Timely action required for market-linked pensions

The bill rectified an issue where the value of a market-linked pension (MLP) was being double counted for transfer balance cap purposes where the pension was restarted.

DBA Lawyers director Daniel Butler explained that following the introduction of the transfer balance cap rules, many clients looked to commute and recommence their market-linked pensions due to the impact of pre-1 July 2017 MLP on the transfer balance cap.

Market-linked pensions that existed prior to 1 July 2017 qualify as capped defined benefit income streams (CDBIS) and are subject to modified transfer balance cap rules.

“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,” Mr Butler said.

“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.”

Another important aspect of MLPs that qualify as CDBISs, Mr Butler said, is the tax treatment of the MLP payments in the member’s hands.

“Due to the operation of the defined benefit income cap in subdiv 303-A of the ITAA 1997, for members aged 60 or over, 50 per cent 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,” he said.

“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 took the opportunity to restructure their pre-2017 MLP by commuting it and applying the commuted amount to commence a fresh MLP that no longer qualifies as a CDBIS, Mr Butler said.

In order to provide a practical workaround to the nil debit concern prior to the legislative fix being passed, the ATO published CRT Alert 066/2018 on 2 August 2018.

The ATO stated that for those who had already commuted a market-linked pension that was also a CDBIS and reported the commutation as other than nil, it would not apply compliance resources.

“This ATO guidance provided no comfort, however, to members who commuted on or after 3 August 2018,” Mr Butler noted.

After the legislative amendment to fix the issue was passed, the ATO issued a new alert, CRT Alert CRT Alert 031/2020, on 19 June 2020.

The ATO stated that it would be reviewing its compliance approach where it had previously advised funds that it would not take compliance action if a fund did not report the required transfer balance account events of the commutation and restart of a market-linked pension, or reported a commutation amount other than nil.

“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,” the ATO stated.

The ATO also said that it would not be engaging with funds on how the legislation impacts their reporting obligations until August 2020, and that it would not take compliance action against funds who do not review their reporting before this time.

With August now here, Mr Butler said SMSFs with members who have previously commuted an MLP that was also a CDBIS should have their position reviewed to ensure that the correct debit is reflected in their transfer balance account before the ATO follows them up.

“Given the complexity of the new debit rules, in many cases funds will need to re-report the correct debit. This is likely to require the prior debit event to be cancelled and a new debit event reported as soon as practicable,” he said.

“Given the new debit rules were far more complex than expected by numerous SMSF advisers –– many expected a more simple approach rather than the complex method which has appeared years after the issue was first discovered, re-reporting may result in excess transfer balances for many members with consequential ETB tax liabilities.”

Mr Butler warned that this could result in affected members being required to pay significant ETB tax, given several years of deemed excess transfer balance earnings could have accrued already.

“This ETB tax is calculated on deemed or notional excess transfer balance earnings for the period when the member starts to have an excess transfer balance to when your transfer balance account is rectified and no longer in excess,” he said.

For many adversely affected members, Mr Butler said 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 per cent.

“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 per cent on these deemed earnings from an excess transfer balance for FY2018. From 1 July 2018 onwards, the tax rate is 15 per cent for first-time offenders and 30 per cent for second and subsequent offenders.”