A little-known quirk and how to use it for clients to cherry pick
A little-known quirk in the preservation rules can be advantageous and have important implications for clients.
This article intends to explain how the quirk arises, and then how to use it to clients' advantage.
In a nutshell, the quirk allows trustees of super funds to ‘cherry pick’ whether to fund pensions from unrestricted non-preserved benefits or preserved benefits.
Certain rules — commonly called the ‘preservation rules’ — are contained in part 6 of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’). They divide benefits into different classes. The two main classes are preserved benefits and unrestricted non-preserved benefits.
The default position is that all benefits are preserved benefits (SISR regs 6.03 and 6.15).
As the name suggests, preserved benefits must be preserved until a condition of release is satisfied (SISR reg 6.18(1)). Even then, preserved benefits can only be cashed in a form that meets the associated cashing restriction (SISR reg 6.18(3)).
Naturally, one common condition of release is attaining preservation age. For those born before 1 July 1960, preservation age is 55. The associated cashing restriction is broadly that the pension be paid as a transition to retirement income stream (‘TRIS’).
Naturally though, there are ways for benefits to be transformed from preserved benefits into unrestricted non-preserved benefits. One common instance is where the member retires.
The key question
It is quite possible that a super fund member has various classes of benefits in their super fund. This can occur where a member retires and then goes back to work. (However, there are also many other ways that this can occur.)
Consider a member who has $1 million of benefits in a super fund, $500,000 of which are unrestricted non-preserved benefits, and $500,000 are preserved benefits.
Assume the member is 58 years' old and wishes to start a TRIS with $400,000 of their benefits.
The key question is: what components should fund that TRIS? Some might say that it should come entirely from the unrestricted non-preserved benefits. Some might say that it should come entirely from the preserved benefits. Others might say that it should come out in proportion, much like the tax-free and taxable components do.
The answer appears to be in reg 6.22A(2). It provides:
In cashing benefits in accordance with the restriction, the trustee must give priority to benefits in the following order:
(a) first—to unrestricted non-preserved benefits;
(b) second—to restricted non-preserved benefits;
(c) third—to preserved benefits
Accordingly, the answer appears to be that benefits must come first from unrestricted non-preserved benefits.
However, not all is as it seems.
What the regulators say
Firstly, note that reg 6.22A talks about cashing a benefit.
APRA has previously stated that ‘cashed refers to the payment of a benefit from the superannuation system’ (see Superannuation Circular No. I.C.2 (since withdrawn)). Accordingly, they take the view that commencing a pension (eg, a TRIS) would not constitute the ‘cashing’ of a benefit.
The ATO has expressed a view consistent with APRA's. See item 6.2 of the June 2009 NTLG Super Technical minutes. More specifically, the ATO has stated:
The mere conversion of a member’s interest from accumulation phase to pension phase, for example, on commencing a superannuation income stream using the entire value of a member’s superannuation interest, is not the cashing of a benefit. The cashing of a benefit occurs each time a member receives an income stream payment.
This means that there is no express direction in the SISR as to how preservation components should be selected when commencing a pension.
In the absence of express direction, the ATO has determined that trustees are able to choose, or, to express it more colloquially, trustees can ‘cherry pick’. The ATO has stated that the ‘SIS Regulations do not provide any priority in relation to the commencement of [a pension]’.
Therefore, returning to the original example, it is possible that the TRIS be started entirely from the unrestricted non-preserved benefits. Similarly, it is also possible that the TRIS be started entirely from the preserved benefits. The ATO did not expressly address whether the TRIS also could have been started with some unrestricted non-preserved benefits and some preserved benefits, but presumably this would be also acceptable to them.
Why does it matter?
There are several instances in which it might matter tremendously. The two most common instances are illustrated with case studies.
Case study 1 — Joey wants flexibility
Consider a super fund member, Joey, who wants to draw a TRIS now, but also wants to keep his options open in the future.
Joey might be keen to fund his TRIS from preserved benefits. This way, he is wearing down the preserved benefits and leaving the unrestricted non-preserved benefits intact. Effectively, this means Joey is maximising his unrestricted non-preserved benefits.
Naturally, this is counterintuitive to a quick reading of reg 6.22A. However, I think advisers should set this (ie, use preserved benefits first) as their default option, unless a client wishes to pursue case study 2.
Case study 2 — Jimmer wants to use reg 995-1.03 election
Secondly, consider a super fund member — Jimmer — who wants to use the election in reg 995-1.03 of the Income Tax Assessment Regulations 1997 (Cth) (‘ITAR 1997‘). This election provides that in certain circumstances the recipient of a pension can elect for that pension to be taxed in their hands as a lump sum. More specifically, reg 995-1.03 provides:
A payment from an interest that supports a superannuation income stream is not a superannuation income stream benefit if:
(a) the conditions to which the superannuation income stream is subject allow for the variation of the amount of the payments of benefit in a year in circumstances other than:
(i) the indexation of the benefit under the rules of the product; or
(ii) the application of the family law splitting provisions; or
(iii) the commutation of the benefit (including commutation to pay a surcharge liability); or
(iv) the payment of an assessment of excess contributions tax; and
(b) the person to whom the payment is made elects, before a particular payment is made, that that payment is not to be treated as a superannuation income stream benefit.
The ATO takes the view that this election can only be used if the pension being paid is an account-based pension (‘ABP’), not a TRIS. See self-managed superannuation fund determination SMSFD 2013/2 and taxation ruling TR 2013/5.
Where the election can be used, it is very powerful. It means that:
• At the super fund level, the payment counts towards satisfying the minimum pension requirements.
• At the recipient level, the payment is taxed as a lump sum not as a pension payment.
In turn, this means:
• No tax at the SMSF level — the super fund to be eligible for pension exemption in subdiv 295-F of the ITAA 1997.
• No tax at the recipient level — the first $180,000 of taxable component can be received tax-free pursuant to low rate cap amount in s 301-20 of the ITAA 1997.
However, there are certain difficulties.
Firstly, an election must be made.
Secondly, again, the ATO take the view that this election can only be used if the pension being paid is an ABP, not a TRIS. An ABP can only be paid with unrestricted non-preserved benefits. Accordingly, in this instance, Jimmer might be keen to ‘cherry pick’ the pension from the unrestricted non-preserved benefits so that the pension can be an ABP rather than a TRIS.
Due to a distinction between ‘commencing a pension’ and ‘cashing a benefit’, the ATO has allowed certain flexibility when commencing a pension. This can be put to great effect for certain clients.
Bryce Figot is a director at DBA Lawyers.