to obtain an actuarial certificate to claim ECPI if:
- you want to claim the tax exemption using the segregated assets method,
- the assets were segregated for the entire year of income
- at all times that pensions were payable during the income year, the SMSF only paid allocated pensions, market-linked pensions or account-based pensions, and no other type of pension.
We note that s 295-385(3) of the ITAA 1997 recognises that assets can be segregated assets for a PFY as the provision states ‘at a time assets are solely funding pensions …’ provided an actuarial certificate is obtained.
In contrast, s 295-385(4) provides that segregated assets supporting account style pensions ‘at a time’ do not require an actuarial certificate provided sub-s 295-385(5) is satisfied. It is interesting to note that s 295-385(5) provides that sub-s 295-385(4) ‘does not apply unless, at all times during the income year’ the liabilities are in respect of account style pensions.
The ATO at  in Taxation Determination (‘TD’) 2014/7 while not expressly confirming that PFY segregation in this TD is available, states:
- Subsection 295-385(4) applies, subject to segregation requirements, when the liabilities of the fund to pay superannuation income stream benefits during an income year are liabilities to pay only superannuation income stream benefits that are prescribed by the regulations. …
As noted above, the ATO website extract does confirm that segregation for PFY applies (reference QC 47029). The ATO issued the above paragraph 42 as an addendum to clarify this position. However, it is only by contrasting the wording in the current paragraph 42 in the addendum to the prior wording in the original determination that provides a clue of the ATO’s revised position where it accepts PFY segregation.
- Subsection 295-385(4) applies when the liabilities of the fund are to pay only superannuation income stream benefits prescribed by the regulations for the whole income year and there are no liabilities to pay any other kind of superannuation income stream benefits. This requirement is clearly stated by subsection 295-385(5).
Thus, based on the ATO materials, we conclude that:
- s 295-385(3) supports PFY segregation but this subsection is relevant where an actuarial certificate is obtained, eg, the fund has lifetime or life expectancy pensions; and
- ss 295-385(4) and 295-385(5) supports PFY segregation where the pensions are account-based pensions or TRISs (refer to the ATO’s website clarification and the revised paragraph 42 in the addendum to TD 2014/7 and this TD has the force of a public ruling).
We will now examine several examples.
Example — a segregated fund
The Charlie Super Fund is entirely (100%) in accumulation phase for the first 4 months of FY2017. Charlie is the sole member of the fund which has $1.65m in accumulation.
Charlie however decided to commence a pension on 1 November 2016 so he would be entirely (100%) in pension mode for the remainder of FY2017.
The segregated CGT relief applies where an asset of the fund was segregated on 9 November 2016. This is the case as the fund was deemed to be segregated on that date under the ATO view that all (ie, 100%) of the fund’s assets were supporting pension liabilities that that time. Further, there is no need for an actuarial certificate having regard to the above analysis as the ATO accept that PFY segregation applies (see the addendum to TD 2014/7 inserting new paragraph 42).
If an SMSF was segregated for PFY and then unsegregated for the remainder of that FY (ie, PFY segregated and PFY unsegregated) an actuarial certificate would be required to claim an ECPI exemption under ss 295-390(3)–(5) but the segregated assets are excluded. The formula in s 295-390(3) excludes segregated current pension assets from the numerator, and segregated non-current assets from the denominator.
Example — an unsegregated fund
Mrs Spin, being the sole member of the Spin Super Fund, is entirely (100%; so deemed segregation applies) in pension mode from 1 July 2016. Mrs Spin has $1.8m in an account-based pension.
However, she makes a contribution on 20 June 2017 which converts her SMSF to an unsegregated fund.
An actuarial certificate is required and, broadly, the earnings in respect of the PFY (ie, 1 July 2016 to 19 June 2017 inclusive) segregation period should be exempt. Broadly, the earnings from 20 June 2017 to 30 June 2017 (inclusive) will be exempt to the extent of the unsegregated proportion as certified by an actuary.
Now, analysing the CGT relief, the segregated CGT relief applies where an asset of the fund was segregated on 9 November 2016. This is the case as the Spin Super Fund was deemed to be segregated on that date under the ATO view that all (ie, 100%) of the fund’s assets were supporting pension liabilities at that time.
