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When advisers hear the word \u2018segregation\u2019 in an SMSF context, they typically think of segregation for tax purposes. Broadly, this type of segregation involves calculating a fund\u2019s exempt current pension income exemption for a financial year under the segregated method, with any capital gains (or losses) in respect of \u2018segregated current pension assets\u2019 being disregarded.<\/p>\n
Segregated current pension assets are fund assets excluding \u2018disregarded small fund assets\u2019 that are invested, held in reserve or otherwise dealt with solely to enable a fund to discharge all or part of its liabilities in respect of retirement phase pensions. Most commonly, segregated current pension assets arise where 100% of a fund\u2019s assets are supporting retirement phase pension liabilities under the ATO\u2019s view of deemed segregation.<\/p>\n
This article examines a different kind of segregation; namely, segregation for accounting or investment purposes. In broad terms, investment segregation involves fund assets being designated to particular members or superannuation interests, eg, for the purposes of allocating investment returns and capital appreciation. Investment segregation can essentially be thought of as a form of member investment choice that is implemented within an SMSF. Naturally, all SMSFs provide a certain degree of member investment choice by virtue of being \u2018self managed\u2019. However, this article draws a distinction between genuine member investment choice and the typical investment approach for SMSFs where there is a general pool of fund assets that do not \u2018belong to\u2019 any particular member.<\/p>\n
Investment segregation potentially offers unique planning opportunities due to the flexibility it provides in relation to apportioning growth between different member accounts. For example, with an appropriate allocation of assets, investment segregation can be used to ensure that Member A\u2019s account balance grows faster than Member B\u2019s account balance, or it can be used to ensure that Member\u2019s A retirement phase account grows faster than Member A\u2019s accumulation account. Accordingly, this flexibility can be used to provide more tax effective outcomes, including in respect of the $1.6 million transfer balance cap (\u2018TBC\u2019).<\/p>\n
We now examine the relevant rules for implementing investment segregation in an SMSF. The discussion will focus on allocation of investment returns rather than an apportionment of costs.<\/p>\n
Regulation 5.03 of Superannuation Industry (Supervision) Regulations 1994<\/em> (Cth) (\u2018SISR\u2019) provides that trustees must determine how investment returns are to be credited or debited to a member\u2019s benefits in a way that is fair and reasonable as between all the members of the fund and the various kinds of benefits of each member of the fund. There is an equivalent rule in relation to charging of costs (see reg\u00a05.02 of the SISR).<\/p>\n This begs the question: what does \u2018fair and reasonable\u2019 require? In the context of the usual pooled investment approach, SMSF trustees generally distribute investment returns in accordance with the existing proportions of member benefits in the fund, subject to the terms of the SMSF deed. Naturally, the \u2018fair and reasonable\u2019 standard would require adjustments to be made where there are other variables at play, such as new members being admitted or members ceasing membership during a financial year.<\/p>\n The \u2018fair and reasonable\u2019 standard allows for departures from the pooled approach where there is a segregation of member investments in place. For example, under such a strategy, Member A could pick certain assets for investment purposes and it would be entirely consistent with the fair and reasonable standard if the investment returns on those particular assets were credited to Member A\u2019s account.<\/p>\n The ATO acknowledge on their website that investment segregation is allowable (\u2018Super changes \u2013 frequently asked questions\u2019 https:\/\/www.ato.gov.au\/misc\/downloads\/pdf\/qc51875.pdf<\/a>\u00a0(QC 51875)):<\/p>\n Where my SMSF cannot use the segregated method to claim ECPI (exempt current pension income), can I still segregate assets for investment returns?<\/strong><\/p>\n The change which limits an SMSF from using the segregated method only relates to the ability for that SMSF segregate for the purposes of claiming ECPI. So in these cases, even though the SMSF may be required to use the proportionate method to calculating its ECPI, the trustee can still decide which assets will support pension accounts. In essence, the returns on the segregated assets would continue to be allocated to the respective pension account(s) and the allocation of any tax would be done proportionately.