One of the greatest misconceptions relating to self-managed superannuation funds (SMSFs), or any superannuation fund for that matter, is that funds with members receiving pensions do not pay tax on the income generated from the pension assets. The fact is this is not necessarily true. Many fail to realise that income earned from pension assets is only tax free when the fund trustee complies with the relevant legislation and regulations governing the payment of pensions. Just as many may not realise this fact, so too are many unaware of the consequences of failing to comply with the regulatory and legislative requirements contained in the SIS Regulations and Income Tax Act respectively.
It is important for superannuation professionals to understand the pension requirements for three reasons. Firstly, the number of SMSF members commencing pensions is continuing to rise and therefore superannuation professionals will encounter these funds more regularly. Secondly, for a number of years the Australian Taxation Office (ATO) has indicated they will focus their attention on SMSFs paying pensions to ensure they are complying pensions. And finally, the consequences for a non-complying pension may be an unexpected tax liability payable by the fund.
Pension regulations and legislation
The main requirements contained within the SIS Regulations 1994 relating to pensions are found in Regulation 1.06 which state that a benefit is taken to be a pension if:
- The payment of the pension is made at least annually;
- The total of payments in any year is at least the minimum amount required by regulations; and
- The capital supporting the pension is not added to by way of contribution or rollover after the pension has commenced.
Section 295.385 of the Income Tax Assessment Act 1997 requires that for income from pension assets to be exempt from tax, the income must come from segregated current pension assets. The assets may be segregated, or an actuarial certificate will suffice.
Finally, Taxation Ruling TR 2013/5, released in July 2013, explains the Commissioner’s views about when a pension commences and ceases. The Ruling states that an income stream (pension) exists when the superannuation trustee has as a liability to make a series of periodic payments that relate to each other over an identifiable period of time. I will discuss the risks stemming from this definition below that result from the existence of re-contribution strategies.
Key risks associated with complying pensions
The purpose of this article is not to discuss in depth the pension requirements and ATO pronouncements referred to above. Nor is it to discuss all the risks associated with the payment of a pension. Rather it is intended to bring to the reader’s attention a number of risks the industry have recently encountered and the impact these risks will have on whether a pension complies with the relevant legislative and regulatory requirements.
Risk 1: Requirement to value assets at market value and the impact on minimum pension amounts
For years ending on or after 30 June 2013, SIS Regulation 8.02B requires all SMSF assets to be valued at market value each year. For prior years, ATO Superannuation Circular 2003/1 suggested assets in general should be valued at market value, and Taxation Determination TD 2000/29 required that where an accumulation fund has underlying assets that commence to provide for the pension, the assets must be valued at their net market value on the commencement day of the pension. For subsequent years, SMSF assets used to pay a pension may not have been valued correctly after commencement of the pension.
The risk associated with Regulation 8.02B which may possibly cause the fund to fail to meet the minimum pension payments, or exceed the maximum pension payments for Transition to Retirement Income Streams (TRIS) (not discussed in this piece), lies when the fund has investments in private trusts or companies. Or other assets difficult to value. Unlike SMSFs that must value assets at market value, private trusts and companies are generally not subject to similar requirements. Therefore, these entities may adopt a different valuation method such as cost. The impact of the different valuation methods is that the fund’s investment in the private unit trust or company may not be valued at market value, with the implication being that the fund fails to meet the minimum payment required by the regulations.
Risk 2: Pension fails to meet the definition of an ‘income stream’ due to re-contribution strategy
A strategy adopted by many trustees to reduce the taxable component of of a member’s balance is a ‘re-contribution strategy’. Such strategy sees a trustee make a large pension payment, revert the pension back to accumulation, re-contribute the amount taken as a pension to the accumulation interest, and re-commence a new pension. As mentioned above in TR 2013/5, for an income stream (pension) to exist, a ‘series’ of payments must be made. This may include a series of payments over a particular year, or a series of single annual payments over a number of years.
The risk presented by trustees adopting such a strategy is that if a pension is established in year 1, then converted back to accumulation, and re-commenced after mixing the two interests, should a single pension payment have been made in year 1, and this is the only pension payment, the definition of a pension may not have been met as a ‘series’ of payments has not been made.
Risk 3: Adding to the capital supporting the pension
As mentioned above, a pension fails to meet the regulatory requirements when the capital supporting the pension is added to. I normally see this occurring for two reasons.
The first reason results from either incorrect or incomplete professional advice whereby trustees are informed they have unrestricted access to their superannuation upon meeting the appropriate condition of release. What the trustees are either not informed of, or simply don’t understand, is that for a pension to meet the legislative and regulatory requirements, the members are not permitted to re-contribute to their superannuation fund unless specific requirements are adhered. These include contributing to a separate accumulation account provided the trustee is permitted to accept the contribution, and keeping accumulation and pension assets segregated if an actuarial certificate is not obtained.
The second reason arises when a SMSF member in receipt of a pension, without consulting their professional advisor, requests a rollover from another fund into their SMSF. When this is not done correctly, by accepting the rollover, the trustees may find themselves failing the pension regulation requirements and therefore losing the fund’s entitlement to tax free income from the pension assets.
Implications of non-compliance
Note, the above risks are not an exhaustive list of risks which would cause the fund to fail the regulatory and legislative pension requirements. They simply represent some of the issues I have recently encountered which are not often discussed.
Should the trustees contravene the regulatory or legislative requirements governing the payment of a pension, the good news is that neither SIS Regulations 1.06 or 1.06(9A) are not reportable to the ATO. Nor is Section 295.385 of the ITAA 1997. Note however the regulatory breach may result in a qualified auditor’s report if the contravention is material.
The bad news is that by failing to comply with the above requirements, the pension is considered not to have existed at any time during the financial year. Therefore any income earned on the fund’s assets will be subject to tax at the normal fund rate.
You should note however, that whilst a contravention of the pension requirements is not reportable, the consequence of non-compliance associated with accepting contributions discussed in risk 2 above may result in a reportable contravention if the trustee accepts contributions on behalf of the member which is not permitted by SIS Regulations. Any contravention would therefore be of the contributions regulations rather than the pension requirements.
Summary
To ensure your clients avoid the nasty surprise of an unexpected tax bill when they were of the understanding there was no tax payable upon reaching a relevant condition of release, I strongly suggest that prior to commencing a pension, you educate your clients on the various requirements that must be adhered relating to the payment of a superannuation pension.