Since an actuarial certificate is required for the Spin Super Fund’s ECPI, many may be led to believe (or fall into the trap) that the unsegregated CGT relief applies since there is an amount of unsegregated ECPI. In particular, one key criterion of the proportionate CGT relief applying is s 294‑115(1)(b) of the Income Tax (Transitional Provisions) Act 1997 (Cth) (‘ITTPA’) which provides:
ATO view on the segregated method
The ATO holds the view that an SMSF that is solely (ie, 100%) in pension phase at any time during a FY, has segregated current pension assets at that time; even if this was one day (for the purposes of s 295-385). This view gives rise to no great issue for SMSFs that are 100% in pension phase for the EFY. However, we understand that it would potentially give rise to considerably more work and costs (especially by advisers, such as accountants and actuaries), where an SMSF may, for example, be partly in accumulation phase and partly in pension phase for a period of a FY (say where only one member is in pension), then becomes entirely in pension phase for a period of the same FY (say where the second member commences a pension), and then changes back to partly in accumulation phase and partly in pension phase for a further period of the same FY (eg, say after a contribution is received prior to 30 June).
We understand that the ATO/strict legal view differs from current actuarial practice, where actuaries generally treat a fund as being unsegregated for the EFY in factual situations similar to this example. This practice avoids considerable cost and work. For example, interim accounts would first need to be prepared for each of the three stages so the actuary could undertake a calculation to determine the exempt proportion after excluding the segregated period (in between the two unsegregated periods in that FY).
Naturally, this mismatch between law and practice, is unfortunate and may result in unintended consequences. Interestingly, if there was a legal dispute on what is the construction of the law here, an actuary would be called as an expert witness on how the law applies in practice.
What are segregated non-current assets
Moreover, further unintended consequences may follow from the ATO view that segregated non-current assets include accumulation accounts: see LCG 2016/8 at footnote 3 which states:
 The segregated current pension asset pool supports superannuation income streams (subsections 295-385(3) and 295-385(4) of the ITAA 1997). The segregated non-current asset pool supports accumulation interests (subsection 295-395(2)).
This would result in many unsegregated funds becoming disqualified from any transitional proportionate CGT relief. The ATO in LCG 2016/8 at [21A], [29C] and  confirm the following:
- If a fund is using, and continues to use, the proportionate method throughout the pre-commencement period, it may choose CGT relief for a CGT asset provided:
- throughout the pre-commencement period, the asset was not a segregated current pension asset or a segregated non-current asset,
Thus, the ATO’s LCG is at cross-purposes. It first states that the proportionate CGT relief is not available if the fund has any segregated non-current asset (see, eg, paragraphs [21A], [29C] and ) and then states that a segregated non-current asset is equivalent to an accumulation interest at footnote 3. If the ATO’s logic was correct:
- since most unsegregated funds also have some accumulation interest, on the ATO’s own reasoning, the vast majority of unsegregated SMSFs would not be entitled to any proportionate CGT relief; and
- furthermore, an SMSF that is entirely in accumulation mode would require an actuarial certificate.
To confuse things even more, we understand that computer software systems and actuarial practice may not be aligned with the above analysis and there may be further differing practices and views at play. Therefore, advisers need to carefully check that they are applying the ECPI and CGT rules correctly and do not simply accept what is produced by their computer software or actuarial service provider.
Thus, this complexity may well result in SMSF trustees and their advisers choosing the wrong CGT relief method. As discussed below, this is a very complex and technical area of the law that involves actuarial expertise, legal analysis and a sound understanding of ATO practice. This area is in need of an urgent legislative simplification. Failing that, we hope the ATO may resolve the issues that are likely to arise by issuing a new practical compliance guideline along the lines that the ATO will not apply its administrative resources to reviewing whether a particular fund has chosen or applied the correct ECPI or CGT relief method in accordance with the strict letter of the law or different actuarial practice. One would hope that if an SMSF trustee or adviser, in good faith, relies on an actuary or SMSF expert (who has expertise in respect of ECPI and CGT relief) that they should not be subject to any adverse consequences.
Indeed, arguably expert tax, actuarial, financial product, accounting, legal and commercial advice should be obtained before a choice is made in respect of claiming any CGT relief, so an adviser who provides advice will not be subject to any future legal action for advising on a choice that may require a skill set that is outside their expertise.
Changes from 1 July 2017
From 1 July 2017, both methods of ECPI will be subject to the new requirement that the relevant pension is in retirement phase. TRISs are expressly excluded from being in retirement phase. Accordingly, account-based pensions will be tested for the transfer balance cap, but not TRISs.
Additionally, certain SMSFs will be precluded from using the segregated method to determine their exempt income from 1 July 2017. This restriction will apply to an SMSF where a member of the fund has a superannuation interest in tax free retirement phase and a total superannuation balance in excess of $1.6 million. Note that s 295-387(2)(c) expressly states that the total superannuation balance threshold is ‘$1.6 million’ rather than the general transfer balance cap, so this $1.6 million threshold will not be indexed in the future.
