One of the popular benefits of SMSFs has been their potential to defer capital gains tax forever. By accumulating assets in the accumulation phase, and not realising capital gains until the pension phase when the income tax rate is zero, no CGT ever becomes payable.
This is an important practical advantage of SMSFs over collective funds. Collective funds generally accrue CGT on unrealised capital gains in their unit prices, and in most cases (mainly due to system limitations) are unable to credit back when a member transfers to the pension phase.
It has also been an article of faith. So there were shockwaves last week when the ATO released a draft tax determination (TD 2013/D7 if you want to check it out), which suggested that this might not necessarily be the case.
Notwithstanding this is only a draft determination, it may signal a further tightening of concessions around tax exemptions for pension income. The determination applies to all complying super funds, including wraps where CGT deferrals can also be achieved, but most of the examples used by the ATO refer to SMSFs.
The topic gets technical very quickly: “to benefit from the exemption, an asset must be invested, held in reserve or otherwise dealt with for the sole purpose of enabling a fund to discharge liabilities payable in respect of superannuation income stream benefits, where the whole asset is so invested, held or dealt with.” And that single sentence has an additional three footnotes.
The ATO appears to be aiming at three issues of concern:
- Timing: the realisation of assets soon after entering the pension phase, thus avoiding CGT.
- Sole purpose: assets must be 100% invested for the sole purpose of providing pensions.
- Indivisibility: no part of the asset can be invested for another purpose.
The part of the determination which has got people excited is paragraph 10. This states that if you dispose of an asset shortly after entering the pension phase, depending on the circumstances, the ATO might apply the Part IVA general tax avoidance provisions to disallow the capital gains tax exemption. That is a bombshell.
The determination works through a series of examples which highlights the need to clearly segregate pension assets and the complications in doing this successfully. Perhaps the most interesting is Example 5:
- An SMSF with 4 members: two of whom are retired and in pension phase, and two whom are still in accumulation phase.
- The value of the SMSF’s pension liabilities for the 2 pension members is $900,000 (based on an actuarial certification).
- The SMSF has ~$2m in assets, including a commercial property valued at $950,000.
Here’s the question – if the commercial property was sold, would the capital gains be exempt from tax?
According to the ATO, the answer is no, because even putting the timing issues to one side, the value of the property is more than the value of the SMSF’s pension liabilities. It’s an all or nothing situation so the property cannot be a segregated pension asset at all under these conditions. All the income it produces and any capital gains on its sale would be taxed at accumulation phase rates.
This hints at some significant problems. Say the situation was slightly different – the property worth ~$1.5m and other assets only $500,000. The SMSF has pension liabilities of $900,000 but can only get tax exemptions relating to the other assets of $500,000 because the property is ineligible.
Alternatively, consider a $1m SMSF with husband and wife members, where the primary asset is a single $750,000 property. Returns from the property may not be tax exempt until both members are retired and in pension phase. Where there is a large age gap between the members, that may cause issues.
These sound like extreme situations, but may become more common with increasing numbers of family SMSFs and large single assets such as geared real estate.
It’s a complex area, it's only a draft determination, and not everyone agrees with the ATO’s views on the subject – noted super lawyer Noel Davis disputed them immediately via the AFR. But it's an unpleasant surprise which does suggest that the exceptional flexibility of SMSFs and their effectiveness as tax planning vehicles are getting more attention from a revenue hungry government.
Andrew Baker is managing partner at Tria Investment Partners.
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