The Federal Government’s October 2012 Mid-Year Economic and Fiscal Outlook (‘MYEFO’) included an important announcement that provided a great boost of confidence to the SMSF industry.
Namely, with effect from 1 July 2012, a tax exemption will apply following the death of an SMSF member in receipt of a pension until that pension has been paid out of the fund. That is, the ‘pension exemption’ will continue following a member’s death.
This announcement has caused many to question the necessity of ‘auto-reversionary’ pensions (‘ARPs’).
What is an auto-reversionary pension?
Broadly, what is colloquially referred to as an ARP is a pension that is structured to automatically revert to one or more dependent beneficiaries upon a pensioner’s death.
Not all reversionary pensions are ARPs.
The recent popularity of ARPs
In TR 2011/D3 the ATO stated that:
A [pension] ceases as soon as the member in receipt of the [pension] dies, unless a dependent beneficiary of the deceased is automatically entitled under the superannuation fund’s deed, or the rules of the [pension], to receive [a pension] on the death of the member.
With correct documentation in place, it is possible for the member’s pension to be structured so that upon death it automatically continues.
The release of TR 2011/D3 caused considerable concern within the industry.
Implications of TR 2011/D3 — pension exemption
Consider an SMSF with a member who is currently receiving a pension. Due to the pension income tax exemption in subdiv 295-F of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997), the SMSF probably has not paid any income tax, including capital gains tax (‘CGT’), for a number of years. Now assume the member dies.
The SMSF assets might be carrying a large, unrealised capital gain. The Superannuation Industry (Supervision) Regulations 1994 (Cth) require that the deceased member’s benefits be cashed as soon as practicable after death. Accordingly, the assets might either be transferred out of the SMSF in specie or alternatively the assets might be sold and the proceeds used to pay out the death benefit.
Either way, the SMSF will have a CGT event. Under the view in TR 2011/D3, there is no longer any pension and thus there is no longer any pension exemption. Accordingly, the CGT event could result in a significant tax bill for the SMSF.
Implications of TR 2011/D3 — mixing of interests
In an SMSF environment, a member is generally required to have one or more separate pensions to have more than one superannuation interest.
For example, consider Joanne. Joanne might have two pensions in her SMSF that do not automatically revert upon her death. One of these pensions is comprised entirely of the taxable component and one is comprised entirely of the tax free component.
Under the approach in TR 2011/D3, the default position is that these pensions cease upon Joanne’s death. In this case the two interests would merge and there would then be one interest comprised half of the taxable component and half of the tax free component.
The above gives rise to succession planning and adverse tax concerns.
The MYEFO announced that:
The Government will amend the law to allow the tax exemption for earnings on assets supporting superannuation pensions to continue following the death of a fund member in the pension phase until the deceased member’s benefits have been paid out of the fund.
The above is to have effect from 1 July 2012. Further, it is subject to the existing superannuation law requirement that a member’s benefits be cashed as soon as practicable following their death.
As noted above, the extension of the pension exemption following the death of the member will apply from 1 July 2012. However, TR 2011/D3 applies from 1 July 2007.
This means that for pensioners who died on or prior to 30 June 2012, unless they had an ARP, the ATO consider that the pension exemption ceased on the pensioner’s death.
Are ARPs still required?
The MYEFO announcement is positive and has given rise to the question: once the MYEFO extended pension exemption announcement becomes law, will an ARP ‘locked in’ reversion still be required? The answer is twofold.
Moving forward, an ARP will not strictly be required for the pension exemption to continue beyond a pensioner’s death. However, an ARP was required for pensioners who died on or before 30 June 2012.
That being said, considering the proportioning rule in s 307-125 of the ITAA 1997, there can be significant advantages to ensuring each pension is an ARP.
Broadly, the proportioning rule prevents ‘cherry picking’ of the tax free or taxable component when paying out a benefit; a benefit paid must reflect the proportion of underlying (tax free and taxable) components.
As discussed above, given the ATO’s views in TR 2011/D3, the death of a pensioner with two or more interests may result in the merging of interests. This could result in mixed taxable and tax free components, which cannot be separated or untangled again.
The announcement in the MYEFO does not address this aspect.
Ensuring ARPs exist in respect of each pension will ensure that each interest remains separate until they are cashed and will thus overcome this risk.
Setting up an ARP
Most reversionary nominations are mere wishes and are not binding. Thus to implement an ARP a ‘locked in’ reversionary nomination must exist.
Typically, in an SMSF this requires a special deed that facilitates a nomination that binds a trustee’s discretion (ie, an effective fetter binds a trustee’s discretion based on a specific power in the deed).
Alternatively, the ARP can be facilitated by a binding death benefit nomination (‘BDBN’) that specifies not just to whom the death benefit is to be paid (eg, to spouse) but also how (eg, as a pension).
(DBA provides such a template BDBN with all of its deed updates and new super fund documents.)
Expert advice should be sought if an ARP is being considered.
The announcement in MYEFO is great news for the SMSF industry. However, there are still reasons to ensure a pension is an ARP to protect against adverse tax consequences.
Quality SMSF documentation is a key factor in achieving an effective strategy.
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DBA News contains general information only and is no substitute for expert advice. Further, DBA is not licensed under the Corporations Act 2001 (Cth) to give financial product advice. We therefore disclaim all liability howsoever arising from reliance on any information herein unless you are a client of DBA that has specifically requested our advice.