Transitional CGT relief
The transitional CGT provisions in sub-div 294‑B of the ITTPA rely on an understanding of both ECPI methods in ss 295-385 and 295-390 of the ITAA 1997. In particular, the CGT relief provisions broadly work on a point in time basis for the purposes of the pre-commencement period which is 9 November 2016 to just before 1 July 2017.
Accordingly, funds that were 100% in pension phase on 9 November 2016 (including funds with members in TRIS phase prior to 1 July 2017) are deemed to be segregated at the relevant time and are potentially eligible for the segregated CGT relief that applies to SMSFs which are under the segregated ECPI method on 9 November 2016. If the segregated CGT relief applies, a cost base reset occurs for elected assets at the time that the relevant asset ceases to be a segregated current pension asset of the fund applies and any notional capital gain is fully disregarded.
In contrast, funds that were not segregated on 9 November 2016 will potentially be eligible for the proportionate CGT relief that applies to SMSFs using the unsegregated method. If this relief is enlivened, the fund will need to account for the non-exempt portion of any notional capital gain on any elected assets in the fund’s FY2017 tax return, or opt to defer this notional capital gain indefinitely until such time as the relevant asset is disposed of by the SMSF trustee. One danger however arise, based on the ATO view discussed above, is where an SMSF that is unsegregated on 9 November 2016 becomes solely (100%) into pension phase before 1 July 2017 (eg, dad was in pension from 1 July 2016 and then mum moved into pension after 9 November 2016 and before 30 June 2017). Under this scenario, the SMSF would be entirely precluded from any CGT relief as the fund had a segregated current pension asset during the pre-commencement period.
Ceasing to be segregated –– CGT relief
SMSFs that were segregated on 9 November 2016 must ensure the relevant fund asset ceases to be a segregated current pension asset prior to 1 July 2017.
Typically this is evidenced by a trustee resolution and where a commutation is involved, the ATO in Practical Compliance Guideline (‘PCG’) 2017/5 has confirmed that a commutation can be documented even though the value of the member’s superannuation interests are not available on 30 June 2017, subject to a number of qualifications. DBA Lawyers commutation documents satisfy PCG 2017/5.
This pre-1 July deadline applies to an SMSF to ensure that an asset ceases to be segregated prior to 1 July 2017 despite an SMSF having up to the lodgement date of its FY2017 tax return to complete the choice in the approved form. (We still await the ATO to issue this approved form.)
A ‘perfect storm’ in the making and part IVA?
The above ingredients have the potential for the making of a ‘perfect storm’ whereby potentially many SMSF trustees may lose out unless they correctly apply the CGT relief within the prescribed deadlines.
We therefore recommend the CGT relief provisions be simplified and further time be permitted to comply with the transitional CGT relief. The CGT provisions combine, among other things, complex legal, tax, actuarial and superannuation rules and the time and complexity of getting a sound understanding of these rules, let alone implementing the CGT relief appropriately and on time is an extremely difficult task for many advisers. Moreover, SMSFs will incur considerable costs in seeking appropriate advice to cover off each skill set. Thus, unless the rules are simplified, many SMSFs may be dissuaded from making a choice due to the complexity and costs involved.
Furthermore, the explanatory memorandum to the Bill that became the Treasury Laws Amendment (Fair and Sustainable Superannuation) Act 2016 (Cth) and the ATO’s comments in LCG 2016/8 on pt IVA of the Income Tax Assessment Act 1936 (Cth) relating to the general (tax) anti-avodiance provisions is making the application of the transitional CGT relief more difficult in practice, and further guidance on what is possible without being subject to pt IVA is required to ensure there is greater certainty in applying CGT relief.
Understanding the ECPI and transitional CGT relief provisions is critical to ensure that SMSF assets are appropriately treated. Hopefully some relief from the complex rules will soon eventuate.
Related articles and resources
DBA Lawyers has created a CGT Relief Kit for SMSFs to provide practical guidance to advisers and SMSF trustees on the transitional CGT relief measures. For further information about this resource see here:
For those advisers who would like to have training on this important topic, we also offer a dedicated webinar on the transitional CGT relief through DBA Network. See here for further information:
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.
For more information regarding how DBA Lawyers can assist in your SMSF practice, visit www.dbalawyers.com.au.
30 May 2017 – revised article issued 1-6-2017