Timely action required for market-linked pensions

The new legislation impacts MLPs (ie, term pensions that meet the standards of reg 1.06(8) of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’)) that are also capped defined benefit income streams (‘CDBISs’) — ie, because they were in the retirement phase just before 1 July 2017.

We examine below how the new rules apply where an MLP that is a CDBIS is or has already been commuted.

Background on CDBIS 

Retirement phase pensions that qualify as CDBISs under s 294-130 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’) are subject to modified transfer balance cap rules. In broad terms, a CDBIS such as a pre-1 July 2017 MLP cannot, by itself, give rise to an excess transfer balance. This is the case even where the total market value of the assets supporting the MLP exceeds $1.6 million by a significant amount. 

On the other hand, 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. For fund members with an MLP account balance less than $1.6 million, this means valuable cap space is effectively taken up by the MLP’s special value that could otherwise be used to commence one or more additional retirement phase income streams, e.g., an account-based pension. 

Another important aspect of MLPs that qualify as CDBISs is the tax treatment of the MLP payments in the member’s hands. Due to the operation of the defined benefit income cap in sub-div 303-A of the ITAA 1997, for members age 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 is comprised of a tax-free component in part or in full.

Accordingly, there are certain drawbacks associated with receiving an MLP that is a CDBIS where the MLP has an account balance below $1.6 million. Due to these issues, some clients have taken the opportunity on or after 1 July 2017 to restructure their pre-1 July 2017 MLPs by commuting it and applying the commuted amount to commence a fresh MLP that no longer qualifies as a CDBIS, i.e., so that their transfer balance cap is not overstated and to remove any income tax implications under the defined benefit income cap. 

A problem with the commutation rules under the old law?

For some time now, the ATO has been expressing its concern that the debit rules that apply to the commutation of an MLP that qualifies as a CDBIS do not function appropriately.

This is broadly because the ATO considers the transfer balance debit calculation under the prior rules in s 294-145 of the ITAA 1997 that apply to a full or partial commutation of an MLP produced a ‘nil’ value due to the formula being based on the first pension payment that the member is entitled to receive after the commutation occurs.

The explanatory memorandum to the Treasury Laws Amendment (2019 Measures No. 3) Bill 2019 explains the problem as follows ([3.178]–3.183]):

Full commutation

For a commutation of a capped defined benefit income stream as set out in items 3 to 7 of the table in subsection 294-130(1) of the Income Tax Assessment Act 1997, the transfer balance debit for a full commutation of the superannuation income stream is currently required to be calculated by reference to the first superannuation income stream benefit the individual is entitled to receive after the commutation occurs.

However, in the case of a full commutation the individual is not entitled to receive any further payments after the commutation occurs because the income stream has ceased, in which case the transfer balance debit will be nil. This is not the correct outcome and was not the original policy intent of the legislation.

Partial commutation

For a commutation of a capped defined benefit income stream as set out in items 3 to 7 of the table in subsection 294-130(1) of the Income Tax Assessment Act 1997, the transfer balance debit for a partial commutation of the income stream is currently required to be calculated by comparing the special value of the pension the person is entitled to receive just before the partial commutation occurs and the special value of the pension that the person is entitled to receive just after the partial commutation (see paragraph 294-145(1)(b)).

However, the amount required to be paid for a market linked pension in a financial year is determined on 1 July of that year and is not adjusted to take into account any partial commutations that are made during the year. 

This means that the amount derived by applying the formula in paragraph 294-145(1)(b) to such a pension is zero and, hence, the transfer balance debit arising on the partial commutation is also nil. 

These unintended outcomes create the potential for an individual to incorrectly exceed their transfer balance cap and may result in an amount needing to be commuted and a potential tax liability. This is not the correct outcome and was not the original policy intent of the legislation

Due to this nil debit concern outlined above, on 3 August 2018 the ATO published CRT Alert 066/2018 which provided the following guidance to clients who had already commuted an MLP that qualified as a CDBIS as at that date and reported a non-nil debit via the ATO’s transfer balance account report system: 

We will not apply compliance resources, at this stage, where the fund has reported the transfer balance debit for the commutation as other than nil.

Importantly, however, clients who were still contemplating restructuring their MLPs were left without any comfort that compliance resources could be being applied to the commutation of a CDBIS MLP on or after 3 August 2018. 

The new law 

The legislation amends s 294-145 of the ITAA 1997 and is intended to address the nil debit issue so that transfer balance cap treatment of a commuted MLP that qualifies as CDBIS functions as intended.

More specifically, under the new rules the debit value for a commuted MLP just before the full commutation is the amount of the original transfer balance credit in respect of the MLP less the sum of the following amounts:

• the amount of any transfer balance debits (other than a debit arising a family law payment split covered under item 4 of the table in subsection 294-80(1) of the ITAA 1997) in respect of the MLP before the commutation;
• the total amount of superannuation income stream benefits (i.e., pension payments) the person was entitled to receive before the start of the financial year in which the commutation takes place; and
• the greater of:

• the sum of the superannuation income stream benefits paid during the financial year in which the commutation takes place; or
• the minimum amount required to be paid under regs 1.07B and 1.07C of the SISR during the financial year in which the commutation takes.

