SMSFs paying market linked pensions (‘MLPs’) should carefully review the potential impact of recent changes to the transfer balance cap (‘TBC’) rules where an MLP that commenced prior to 1 July 2017 was commuted or restructured on or after that date.
The Treasury Laws Amendment (2019 Measures No. 3) Act 2019 (Cth) received royal assent on 22 June 2020 and is retrospective with effect from 1 July 2017. The new legislation impacts MLPs (ie, term pensions that meet the standards of reg 1.06(8) of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’)) that are also capped defined benefit income streams (‘CDBIS’) under s 294‑130 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’), ie, the MLP commenced in retirement phase before 1 July 2017.
We examine below how the new rules apply where an MLP that is a CDBIS is commuted. We also examine how ATO compliance scrutiny and/or adverse tax consequences may arise, unless timely action is taken. In particular, we note that many unsuspecting SMSF members receiving an MLP may have misreported their transfer balance account position, and thus, potentially be subject to a hefty excess transfer balance tax (‘ETB Tax’) assessment.
Background on CDBIS
Retirement phase pensions that qualify as CDBISs are subject to modified TBC rules. In broad terms, a CDBIS such as a pre-1 July 2017 MLP cannot, by itself, give rise to an excess transfer balance. This is the case even where the total market value of the assets supporting the MLP exceeds the usual $1.6 million TBC.
On the other hand, the statutory formula used to calculate the special value of an MLP that is a CDBIS typically inflates the value of the actual assets supporting the MLP (eg, the MLP factors assumed such things as a shorter life expectancy and higher earnings and inflation rates compared to what we have today). Thus, for members with an MLP account balance less than $1.6 million, this may result in valuable (transfer balance) cap space being effectively taken up by the MLP’s special value that could otherwise be used to commence one or more additional retirement phase income streams, eg, an account-based pension.
Another important aspect of MLPs that qualify as CDBISs is the tax treatment of the MLP payments in the member’s hands. Due to the operation of the defined benefit income cap in sub-div 303-A of the ITAA 1997, for members aged 60 or over, 50% of any pension payments above $100,000 is included in the member’s personal assessable income and taxed at their marginal tax plus the Medicare levy. This applies even if the amount comprised a tax free component.
Accordingly, there are certain drawbacks associated with receiving an MLP that is a CDBIS where the MLP has an account balance less than $1.6 million. Due to these issues, some clients have taken the opportunity on or after 1 July 2017 to restructure their MLP by commuting it and applying the commuted amount to commence a fresh MLP that no longer qualifies as a CDBIS, ie, so that their transfer balance is not overstated and to remove any income tax implications under the defined benefit income cap.
A problem with the commutation rules under the old law?
Prior to the above legislative change, the ATO asserted that the debit rules that originally applied to a commutation of an pre-1 July 2017 MLP (ie, an MLP that was also a CDBIS) produced a ‘nil’ value for TBC purposes. The explanatory memorandum to Treasury Laws Amendment (2019 Measures No. 3) Bill 2019 (‘2019 Bill’) provides relevant background information in relation to Treasury’s view of how the nil debit issue arose (see paragraphs [3.178]–[3.183]).
To provide a temporary practical work around to this nil debit concern, the ATO published CRT Alert 066/2018 on 3 August 2018. CRT Alert 066/2018 provided the following guidance to clients who had already commuted an MLP that was also a CDBIS and reported a non-nil debit via the ATO’s transfer balance account report (‘TBAR’) system:
We will not apply compliance resources, at this stage, where the fund has reported the transfer balance debit for the commutation as other than nil.
This ATO guidance provided no comfort however to members who commuted their MLP on or after 3 August 2018.
