Avoiding snares with CGT relief strategies
The CGT relief can provide significant tax advantages to SMSFs impacted by the super reforms. However, it’s vital that every scenario is analysed when deciding how it should be applied for the client or if it should be used at all.
From 1 July 2017, a cap of $1.6 million will be introduced on the amount a person can transfer into the tax-free retirement phase. Anyone with a total retirement phase balance in excess of $1.6 million will generally be required to either commute the excess amount back to accumulation phase or withdraw the excess from superannuation altogether. Further, transition to retirement (TTR) pensions will not be treated as retirement phase income streams from 1 July 2017.
CGT relief overview
Earnings on assets supporting retirement phase income streams are eligible for an exemption from income tax. To compensate those who will need to transfer assets out of retirement phase in order to comply with the new rules, any SMSF with a member who finds themselves affected by this transfer balance cap or TTR modification will have access to capital gains tax (CGT) relief on the impacted assets. This CGT relief will allow the trustee to elect to reset an asset’s cost base in 2016-17. This effectively locks in the capital gains tax treatment of the assets up to 30 June 2017 prior to the new rules applying from 1 July 2017. How this relief applies is different, depending on whether the fund is using the segregated or proportionate method from 9 Nov 2016.
For assets using the proportionate method at 9 Nov 2016, unrealised gains or losses can be locked in on 30 June by applying the CGT relief. The capital gain will be taxed based on the fund’s 2017 financial year’s tax-exempt percentage. The taxable proportion of the gain can be realised in the 2017 annual return or deferred. Capital losses cannot be deferred.
For assets using the segregated method at 9 Nov 2016, unrealised capital gains on segregated current pension assets can be locked in as tax-free. Any gain or loss will be disregarded. Which assets are eligible for this relief depends on whether the assets are segregated to accumulation or are treated under the proportionate method from the date they cease to be segregated current pension assets.
Resetting the cost base will also mean assets need to be held for a further year in order to access the CGT discount.
While beneficial for many funds, the decision to apply the CGT relief is not entirely straightforward. In this article, we highlight two key strategies to consider before making any decisions on applying CGT relief.
1. Moving to the proportionate method on 30 June 2017 may provide the best outcome for segregated assets
Trustees currently employing a segregation strategy should carefully consider how their asset segregation will be impacted on applying CGT relief. Assets which were segregated current pension assets at 9 Nov 2016 must use the segregated method to claim CGT relief. However, they have two options for how the relief is applied. An asset can apply the CGT relief if it ceases to be a segregated pension asset in order to comply with the new transfer balance rules.
Option 1: If specific segregated pension assets are commuted to reduce the retirement phase balance to below $1.6 million and the assets remain as segregated accumulation assets, only these particular assets are affected by the requirement to comply with the transfer balance cap. This will mean that only the specific assets chosen are eligible to apply CGT relief. Remaining fund assets, both those in pension and accumulation, will not be affected and, as such, would not be eligible for the CGT relief.
Remember that even if the segregation strategy is maintained in 2016-17 through commuting specific assets to accumulation, if a member has over $1.6 million in superannuation and a member has a retirement phase balance, the fund will be unable to employ a segregated asset strategy for tax purposes in the 2017-18 financial year.
Option 2: The trustee may decide to unsegregate all segregated pension assets where they do not wish to select specific assets to commute to accumulation or if they can’t because assets are greater in value than the excess required to be commuted. The fund could cease to treat assets as segregated current pension assets and use the proportionate method from 30 June 2017 in order to comply with the transfer balance cap. This will allow the fund to apply the CGT relief to all segregated current pension assets on 30 June when assets cease to be segregated current pension assets.
A consequence of this option is that the fund will be unsegregated for one day on 30 June and technically require an actuarial certificate in order to determine the tax-exempt percentage to claim exempt current pension income on income earned on 30 June. However, for most funds, the cost of obtaining an actuarial certificate for this single day would outweigh the benefit of disregarding capital gains on all segregated current pension assets.
