Segregated SMSFs can be effective for tax planning and offer greater flexibility; however, they do come with greater complexity.
Auditing a segregated SMSF is labour-intensive; it is an audit of at least two sets of transactions for two sub-funds. Segregation also triggers a more extensive application of legislation. In addition, accounts within segregated funds have to interact and transact with each other in a specific way.
The term ‘segregation’ is sometimes used, in practice, as the fund members' choosing to have different investment choices and manage their individual portfolios separately. But allocation of assets under different members is not a tax scenario itself. From a tax perspective, ‘segregation’ is only used in the context of ‘segregated current pension assets’. That is, it refers to the tax status of the assets.
The definition of segregated current pension assets can be found under s.295-385 of the SIS Act.
Reasons for segregation
It is helpful for an auditor to understand why the trustee has chosen this particular tax structure.
Segregation can be used in tax planning. Large capital gains triggered in the pension phase but accrued in the accumulation phase can be fully exempt if the assets are segregated. CGT is not proportioned between pension and accumulation accounts. Income-producing assets can be specifically identified and held in the pension account, creating tax savings.
Segregated current pension assets can also be created when adult children join the fund with mum and dad. Two different member groups have two different risk profiles and prefer different investment strategies. Both mum and dad are in pension, and both children are in accumulation.
Occasionally, husband and wife choose to manage their individual accumulation accounts separately, and identify assets for each member. This means there are no ‘segregated current pension assets’ until the time when one member converts to pension.
Most funds choose not to segregate but to obtain an actuarial certificate when there is a mix of accumulation and pension accounts. However, it is not normally a good reason to segregate solely to avoid actuarial fees. The administration and audit time will outweigh the savings on the actuarial fee.
A pension fund is a segregated fund
When a fund is fully in pension, all assets in the fund are considered segregated.
Interesting scenarios arise when a fund converts fully in pension at a specific point during the financial year. For example, when both members of a fund convert their accumulation accounts to pension on 1 April 2015, the fund is by definition segregated from that date, and technically doesn’t need an actuarial certificate. Certain SMSF accounting software packages accommodate the segregation by providing an income summary for the period when the fund is wholly in pension phase, but others don’t.
When a fund starts fully in pension, receives contribution during the financial year, and then at a later stage converts the new accumulation account into pension and is in full pension mode again, the fund is segregated in the beginning and at the ending period of the year. Technically, only the middle part of the year would require an actuarial certificate.
In practice, unless a fund is in pension for the entire financial year, it’s often ignored that a fund fully in pension for part of the financial year is still segregated for that part of the year. The most common approach is to obtain actuarial certificates for funds covered in these scenarios.
SMSF trust deed and record-keeping
Another area that requires attention from SMSF practitioners is the SMSF trust deed. There is no power in SIS that allows asset segregation. As a result, segregation has to be mentioned in the SMSF trust deed somehow and provides a positive power.
Record-keeping for segregated funds occurs on a whole new level. Assets initially identified as segregated current pension assets must be formally documented. Ongoing administration requires a separate set of general ledger to record transactions specific to these assets.
TD 2014/7 allows informal sub-bank accounts to be maintained by the fund accountant. Where practical, keeping separate bank accounts makes record-keeping and transacting within the fund a lot easier.
Record-keeping also needs to ensure that the market value of segregated current pension assets cannot exceed the account balance supporting the pension at any time during the financial year.
CGT, exempt current pension income (ECPI), apportionment for general fund expenses and tax refund
Capital gains/losses generated by the separated current pension assets are ignored. However, capital losses from before the segregation are carried forward indefinitely. If an accountant is not using good SMSF accounting software, sometimes this loss has to be entered manually. It’s always helpful to check on this in case a carried forward capital loss is missed.
Most accounting software does not provide detailed schedules on how ECPI and pension non-deductible expenses are calculated, so auditors need to calculate and verify these two figures on the tax accounting reconciliation themselves.
Interest, rent and dividend income generated by the segregated current pension assets are included in ECPI. As mentioned previously, capital gain is ignored. Only the taxable portion of the income from trust distributions is included in ECPI; gross foreign income is included, tax-exempt and tax-deferred distributions, and capital gain distributions, are not.
Expenses directly incurred in generating ECPI are non-deductible. Fund level general expenses such as accounting fees are to be apportioned with reference to the amount of exempt income and total income. The proportion method is the same for both segregated funds and unsegregated funds. Total income for this calculation includes assessable income plus non-assessable contributions and rollovers.
Supervisory level and insurance premiums are not apportioned since they are deductible under specific sections of the ITAA 1997 rather than s.8-1.
Tax refund needs to be allocated to between segregated pension account and accumulation account. The easiest way to achieve this is to add up all imputation credits generated by the segregated current pension assets, and allocate the remaining refund to the accumulation account.
Vivian Bai, director, Access Super Audit
SUBSCRIBE TO THE SMSF ADVISER BULLETIN
- 21 Aug 2017ATO releases position paper, penalties approachBy Katarina Taurian
- 21 Aug 2017Top investment mechanisms for tax savings revealedBy Staff Reporter
- 21 Aug 2017SMSFA appoints high-profile Australian as patronBy Staff Reporter
- 21 Aug 2017Lawyer challenges ATO view on two fund strategiesBy Miranda Brownlee
- 21 Aug 2017Risks flagged with real estate appraisal valuesBy Miranda Brownlee
- 18 Aug 2017ATO locks in details, addresses panic on real-time reportingBy Katarina Taurian
- view all
- Top investment mechanisms for tax savings revealed
While super remains one of the most tax-effective ways to save for retirement, if you’re unable to stay within caps then it may be worth c...read more
- view all