The legislative fix
Section 294-145 of the ITAA 1997 is amended to provide a new method of calculating the debit value on commuting an MLP that is also a CDBIS. More specifically, under the new rules the debit value for a commuted MLP just before the full commutation is the amount of the original transfer balance credit in respect of the MLP less the sum of the following amounts:
- the amount of any transfer balance debits in respect of the MLP before the commutation (other than a debit arising a family law payment split covered under item 4 of the table in s 294-80(1) of the ITAA 1997);
- the total amount of superannuation income stream benefits (ie, pension payments) the person was entitled to receive before the start of the financial year in which the commutation takes place; and
- the greater of:
- the sum of the superannuation income stream benefits paid during the financial year in which the commutation takes place; or
- the minimum amount required to be paid under regs 1.07B and 1.07C of the SISR during the financial year in which the commutation takes.
In the case of a partial commutation, the new rules provide that the transfer balance debit is the lesser of:
- the debit value that would arise if the commutation was a full commutation; and
- the amount of the superannuation lump sum that results from the partial commutation.
As noted above, these new debit rules apply retrospectively from 1 July 2017.
Example — fully commuting an MLP that qualifies as a CDBIS
The new rules are best illustrated with an example. The following example is taken from the explanatory memorandum to the 2019 Bill:
Example 3.1: Full commutation of a market linked pension
Daniel was the recipient of a market linked pension (MLP1) from before 1 July 2017 and this was the only superannuation income stream he was receiving on 1 July 2017. The transfer balance credit that arose in his transfer balance account on 1 July 2017 was $1,829,697 (being the special value of his market linked pension at that time).
In the 2017–18 income year, Daniel received superannuation income stream benefits from the pension totalling $91,485. In the 2018-19 income year, he received superannuation income stream benefits from the pension totalling $91,941 (the minimum amount required to be paid to Daniel under the regulations). The account balance of MLP1 as at 30 June 2019 is $1,218,994.
As at 30 June 2019, no transfer balance debits have arisen in Daniel’s transfer balance account in respect of his market linked pension.
Daniel fully commutes MLP1 on 30 June 2019. The debit that arises from this commutation is calculated as:
-
- the original transfer balance credit in respect of the pension ($1,829,697); less
- the amount of any transfer balance debits that have arisen in respect of the pension (nil); less
- the total amount of superannuation income stream benefits Daniel was entitled to receive before the start of the 2018–19 financial year ($91,485); less
- the greater of the superannuation income stream benefits Daniel has received in the 2018–19 financial year, and the minimum amount required to be paid to him under the regulations ($91,941).
Therefore, the debit that arises in Daniel’s transfer balance account as a result of the commutation is $1,646,271.
Due to the regulatory restrictions associated with market linked pensions, after the commutation, Daniel is required to commence a new market linked pension. As the new market linked pension (MLP2) is not a capped defined benefit income stream, the transfer balance credit that arises reflects its opening account balance of $1,218,994. Following this credit, Daniel’s transfer balance is $1,402,420. This figure is calculated as the net balance of Daniel’s transfer balance account after the following amounts have been accounted for:
-
- the original credit for MLP1; less
- the debit for MLP1; plus
- the new credit for MLP2.
That is $1,829,697 – $1,646,271 + $1,218,994= $1,402,420.
The ATO’s compliance approach — CRT Alert 031/2020
In response to the new debit rules, the ATO’s issued CRT Alert 031/2020 on 19 June 2020. The ATO provide the following guidance on its compliance approach:
As a result of these changes the ATO is reviewing its compliance approach where we had previously advised funds that we would not, at that time, take compliance action if a fund did not report the required transfer balance account events of the commutation and re-start a market linked pension, or reported a commutation amount other than nil to us.
Funds will need to review the information already reported to us and consider whether they need to amend any reporting in line with the legislation.
Acknowledging the focus that funds, agents and other tax professionals have at this time in responding to the Government’s stimulus measures and tax time, we do not intend to engage with funds on how this legislation impacts their reporting obligations until August 2020. We will not take compliance action against funds who do not review their reporting before this time.
Funds which identify that they will have a need to amend their reporting should not do so before engaging with us so we can work with them to manage the re-reporting.
Timely action required
SMSFs with members who have previously commuted an MLP that was also a CDBIS should have their TBC position carefully reviewed to ensure that the correct debit is reflected in their transfer balance account before the ATO follows them up (based on CRT Alert 031/2020 it appears that follow ups may occur from August 2020 onwards). Given the complexity of the new debit rules, in many cases funds will need to re-report the correct debit value based on the revised formula. This is likely to require the prior debit event to be cancelled and a new debit event reported as soon as practicable and prior to August 2020.