2. Are your clients fully retired? Those who aren’t might be better off not applying the CGT relief
For funds that were using the proportionate method as at 9 November 2016, the CGT relief provisions allow the trustee to elect for unsegregated assets to lock in the 2016-17 financial years’ tax exempt percentage on their unrealised capital gains or losses. While for many this will be advantageous, there are certain situations where it may actually be better to retain the existing cost base and not lock in the current tax position on capital gains until the year in which the asset is actually sold. The main argument for not applying the CGT relief and resetting the cost base is where the fund’s tax-exempt percentage is expected to increase in the future. This may occur when a fund member is not yet in retirement phase but is expected to satisfy a condition of release and convert their balance to retirement phase prior to the sale of the asset.
An example of this may be a fund that over the next three financial years from 2017 to 2019 will experience tax-exempt percentages of 60 per cent, 40 per cent and 80 per cent. One member is in pension and one member is in accumulation in 2017. The change in the tax-exempt percentage is caused by the pension member commuting part of their pension back to accumulation at 30 June 2017 in order to comply with the incoming transfer balance cap, resulting in a lower tax-exempt percentage for 2018. At this point, it does look like resetting the cost base in 2017 would be a good idea. However, let’s assume in the 2019 financial year the accumulation member has now satisfied a condition of release and converts their balance to retirement phase. The fund will have a better tax-exempt percentage in 2019 than in 2017. Based on this example, we can see that the decision on whether to apply the CGT relief per asset depends on the timing of future capital gains tax events.
The trustee should consider this decision on a per asset basis. If an asset is expected to be sold in a period where the tax-exempt percentage under the unsegregated method is likely to be the same or lower than it is in the 2017 financial year, applying the CGT relief may provide the fund with a better tax outcome. This may be the case where the trustee does not expect any further movement of member balances into retirement phase and pension assets are expected to reduce over time compared to accumulation balances.
Alternatively, if members are expected to move into retirement phase, or members intend to draw down their new accumulation balances, prior to when the trustee expects to sell an asset, it may be better not to apply the CGT relief to that asset.
Essentially, if the tax-exempt percentage (approximately the ratio of retirement phase assets to fund assets) in the future income year the asset is sold is expected to exceed the current 2017 financial year tax exempt percentage, the trustees may be better off from a tax perspective not applying the CGT relief in the 2017 financial year.
The CGT relief provides a great opportunity for SMSFs to reset the cost base of fund assets and lock in capital gains which would currently be tax-free or based on a tax-exempt percentage that is better than that expected in future income years because of the transfer balance cap. However, while beneficial at first glance, there are some scenarios which require further consideration.
Funds currently employing a segregation strategy may wish to move to the proportionate method to ensure all current pension assets can obtain the CGT relief and lock in current unrealised gains as tax-free. In addition, depending on the current tax-exempt percentage and expectation for future years, it may also be best to choose to not employ CGT relief at all.
The fund should, prior to 1 July 2017, carefully consider the impact of applying the CGT relief on a per asset basis before decisions are made.
Please also note that there is uncertainty as to when and how assets that are currently supporting TTR pensions will be eligible for CGT relief. We understand there is discussion between Treasury and the ATO on this issue and we will keep you up-to-date as we learn more.
Melanie Dunn, SMSF technical services manager, Accurium
This information has been prepared by Accurium Pty Ltd ABN 13 009 492 219 (Accurium). It is general information only and is not intended to be financial product advice or legal advice and should not be relied upon as such. Whilst all care is taken in the preparation of this material, no warranty is given with respect to the information provided and Accurium is not liable for any loss arising from reliance on this information. Scenarios, examples and comparisons are shown for illustrative purposes only and should not be relied on by individuals when they make investment decisions. We recommend that individuals seek professional advice before making any financial decisions.