<\/p>\n The above commentary from the ATO makes it clear that the rules in s\u00a0295\u2011387 of the Income Tax Assessment Act 1997<\/em> (Cth) that preclude certain SMSFs from using the segregated method for claiming exempt income does not preclude such funds from using investment segregation.<\/p>\n The governing rules of the SMSF should allow for investment segregation and the investment strategy of the fund should be appropriately drafted to reflect the principles of member investment choice.<\/p>\n A fund\u2019s investment strategy documentation is also important for a host of other reasons. For instance, in SMSFR 2008\/1 [13], the ATO state that if the activities and investments of an SMSF are undertaken in accordance with the fund\u2019s investment strategy, this is a factor that weighs in favour of the conclusion that the SMSF is being maintained in accordance with the sole purpose test. Additionally, under s 55(5) of the Superannuation Industry (Supervision) Act 1993<\/em> (Cth) (\u2018SISA\u2019), SMSF trustees can be afforded a defence against damages when acting in accordance with the fund\u2019s investment strategy and other applicable SISA covenants, including having regard to investment choice (see s\u00a052B(4) of the SISA).<\/p>\n As explained below, investment segregation may assist in managing a member\u2019s TBC.<\/p>\n The TBC is a cap on the value of assets which can be transferred into tax-free retirement phase. As the TBC is measured through a static system of debits and credits, growth above that cap (ie, $1.6 million limit as indexed) is not tested and does not trigger an excess transfer balance.<\/p>\n Segregation of investment returns provides an opportunity to pinpoint allocation of growth on an asset-by-asset basis, assuming that asset returns and growth can be accurately predicted. For example, if a well-performing parcel of shares is linked to a member\u2019s pension account, that pension can benefit from the growth in the shares (eg, due to large dividends being paid and the share price increasing) without impacting the member\u2019s transfer balance. Take the following example:<\/p>\n Example<\/strong><\/p>\n Mr and Mrs Renner are members of the Renner Family SMSF. On 1 July 2018, Mrs Renner turned 65 and commenced a pension. Due to the fund adopting investment segregation, it is agreed that the asset supporting the pension is real estate in the fund valued at $1.6 million. Assume that minimum the annual pension payment is made each year in respect of the pension.<\/p>\n Due to decent rental returns and capital appreciation on the real estate, Mrs Renner\u2019s pension account balance increases to $1.85 million by 30 June 2021 which provides a better outcome for her TBC than if she had merely received a proportion of overall fund growth.<\/p>\n Naturally, appropriate records should be retained in relation investment segregation \u2014 ie, based on an appropriate and regularly reviewed investment strategy that provides a proper basis for investment segregation.<\/p>\n Moreover, it should be borne in mind that if investment segregation is maintained solely for tax purposes, the ATO may seek to apply the general anti-avoidance provisions in pt IVA of the Income Tax Assessment Act 1936<\/em> (Cth), ie, if the sole or dominant purpose of the segregation is to obtain a tax benefit.<\/p>\n If implemented appropriately and authorised under the SMSF\u2019s governing rules, investment segregation can offer unique planning opportunities for SMSF trustees and advisers due to the flexibility it provides in relation to apportioning growth between different member accounts.<\/p>\n Expert advice should be obtained before implementing investment segregation.<\/p>\n *\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 *\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 *<\/p>\n This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional. The above does not constitute financial product advice. Financial product advice can only be obtained from a licenced financial adviser under the Corporations Act 2000 <\/em>(Cth).<\/p>\n Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au<\/a> or call 03 9092 9400.<\/p>\n By William Fettes<\/em> (wfettes@dbalawyers.com.au<\/a>), Senior Associate and Shaun Backhaus<\/em> (sbackhaus@dbalawyers.com.au<\/a>), Lawyer, DBA Lawyers<\/em><\/p>\n DBA LAWYERS<\/strong><\/p>\n 30 September 2020<\/p>\nWhat does the ATO say?<\/h3>\n
Other relevant considerations<\/h3>\n
How can this be used?<\/h3>\n
Conclusion<\/h3>\n
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