The new debit rules are far more complex than expected by many SMSF trustees and advisers. Many industry observers expected a more simple approach (eg, with the revised debit value being equivalent to the original (special value) credit recognised for an MLP that was in place on 30 June 2017) rather than the complex method which has appeared years after the issue was first discovered. Thus, reviewing prior TBAR reporting and taking action to re-report where appropriate is highly recommended to ensure that SMSF members are not subject to adverse ATO compliance scrutiny.
Moreover, there is some likelihood that fund members who have previously commuted an MLP that is also a CDBIS may have taken action (eg, commencing a fresh account-based pension) on the basis of them having more TBC cap space available than provided for under the revised debit rules. Thus, such members may have an excess transfer balance problem arising when they re-report with consequential ETB Tax liabilities.
Unfortunately, in the scenario where re-reporting results in an excess transfer balance this is likely to result in affected members being required to pay significant ETB Tax given several years of deemed excess transfer balance earnings would have deemed to arise. This ETB Tax is calculated on deemed or notional excess transfer balance earnings for the period when a member starts to have an excess transfer balance to when their transfer balance account is no longer in excess. Naturally, ignorance of these extremely complex superannuation and tax rules is no excuse!
The earnings that the member pays ETB Tax on currently reflect a deemed 7.1% (for the July to September 2020 quarter) of the excess transfer balance calculated on a daily basis (despite many investments recently decreasing in value and producing losses due to COVID-19).
Unfortunately, for many adversely affected members, these deemed excess transfer earnings may have been accruing for a number of years where the deemed earning rates have generally been considerably higher than 7.1%. Thus, some may soon be ‘hit up’ with hefty excess transfer balance assessments and will be annoyed that they will be asked to pay for faulty law and faulty administration. It is hoped that the ATO will see fit to remit any ETB Tax that did not arise from an oversight by the SMSF trustee or their advisers.
The ETB Tax rate is 15% on these deemed earnings from an excess transfer balance for FY2018. From 1 July 2018 onwards, the tax rate is 15% for first-time offenders and 30% for second and subsequent offenders.
As these assignments can be complex, SMSF and tax experts may be required. Naturally, DBA Lawyers would be pleased to assist both clients and their advisers including preparing objections and seeking a remission of any ETB Tax and any penalties of interest thereon.
Members wishing to restructure their MLP
Members who are still contemplating restructuring their existing MLP should obtain expert advice prior to undertaking any action. This advice should at a minimum cover the following:
- tax advice on the TBC and the defined benefit income cap implications of any restructure;
- superannuation law advice on the succession planning implications of restructuring the MLP including whether it should be made non-reversionary to provide the surviving spouse with access to greater cash;
- actuarial input on the different term scenarios that are available for a new MLP;
- advice on whether there are any adverse social security implications (ie, in respect of Centrelink or the Department of Veteran Affairs), or the Commonwealth Seniors Health Card;
- financial product advice under the Corporations Act 2001 (Cth) in relation to any commutation of the MLP and any new MLP that may be commenced, including the financial and cash flow impacts; and
- any other items to consider including making sure the right documents are completed.
Conclusions
Dealing with MLPs and legacy pensions such as lifetime, fixed term and flexi-pensions involves considerable complexity and often requires input from a range of experts. This is an area where appropriate advice should be obtained prior to making an important decision to commute or restructure one of these pensions.
Related articles
- Check your market linked pension strategy!
- Is there any benefit in commuting a market linked pension from 1 July 2017?
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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 Network Pty Ltd hold a range of SMSF CPD training online. The next live SMSF Online Update webinar is being presented on 4 September 2020. For more details or to register, visit www.dbanetwork.com.au or call Natasha on 03 9092 9400.
By William Fettes, Senior Associate ([email protected]) and Daniel Butler ([email protected]), Director, DBA Lawyers
DBA LAWYERS
3 August 2020
