A recent ATO determination offers some insights regarding the ATO’s views on commuting transition to retirement income streams, and highlights an important tax trap. (Use eWombat search on this site to read the Determination itself - type in SMSFD 2014/1, click on the ATO Law tab and then on the Determination itself).
The ATO has recently released SMSF determination SMSFD 2014/1. SMSFD 2014/1 builds on taxation ruling TR 2013/5 and SMSFD 2013/2 and provides some important insights regarding the ATO’s views on commuting transition to retirement income streams (‘TRIS’). This article discusses some key points arising from the determination.
What is a ‘commutation’?
Although not expressly defined in the determination, from certain comments in the determination, it’s clear that the ATO view a commutation as being where an SMSF trustee’s liability to make pension (eg. TRIS) payments is exchanged or substituted for a liability to pay a lump sum.
I stress an important point at this stage, which applies not just to TRISs but to all pensions: the lump sum that arises upon commutation does not have to be cashed out of the superannuation system. The lump sum can be rolled over. More specifically, subject to the specific terms of the particular SMSF’s deed, it could be rolled over to another fund (SMSF or an APRA-regulated fund) or it could be internally rolled over within the same SMSF. I note that there are still a number of SMSF governing rules (typically contained in the SMSF deed) that do not permit internal rollovers.
Accordingly reviewing deeds — and if necessary updating them — is a must.
Key point: partial commutations count towards satisfying pension minimums
The critical aspect of SMSFD 2014/1 is that if a TRIS is partially commuted and the resulting lump sum is cashed out of the superannuation system, the lump sum counts towards the required TRIS minimum payments. Naturally, this generally can’t occur because, if a TRIS is partially commuted, the preservation rules prevent the resulting lump sum from being cashed out of the superannuation system. However, to the extent that the TRIS is comprised of unrestricted non-preserved benefits, this is able to occur.
Although there are not many who fall into this category (ie, who are young enough to bother with a TRIS yet have unrestricted non-preserved benefits), this is important for who are in this category.
This is because if such a person is under 60 and the benefit is comprised of the taxable component, the person may well want to make use of reg 995 1.03 of the Income Tax Assessment Regulations 1997 (Cth). Regulation 995 1.03 provides that a superannuation pensioner may in certain circumstances elect, before receiving a pension benefit, that the benefit is not to constitute a pension payment in the pensioner’s hands for income tax purposes. Naturally, if a benefit does not constitute a pension payment in the pensioner’s hands for income tax purposes, it will constitute a lump sum.
Lump sums generally attract far more concessional income tax treatment in the hands of recipients than pension payments. For example, when the recipient is aged between preservation age and 60, up to the recipient’s low rate cap amount (currently $185,000), the taxable component of the lump sum is received income tax free. After that, the taxable component of the lump sum is subject to a maximum 15 per cent income tax plus applicable levies. This can be contrasted to pension payments. The taxable component of pension payments received in equivalent circumstances is taxed at up to 30 per cent plus applicable levies.
Not exceeding cap
SMSFD 2014/1 also provides somewhat of a pleasant surprise. Although a lump sum cashed out of the superannuation system due to a TRIS partial commutation counts towards satisfying the minimum pension requirements, it does not count towards the 10 per cent maximum. SMSFD 2014/1 illustrates this — and other important points — with the following example:
Sheldon … is receiving … a transition to retirement income stream …
On 1 July 2013, the account balance of Sheldon's transition to retirement income stream was $300,000. The minimum annual amount required to be paid … was $12,000.
On 1 May 2014 Sheldon requested, in accordance with the governing rules of the fund, to partially commute … to the extent of $20,000 and have paid to him the $20,000 as a result … the $20,000 was permitted to be paid to Sheldon as an unrestricted non-preserved benefit because the amount of Sheldon's unrestricted non-preserved benefits when the commutation took effect was $25,000.
The $20,000 partial commutation payment was paid accordingly to Sheldon on 3 May 2014 as an unrestricted non-preserved benefit.
The partial commutation payment counted towards the minimum annual amount required to be paid from the pension account … As $20,000 exceeded the minimum annual amount … the trustee did not need to pay any further amount …
Subsequently in the 2013-14 financial year, Sheldon advised the trustee that he still wished to be paid $15,000 as an income payment from the income stream before 30 June 2014. That payment was made on 3 June 2014.
… the $20,000 payment does not count towards the maximum annual amount allowed to be paid from the pension account … Even though a total of $35,000 was paid to Sheldon in the 2013-14 financial year, the trustee did not exceed the maximum annual amount for the income stream for that year of $30,000 (being 10% of $300,000).
In specie payments
The ATO have previously expressed the view that a pension payment must be a payment of money and cannot be a non-money (ie. in specie) asset transfer. In SMSFD 2014/1 — consistent with SMSFD 2013/2 — they state that a lump sum that results from the partial commutation of a pension can be in specie. This is the case even though the partial commutation counts towards the required pension minimums.
An important tax trap
Imagine an SMSF trustee that is using its assets to fund a pension. Of course typically subdivision 295-F of the Income Tax Assessment Act 1997 (Cth) would operate to exempt any income generated by those assets from being assessable income. That is, under what is colloquially called the pension exemption, income generated by pension assets is tax free. Naturally, ‘income’ in this context includes net capital gains.
Now consider where an asset is rolled over to another fund. This raises the question of whether any income tax liability arises. On its face it may well because an asset is being transferred to an existing trust (ie. CGT event E2 is occurring).
Some argue that no income tax liability arises because — if the members of both funds are the same — there is no change in beneficial ownership. However, based on Kafataris v DFCT  FCA 1454 this argument is doomed to fail.
Others argue that the pension exemption (or s 118-320) would operate to exempt or disregard any net capital gain or capital gain.
However, SMSFD 2014/1 reminds us that this may well not be the case. The determination states that the payment of a lump sum that results from commutation occurs after the cessation of the TRIS. Accordingly, there might not be a current pension liability at the moment when the CGT event occurs. This is particularly important for SMSF trustees that are not using the actuarial method to calculate the pension exemption, but rather are using the segregation method.
Accordingly, care should be taken when rolling assets from one fund to another as it may well give rise to a CGT-related income tax liability.
(Naturally, stamp duty and GST should also be considered.)
SMSFD 2014/1 provides much in the way of helpful insights and guidance.
Columnist: Bryce Figot
Wednesday 26 November 2014