The application of CGT relief to assets in an SMSF is an irrevocable decision and may involve an analysis of the future direction of the fund’s exempt current pension income.
The super reform transitional capital gains tax relief presents a number of challenges for SMSF advisers. Understanding the technical operation of the transitional provisions is a challenge in itself. A further challenge is the asset by asset assessment of the viability of the election for a potentially large number of assets in possibly dozens or more SMSFs.
The good news is that the elections are not required before the SMSF’s 2016-17 income tax return deadline, so the analysis of whether the election should be made may be postponed until after 1 July 2017. But note that the range of assets to which the CGT relief may be applied will be potentially impacted by events in the SMSF prior to 1 July 2017.
The basic mechanics
The CGT relief allows the CGT cost base of certain assets to be reset to the current market value, at the discretion of the trustee. The election is applied on an asset by asset basis. It must be in approved form, yet to be determined and, once made, it is irrevocable.
The CGT relief is only available for assets held throughout the ‘pre-commencement period’, which began at the beginning of 9 November 2016 and will end just prior to 1 July 2017. Therefore, the election is not available for assets sold prior to 1 July 2017 or purchased on or after 9 November 2016.
Importantly, it is stated in the object in the legislation that the CGT relief is provided only for capital gains that might arise as a result of individuals complying with the introduction of the $1.6 million transfer balance cap or the removal of the tax exemption for transition to retirement income streams.
The first step in understanding which assets the relief may be applied to is to determine the method used to calculate exempt current pension income (ECPI) on 9 November 2016, summarised in the table here.
Super fund’s calculation of ECPI as at
9 November 2016
Range of assets trustee may apply CGT relief to
Uses segregated method
• Continues using segregated method throughout pre-commencement period.
Any or all assets transferred during pre-commencement period from:
• segregated current pension asset pool, to
• segregated non-current asset pool.
• Switches to proportionate method prior to 1 July 2017.
Any or all segregated current pension assets.
Uses proportionate (non-segregated) method and 2016-17 ECPI > 0%.
Any or all assets of the fund
(which were not segregated current pension assets or segregated non-current assets during the pre-commencement period).
SMSFs using the segregated method on 9 November 2016
The table shows two outcomes for SMSFs using the segregated method on 9 November 2016.
Consider a single member SMSF with a single interest – an account-based pension valued at $2 million on 30 June 2017. Being 100 per cent in pension phase, it is taken to use the segregated method. In order to comply with the $1.6 million transfer balance cap, the SMSF member commutes $400,000 and establishes an accumulation account in the fund.
If the segregated method continues to be used until 1 July 2017, the SMSF trustee may apply the CGT relief election to the assets transferred from the segregated current pension asset pool into the segregated non-current pension asset pool to support the $400,000 accumulation interest.
Switching to the proportionate method prior to 1 July 2017 will mean the CGT relief will be available on all assets currently held in the segregated current pension asset pool. That is, it would be available on $2 million of assets, assuming all the asset had been held by the fund throughout the pre-commencement period.
A new rule effective from 1 July 2017 means that SMSFs with members who need to commute existing pensions to comply with the $1.6 million transfer balance cap will generally not be able to use the segregated method. They will be required to use the proportionate method.
SMSFs subject to the new rule may decide it is more commercial to start using the proportionate method sooner. For example, on 30 June 2017 or earlier, as a consequence of the creation of a new accumulation interest in compliance with the $1.6 million transfer balance cap. Anecdotal evidence suggests many SMSFs currently find it more cost efficient to use the proportionate method.
SMSFs using the proportionate method on 9 November 2016
The table also shows that where a fund has at least one pension liability and uses the proportionate method throughout the pre-commencement period, it may apply the CGT relief to all of the fund’s assets which were not treated as segregated during the pre-commencement period.
Commuting a pension interest in compliance with the super reform measures will decrease the ECPI, meaning the fund’s assets will be exposed to a greater proportion of tax. The option to reset the cost base preserves the taxable position of the unrealised capital gains at the point of commutation.
But there’s a catch
For each asset that the CGT relief election is applied to, the trustee must calculate the amount of assessable income that would be subject to tax if the asset had been sold for its current market value at that time.
That amount of assessable income is either taxable in the 2016-17 year or at the trustee’s election (the second CGT election), deferred until a later year when the asset is sold.
Consider an SMSF asset which was purchased for $100,000 and is valued at $200,000 as at 30 June 2017. Making the first election results in a deemed gross capital gain of $100,000. If the fund has held the asset for more than 12 months, the one-third CGT discount will apply, reducing the gross capital gain to $66,667.
In addition, if the fund’s ECPI is 67 per cent for example, only one-third of this amount would be taxable, that is $22,222. The CGT liability would be $3,333 (15 per cent of $22,222) in the 2016-17 income year if the second CGT election for deferral is not made. Otherwise, the fund is required to carry forward $22,222 of assessable income until the asset is sold, in which case that amount will be taxable in the income year in which the asset is sold.
Repeat this process for each asset the first election is applied to.
Making the first election is not a trivial decision
A consequence of the first election is a tax liability may be crystallised, warranting consideration of the pros and cons of making the election.
Assume that the asset above will be sold in the 2020-21 financial year for $300,000 and that the fund’s ECPI has increased to 87 per cent because a spouse who currently has an accumulation interest has commenced an account-based pension.
The asset sale will have two CGT impacts. Firstly, the amount being carried forward ($22,222) will be taxable in 2020-21 – a $3,333 CGT liability.
Secondly, the gross capital gain of $100,000 ($300,000 less the reset cost base) will be reduced by the one-third CGT discount and the fund’s 87 per cent ECPI, so $8,667 will be taxable at 15 per cent. The second CGT impact will be a $1,300 liability.
In total, $4,633 of CGT will result in the 2020-21 income year.
If the fund does not apply the CGT relief, the cost base will remain at $100,000, and a gross capital gain of $200,000 will be realised in 2020-21. Applying the one-third CGT discount and the fund’s 87 per cent ECPI results in $17,333 of non-exempt income which is taxable at 15 per cent.
The total CGT liability would be $2,600.
Application of the super reform CGT relief to assets of SMSFs using the proportionate method throughout 2016-17 may involve analysis of the future direction of the fund’s ECPI.
David Barrett, head of Macquarie technical services, Macquarie
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