The latest rundown on CGT relief for SMSFs
With the election to apply CGT relief required by the lodgement date of the SMSF’s annual tax return, practitioners need to start reviewing this for clients now.
The transitional capital gains tax (CGT) relief or cost base reset rules, allow SMSFs to choose to reset an asset’s cost base to the asset’s market value prior to 1 July 2017.
An article I wrote in February named ‘Transitional CGT relief for pension and TRIS assets for FY2017’ provided a detailed outline of how the relief applies to an SMSF and explained the different treatment of a segregated fund to an unsegregated fund. This article is also worthwhile reviewing for a second time as this article only focuses on some key points that relate to the ‘devil in the detail’ regarding the CGT relief for SMSFs that advisers need to be aware of when advising on CGT relief.
Also, respect the limits of your advice capability if you do not hold an Australian Financial Services Licence! On the other hand, if you hold a licence, respect the limits on who is qualified to provide tax advice and make sure you are registered with the Tax Practitioner Board if you are providing tax advice.
Do you choose to apply the relief?
Each SMSF that was in pension mode during FY2017 should be reviewed to determine which SMSFs to review especially SMSFs with members with more than $1.6m in superannuation. However, some SMSFs with member balances below $1.6m may also be entitled to the relief.
This depends on a range of factors and choosing to apply the relief will not always be the best decision.
The right decision depends on a proper analysis of the unrealised gains on CGT assets and the costs versus benefits of choosing to apply the relief.
In some cases, the relief can provide great upside. However, in some cases the relief could prove more costly to implement that the upside.
Indeed, where a member was in receipt of a transition to retirement income stream (‘TRIS’) prior to 1 July 2017, there was no need for that member to have more than $1.6m to obtain CGT relief provided that member had not satisfied a relevant condition of release such as retirement or attaining 65 years.
The ATO’s view is that the object or purpose of the legislation precludes members with an account-based pension (ABP) below $1.6m from being entitled to CGT relief. (This would also appear to cover a member with a TRIS where that member had satisfied a relevant condition of release, for example, retirement or attaining 65 years). However, there is no provision in the legislation which expresses this view as a criteria and if the legislation intended to preclude this situation, the operative provisions of the legislation should have made this clear.
Does the choice apply to each asset?
The CGT relief applies on an asset by asset basis and only applies to assets held in the fund prior to 1 July 2017. Recall TD 33 confirmed that each individual share can be a separate asset. More specifically, the CGT relief will only apply to an asset that is:
- Held by the SMSF on 9 November 2016; and
- Still held just before 1 July 2017.
The ATO state in LCG 2016/8 ():
The choice is made on an asset-by-asset basis. It is not made on an asset-class basis (for example, a fund's defensive asset class).
Accordingly, there is a need to drill down to the individual assets in each class of assets held by the SMSF, such as shares, units and similar assets as each share in a company, for instance, is a separate asset. For example, an SMSF with 100 shares in a company has 100 separate assets and can make a separate election for each asset. However, in practice, we generally only have to examine each ‘tranche’ of shares purchased. Assume these 100 shares on 30 June 2017 have a market value of $6.00 and:
- 50 shares were purchased at $3.00 each on 1 January 2000 (with the serial numbers 1 to 49 inclusive or ‘tranche 1’); and
- 50 shares were purchased on 1 January 2010 for $8.00 (with the serial numbers 50 to 99 inclusive or ‘tranche 2’),
- each share in tranche 1 has a capital gain of $3.00; and
- each share in tranche 2 has a capital loss of $2.00.
What are some of the key differences between the segregated and the proportionate CGT relief?
Firstly, the time the cost base reset occurs differs as follows:
- Segregated CGT relief: the reset occurs when the asset ceases to be a segregated current pension asset.
- Proportionate CGT relief: the reset always occurs immediately before 1 July 2017.
One attraction to applying the segregated CGT relief is that the entire capital gain is disregarded in relation to the relevant segregated asset under s 118-320 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’). In contrast, under the unsegregated method, a notional capital gain on the non‑exempt proportion is assessable and is included in the fund’s assessable income, subject to making a further choice to defer the notional gain until it is actually realised.
If the proportionate CGT relief applies, a deferral of any unrealised capital gain would generally appear to be the most prudent choice compared to paying tax upfront on an unrealised or notional capital gain. However, deferring tax may not always produce the best outcome as discussed below.
Thus, choosing the proportionate CGT relief may trigger an assessable capital gain. It can also trigger a capital loss.
In contrast, any capital gain or loss is disregarded if segregated CGT relief applied. This is because s 118‑320 of the ITAA 1997 provides:
A *capital gain or *capital loss that a *complying superannuation entity makes from a *CGT event happening in relation to a *segregated current pension asset is disregarded.