In the case of a partial commutation, the new rules provide that the transfer balance debit is the lesser of: 

• the debit value that would arise if the commutation was a full commutation; and
• the amount of the superannuation lump sum that results from the partial commutation.

Retrospective effect

Due to the nil debit issue being a technical deficiency in the law that was never intended, the amendments to s 294-145 of the ITAA 1997 apply retrospectively with effect from 1 July 2017 and thus cover taxpayers who commuted an MLP that qualifies as a CDBIS prior to the enactment of the new legislation. 

Example — fully commuting an MLP that qualifies as a CDBIS

The new rules are best illustrated with an example. The following example is taken from the explanatory memorandum to the Treasury Laws Amendment (2019 Measures No. 3) Bill 2019: 

Example 3.1: Full commutation of a market linked pension

Daniel was the recipient of a market linked pension (MLP1) from before 1 July 2017 and this was the only superannuation income stream he was receiving on 1 July 2017. The transfer balance credit that arose in his transfer balance account on 1 July 2017 was $1,829,697 (being the special value of his market-linked pension at that time).

In the 2017-18 income year, Daniel received superannuation income stream benefits from the pension totalling $91,485. In the 2018-19 income year, he received superannuation income stream benefits from the pension totalling $91,941 (the minimum amount required to be paid to Daniel under the regulations). The account balance of MLP1 as at 30 June 2019 is $1,218,994. 

As at 30 June 2019, no transfer balance debits have arisen in Daniel’s transfer balance account in respect of his market-linked pension.

Daniel fully commutes MLP1 on 30 June 2019. The debit that arises from this commutation is calculated as:

• the original transfer balance credit in respect of the pension ($1,829,697); less
• the amount of any transfer balance debits that have arisen in respect of the pension (nil); less
• the total amount of superannuation income stream benefits Daniel was entitled to receive before the start of the 2018-19 financial year ($91,485); less
• the greater of the superannuation income stream benefits Daniel has received in the 2018-19 financial year, and the minimum amount required to be paid to him under the regulations ($91,941).

Therefore, the debit that arises in Daniel’s transfer balance account as a result of the commutation is $1,646,271.

Due to the regulatory restrictions associated with market linked pensions, after the commutation, Daniel is required to commence a new market-linked pension. As the new market linked pension (MLP2) is not a capped defined benefit income stream, the transfer balance credit that arises reflects its opening account balance of $1,218,994. Following this credit, Daniel’s transfer balance is $1,402,420. This figure is calculated as the net balance of Daniel’s transfer balance account after the following amounts have been accounted for:

• the original credit for MLP1; less 
• the debit for MLP1; plus
• the new credit for MLP2. 

That is $1,829,697 – $1,646,271 + $1,218,994= $1,402,420.

The ATO’s compliance approach — CRT Alert 031/2020

In response to the new legislation, CRT Alert 031/2020 was published on the ATO’s website on 19 June 2020. 

CRT Alert 031/2020 provides the following guidance on the ATO’s compliance approach:

As a result of these changes the ATO is reviewing its compliance approach where we had previously advised funds that we would not, at that time, take compliance action if a fund did not report the required transfer balance account events of the commutation and re-start a market-linked pension, or reported a commutation amount other than nil to us.

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.

Acknowledging the focus that funds, agents and other tax professionals have at this time in responding to the government’s stimulus measures and tax time, we do not intend to engage with funds on how this legislation impacts their reporting obligations until August 2020. We will not take compliance action against funds who do not review their reporting before this time.

Funds which identify that they will have a need to amend their reporting should not do so before engaging with us so we can work with them to manage the re-reporting.

Conclusions

Due to the complexity of the new laws, clients who have previously commuted an MLP that was a CDBIS should obtain expert advice to ensure that the commutation debit recorded in their transfer balance account report at the time is in line with the new laws and CRT Alert 031/2020. Where an amendment is required, the prior debit event will need to be cancelled and a new debit event reported as soon as practicable and prior to August 2020.   

It should also be emphasised that clients who are still contemplating a restructure of their existing MLP should obtain expert advice prior to taking any action. The advice should cover the following: 

• tax advice on the transfer balance cap implications of a restructure;
• tax advice on the income tax implications under the defined benefit income cap;
• superannuation law advice on the succession planning implications of restructuring the MLP;
• actuarial input on the different term scenarios that are available for a new MLP; 
• financial product advice under the Corporations Act 2001 (Cth) in relation to commutation of the prior MLP and the commencement of a new MLP; and
• advice on whether there are any adverse social security implications (i.e., in respect of Centrelink or the Department of Veteran Affairs), or the Commonwealth Seniors Health Card. 

William Fettes, senior associate and Daniel Butler, director, DBA Lawyers