Generally, a pension must be paid in cash. However, not every SMSF has ready cash to satisfy the minimum. Thus, it provides much needed flexibility when a pension can be satisfied in kind, eg. by way of an off-market transfer of listed securities, to ensure the pension exemption can continue and the minimum annual payment condition is satisfied. This article outlines how this balancing act can be achieved and highlights some other advantages and implications of this strategy.
The ATO in SMSFD 2013/2 confirmed that an account-based pension (ABP) can be partially commuted to a lump sum.
A member with an ABP must be paid at least the minimum annual amount each financial year by the trustee of the fund as provided under reg 1.06(9A) of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR). In particular, reg 1.06(9A)(a) provides:
(a) for a pension in relation to which there is an account balance attributable to the beneficiary — the total of payments in any year … is at least the amount calculated under clause 1 of Schedule 7;
The ATO confirmed in SMSFD 2013/2 that the ‘total of payments in any year’ includes a payment made as a result of a partial commutation of an ABP.
A partial commutation by way of a lump sum payment may be evidenced by the member making an election under reg 995-1.03 of the Income Tax Assessment Regulations 1997 (Cth) (ITAR) before the particular payment is made. Broadly, this election results in the amount that would otherwise be taxed as a pension, to be taxed as a lump sum.
Can a commuted amount be paid in kind (ie. in specie)?
The ATO has long held the view that a pension cannot be paid in kind. Thus, this raises the question of whether a payment of an amount that is partially commuted can be paid in kind.
In SMSFD 2013/2 regarding an ABP, the ATO stated:
Further, the partial commutation payment is a lump sum for the purposes of the SISR 1994 and counts regardless of whether the payment is made in cash or in specie.
Thus, the ATO has confirmed that a partial commutation of an ABP can be made in kind (eg. by the transfer of assets of an equivalent market value). This may be attractive to members who are both below and over 60 years of age due to the added flexibility this provides as discussed below.
What about full commutations?
The ATO is comfortable with an amount that results from a partial commutation being able to be converted to a lump sum. However, the ATO position differs in respect of a full commutation of an ABP. Broadly, the ATO’s view is that on full commutation, the pension ceases in accordance with TR 2013/5.
In SMSFD 2013/2 the ATO states:
As the payment of the commutation lump sum is made after the cessation of the account-based pension it cannot count towards the minimum annual payment requirement set out in paragraph 1.06(9A)(a) of the SISR 1994.
Thus, a full commutation is treated very differently to a partial commutation. Under a partial commutation, the pension continues. Under a full commutation, the pension ceases. Once the pension ceases, the member’s account balance, if any, would be considered in accumulation mode. Since a lump sum payment from a member’s accumulation account can generally be paid either in money or in kind, the main difference from a partial commutation strategy is that any assessable gain inside the fund would not be covered by the pension exemption.
Does it suit members under or over 60 years?
A partial commutation can be important for members under 60 so they can take advantage of their low rate cap. This is because the taxable component of a lump sum payment from a superannuation fund for someone under 60 is generally tax free up to the amount of their unused low rate cap under s 301-20 of the Income Tax Assessment Act 1997 (Cth). (A member’s lifetime low rate cap for the 2014/2015 financial year is $185,000.)
A member under 60 years, could, for example, elect to receive $20,000 ($500,000 x 4% = $20,000) of their pension tax free as it would be part of their low rate cap.
For those who have already attained ago 60, superannuation payments whether paid as a lump sum or pension, are generally not taxable. However, a partial commutation may still be attractive for those who have attained 60 seeking to satisfy their minimum annual payment obligation under their ABP by way of an in kind (ie. in specie) payment.
Thus, members both under and over 60 can obtain added flexibility by being able to satisfy their minimum annual payments in kind.
Summary of partial commutation strategy
Where the above election is available, it may prove useful as it may result in:
• At the super fund level, the commuted payment still counting towards satisfying the minimum annual payment requirements of an ABP. The commuted amount can also be paid in kind (even though a pension cannot generally be paid in kind).
• At the recipient (member) level, the payment is taxed as a lump sum not as a pension payment. Thus, for a member who is under 60 years, the first $185,000 (for the 2014/2015 financial year) of the taxable component is tax free up to the low rate cap amount. (Pension payments are tax free in respect of a member once they attain 60 years of age.)
As discussed above, for a member who is over 60 years, the payment of a commuted amount is generally tax free. Such a commuted amount can be paid in kind, eg. by an off-market transfer of shares.
Summary of tax treatment
Broadly, the tax treatment of a commuted lump sum payment from a regulated and complying superannuation fund is as follows:
• If the member is 60 years or over, the member is generally not required to report the payment in their tax return and no PAYG is required to be withheld from the payment.
• If the member has attained their preservation age (see definition below) and is under 60 years of age, the ‘taxable component’ portion of the payment will generally be tax free to the extent the member has any unused low rate cap. If someone below 60 years has used up their low rate cap, then the excess taxable component is subject to PAYG tax and is taxable at applicable tax rates and levies (after taking into account any applicable tax offset). The ATO have prescribed rates of withholding by fund trustees before payments are made. The ‘tax free component’ of each pension payment is non-assessable non-exempt (ie. tax free) income.
‘Preservation age’ is, broadly, 55 years for a person born before 1 July 1960 and 60 years if born after 30 June 1964. If born between 1 July 1960 and 30 June 1964, the age is between 56 to 59 years depending on the person’s date of birth. Broadly, this is generally the minimum age that superannuation benefits can be paid to a member.
Naturally, you should seek advice from your tax adviser before undertaking a partial commutation strategy.
There are other rules that need to be complied with under the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISA).
Any trustee resolutions and supporting documents must generally be retained by the trustee of the fund for at least 10 years. The member should also retain appropriate documents for their tax compliance if they are under 60 years.
To undertake a partial commutation an election notice pursuant to reg 995-1.03 of the ITAR 1997 is required. In addition, the usual trustee resolutions and other paperwork to document a partial commutation and payment of a lump sum is required. Naturally, expert advice should be obtained if there is any doubt.
Please note that the above commentary is limited to ABPs. Moreover, it is generally only applicable to SMSFs.
While it may be possible to apply a similar strategy to a transition to retirement income stream (TRIS), there are various conditions and limitations especially as only the amount of the unrestricted non-preserved components can be commuted from a TRIS.
Expert advice should also be obtained in respect of other pensions such as allocated pensions and market-linked pensions as different conditions and limitations also apply.
Those with allocated pensions may however wish to consider converting to an ABP to access the above flexibility subject to any loss of grandfathering under social security testing of income from a pension.
Daniel Butler, director, DBA Lawyers