What does the $1.6m transfer cap mean for succession planning?

Treasury has now released the draft bill introducing the $1.6 million transfer balance cap. Where does this leave succession planning for your SMSF clients?

Treasury released the exposure draft of the bill that would introduce the $1.6 million transfer balance cap. The draft legislation answers a vital question: what does the $1.6 million transfer balance cap mean for succession planning?

(Note that this article is premised on the dangerous assumption that the ultimate legislation will look exactly like the exposure legislation. Naturally, if the ultimate legislation is different to the draft, the comments in this article could change.)

Why this question is critical

The government announced in the May budget that from 1 July 2017, it will introduce a $1.6 million cap on the total amount of superannuation that can be transferred into a tax-free retirement account.

However, many wondered about the following situation: Consider an SMSF that has, for example, two members, who are spouses of each other. Each member is in receipt of a pension from the fund with capital worth $1 million. The total capital in the fund is $2 million.

Assume the husband dies first. Upon his death, can the wife receive all of the husband’s benefits as a pension? If so, the capital can broadly stay in the fund and only income stream payments need to be paid out.

However, if death benefit pensions (e.g., a pension of the husband that reverts automatically to the wife upon his death) count towards to the wife’s transfer balance cap, it could be that only $600,000 of the husband’s benefits can be paid to the wife as capital pension. The rest (i.e. $400,000) would have to be cashed out as a lump sum.

What the draft legislation reveals

The draft legislation tells us that a death benefit pension will count towards a person’s transfer balance cap. Accordingly, in the example above, broadly $400,000 would need to be paid out as a lump sum. Naturally, this could cause significant issues if the asset supporting the capital was illiquid or ‘lumpy’, such as real estate.

However, mercifully, a death benefit pension does not count towards the transfer balance cap instantly upon death. Rather, it counts six months from the date the beneficiary (e.g. the wife in the above example) becomes entitled to receive the pension.

The draft explanatory memorandum explains the six-month period as follows:

It gives the new beneficiary sufficient time to adjust their affairs following the death of a relative before any consequences – for example, a breach of their transfer balance cap – arise.

It’s noteworthy that there is somewhat of an exception for children who receive death benefits by way of pensions. The exception is that a modified transfer balance account applies and then ceases when children commute all their death benefit pensions (which typically happens upon turning 25) or the capital is exhausted.

Example

The draft explanatory memorandum provides the following example:

John has a reversionary pension worth $1 million at the time of his death on 1 August 2017. The pension reverts to John’s wife, Heather. Heather already has her own pension and a transfer balance account with a balance of $800,000.

In November 2017, Heather is advised that, in August, she became the recipient of John’s pension. Heather is advised that, unless she acts, the combined value of the two pensions will cause her to breach her transfer balance cap. Heather has a number of options to respond to the situation. She can fully commute either pension or she can undertake a partial commutation for the amount of the potential excess, $200,000.

On 1 December 2017, Heather makes a partial commutation of her pension and receives a superannuation lump sum of $200,000. On that date, a debit arises in her transfer balance for that amount (see paragraphs 1.64 to 1.74 (of the draft explanatory memorandum), bringing her transfer balance account down to $600,000.

The $1 million credit in respect of the reversionary pension arises in Heather’s transfer balance account on 1 February 2018. Heather has not breached her transfer balance cap

Are reversionary pensions still a good thing?

Overall, the changes make reversionary pensions less of a good thing. However, there will still be a role for reversionary pensions.

Reversionary pensions will be less of a good thing because generally the six-month period starts instantly upon death. Naturally, many people require far more than six months from the date of death of a loved one before they feel confident making rational financial decisions.

However, in spite of this, there are still circumstances where automatically reversionary pensions are beneficial such as:

- In order to be able to ‘bequeath’ grandfathered social security changes from pre 1 January 2015; and

- Where someone has both a significant tax-free component and a life insurance policy in the fund.

Advisers will need to assist clients to engage in a weighing up exercise to see if the benefits of reversionary outweigh the tighter time frames.

CGT relief

The draft legislation also contains some welcome CGT relief.

Under current law, if someone died with assets in an SMSF that were carrying an unrealised capital gain of say $2 million, so long as the assets were supporting a pension upon death, there is a fair chance that the pension exemption will operate past death to essentially exempt any CGT-related assessable income resulting upon death.

However, under the $1.6 million transfer balance cap, from 1 July 2017 it might largely be impossible to have all of those assets supporting a pension upon death.

As the explanatory memorandum to the draft legislation states:

Complying superannuation funds will now be able to reset the cost base of assets that are reallocated from the retirement phase to the accumulation phase prior to 1 July 2017.

Where these assets are already partially supporting accounts in the accumulation phase, tax will be paid on this proportion of the capital gain made to 1 July 2017. This tax may be deferred until the asset is sold, for up to 10 years.

Although resetting a cost base as at 1 July 2017 can be beneficial, taxpayers should remember the general anti-avoidance provisions and advisers should remember the promoter penalty regime. This is particularly so in light of the following comments from the draft explanatory memorandum:

It would be inappropriate for a fund to wash assets to obtain CGT relief or to use the relief to reduce the income tax payable on existing assets supporting the accumulation phase. Schemes designed to maximise an entity’s CGT relief or to minimise the CGT gains of existing assets in accumulation phase may be subject to the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936.

More details

Naturally, the devil is in the detail and there is much more detail, exceptions and accompanying materials. For full details, see https://consult.treasury.gov.au/retirement-income-policy-division/super-reform-package-tranche-2

Conclusion

Death benefits paid as pensions will count towards to the recipient’s transfer balance cap. This is relevant for husband and wife couples who collectively have more than $3.2 million in superannuation. The new rules make reversionary pensions less attractive and advisers will need to assist clients to engage in a weighing up exercise to see if the benefits of reversionary outweigh the tighter time frames.

By Bryce Figot, director, DBA Lawyers

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