Under the proportionate (unsegregated) method, once any current and prior year capital losses and discount percentages have been applied to the capital gains, the remaining amount is the ‘net capital gain’. The net capital gain is included in the SMSF’s assessable income (ss 6-10 and 102‑5 of the ITAA 1997).
If an SMSF is eligible to choose the proportionate CGT relief, then the SMSF will be entitled to treat the asset as sold and immediately reacquired before 1 July 2017 and is therefore required to reflect the non-exempt portion as an assessable capital gain unless a further choice is made to defer the gain (s 294‑115(1)(b) of the Income Tax (Transitional Provisions) Act 1997 (Cth) (‘ITTPA’)). The exempt portion is specified by an actuary in an actuarial certificate pursuant to s 295‑390(4) of the ITAA 1997. Thus, to the extent that the net capital gain caused by choosing the proportionate CGT relief is not covered by that proportion, the net capital gain (after the application of capital losses and any CGT discount) is included in the fund’s assessable income under s 6-10 of the ITAA 1997. Naturally, after any deductions, tax offsets, etc, have been applied, assessable income can ultimately give rise to an income tax liability.
The following example is illustrative.
Example 1 — proportionate CGT relief
The Oswald Superannuation Fund has total assets of $2.2m. For FY2017, the fund was paying an ABP supported with a $1.3 m account balance. The SMSF is eligible for the proportionate CGT relief. The SMSF’s principal asset is real estate that was purchased several years ago for $600,000 that is now worth $950,000.
The SMSF is not using active segregation. The SMSF chooses to apply the proportionate CGT relief.
The cost base of the real estate is reset to $950,000 as a result of the relief applying. The SMSF has no other capital gains or losses and a net capital gain of $233,333 (calculated as the capital gain (ie, $950,000 less $600,000) and then reduced by a one-third discount).
The proportion specified in the actuary’s certificate is 60%. Accordingly, $140,000 (ie, 60% x $233,333) of the net capital gain is exempt. However, the balance of $93,333 remains as assessable income.
Unless the SMSF chooses to defer this amount, the $93,333 may well give rise to an income tax liability in respect of FY2017 of $14,000 (ie, $93,333 x 15%). Naturally that $14,000 amount could be lower if the SMSF had any deductions, offsets etc.
Thus, if a choice is made to defer a notional gain has not been exercised, the non-exempt proportion of that gain is included in the SMSF’s assessable income for FY2017 (the exempt portion is certified by an actuary, so the non-exempt portion is 1 minus the certified percentage).
In contrast, under the proportionate CGT relief deferral option, the crystallised notional capital gain is subject to a modified version of the method statement in s 102‑5 of the ITAA 1997 whereby it is assumed the fund had no current year or carried forward capital losses, and therefore, these losses are preserved for future FYs. Section 294-120(4) of the ITTPA states:
(4) The deferred notional gain is the 2016-17 non-exempt proportion of the amount of the fund's net capital gain for the 2016-17 income year determined on the assumptions that:
(a) subsection (3) of this section does not apply; and
(b) the fund made no capital gains in that income year other than the gain mentioned in paragraph (1)(b); and
(c) the fund made no capital losses in that income year; and
(d) the fund had no previously unapplied net capital losses from earlier income years.
Example — proportionate CGT relief and capital losses
The Blue SMSF has $2.4m in assets and an investment property with a $900,000 unrealised capital gain at 30 June 2017. The fund also has $350,000 of capital losses carried forward from FY2016. The fund was 90 per cent exempt in FY2017 under the unsegregated method.
Assume the Blue SMSF chooses to apply CGT relief solely to the investment property, the analysis would be as follows:
No deferral of capital gain – so FY2017 the net capital gain is included
Notional capital gain $900,000
Less: capital losses carried forward $350,000
Less: 1/3rd CGT discount $183,333
Net capital gain $366,667
Non-exempt portion x 10% $36,667
(Tax on the non-exempt portion x 15% $7,516.69)
Deferral of notional capital gain
Notional capital gain $900,000
Less: 1/3rd CGT discount $300,000
Net capital gain $600,000
Non-exempt portion x 10% $ 60,000
This example shows that while there is a greater deferred notional gain at $60,000 compared to $36,667 in the no deferral example, the choice to defer the capital gain preserves $350,000 in capital losses. Thus, when the investment property is actually realised and the $60,000 deferred notional gain is brought to account, there should be ample capital losses to result in no tax being paid on the unrealised capital gain as at 30 June 2017.
The above example, illustrates there can be substantially different outcomes resulting from choosing to defer a capital gain compared to disclosing a capital gain in FY2017.
As discussed above, if the unsegregated method applies, choosing a deferred notional gain can result in a more efficient use of capital losses.
For SMSFs using the unsegregated method, an unrealised capital loss can be realised on making a choice applying the proportionate CGT relief. (A capital loss in respect of a segregated asset is disregarded under s 118-320 ITAA 1997, as discussed above).
Further, while there is a choice to defer a notional gain under s 294-120 ITTPA, there is no choice to defer a capital loss. If the proportionate CGT relief applies, then a capital loss that arises under the deemed sale and reacquisition on 30 June 2017 may be utilised in FY2017 by applying that loss against any capital gain that the SMSF has available in accordance with the method statement in s 102‑5 of the ITAA 1997. Any unapplied capital loss can be carried forward to future income years. Thus, if the SMSF chooses to claim the proportionate CGT relief on a loss asset, that loss is incurred in FY2017. If that same SMSF chooses to defer notional gains on all other assets, the capital loss is carried forward until recouped in accordance with the method statement under s 102- 5 ITAA 1997.
Special CGT modifications
Broadly, the CGT regime is the primary code of taxation for SMSFs and most gains on assets are, subject to a few specific exceptions, on capital account; rather than on revenue account. While not all SMSF assets are on capital account (eg, gains and losses on certain securities and trading stock) and a revenue gain or loss can be derived by an SMSF, most assets are dealt with on capital account which therefore may provide an opportunity for the 1/3rd CGT discount to apply if the asset has been held for more than 12 months. This means that an SMSF is still entitled to a 1/3rd CGT discount on capital gains on shares, units and stapled securities acquired after 10 May 2011 even if the SMSF is a share trader (or involved in regular investment trading activities) as these items were removed from the trading stock exception for SMSFs in s 295-85 of the ITAA 1997 provided the asset is held for more than 12 months.
Several exceptions to what constitute CGT assets to an SMSF include:
- where the SMSF owned real estate, a share, unit or a stapled security as trading stock as at 7:30 pm ACT time on 10 May 2011 (Tax Laws Amendment (2012 Measures No. 1) Act 2012 (Cth) sch 2 item 6); and
- the asset is a debenture stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security, deposit with a bank, building society or other financial institution, a loan or some other contract under which an entity is liable to pay an amount (s 295‑85(3)(b) of the ITAA 1997).
Furthermore, some tax advisers are surprised to learn that SMSFs do not have any pre-CGT assets (note the CGT regime commenced on 19 September 1985 for non-superannuation taxpayers) and all assets of regulated and complying superannuation funds were brought into the CGT regime on 30 June 1988. Superannuation funds with assets owned prior to 1 July 1988, were given a choice to adopt the cost base or market value of such assets on 1 July 1988.
The CGT relief also only applies to CGT assets owned by an SMSF. Thus, investments held by an SMSF via a company or trust do not obtain any CGT relief. The following example illustrates this issue.
Ben’s SMSF invested $500,000 in a unit trust on 1 January 2000 and this money was used to acquire a rental property that cost $470,000 and the balance related to acquisition costs. The market value of the property today is $1.5m.
Broadly, while the CGT relief will reset the cost base of the units in the unit trust to $1.5m (a notional capital gain may be assessable under the proportionate method to the extent of the non-exempt portion), the cost base of the property to the unit trust remains at $470,000 (plus any other costs that can be added to the property’s cost base, eg, stamp duty, legal costs relating to the purchase and certain improvement costs; which we will assume is $30,000 in this example).
Thus, when the unit trust sells the property, a $1 million capital gain (prior to any CGT discount) is likely to arise which may result in tax payable by the SMSF trustee.
The SMSF’s cost base in the units is $1.5 million. Thus, if the net capital gain on disposal of the property can be distributed to the SMSF prior to 30 June in the relevant FY and the unit trust is then wound up in the same relevant FY, there may be a capital loss on cancellation of the units that can offset the capital gain distribution to the SMSF from the sale of the property.
The above is discussed in more detail in heading 8.9(b) and expert tax advice should be obtained if the above scenario arises.
It should be borne in mind that the CGT relief provisions can nonetheless provide relief to an SMSF’s unitholdings in a unit trust where the units carry a significant unrealised capital gain due to having a reduced cost base pursuant to CGT event E4.
As you will gather from the above brief summary, there is considerable complexity and unfortunately limited time to become familiar with and implement the CGT relief. Advisers must start taking action now and notify clients of what must be attended to and by when as a choice to obtain CGT relief must be made by the lodgement date of the SMSF’s FY2017 tax return.
Daniel Butler, director, DBA Lawyers