Regulatory unfairness with foreign pensions
The taxation laws around transfers of foreign pension money mean that residents are often hit with excessive taxes when transferring money to Australia. What can be done to help clients?
The royal commission has highlighted misconduct and inappropriate management practices in the financial services industry. However, what is not in its terms of reference — and leads to equally adverse consumer outcomes — is superannuation regulatory unfairness.
The legislation and its regulation can, with the passage of time and a changing economic environment, be inappropriate. Even worse, the legislation may be inherently unfair from the outset. An example of the latter would be the debacle over a market-linked pension, which is inherently an account-based structure, being valued on a remaining term basis before 1 July 2017 for transfer balance cap purposes. Another example is the value of a defined pension on a 16 times basis — irrespective of whether it is an older single pensioner with a fixed rate pension or a younger reversionary pensioner with CPI annual increases. It doesn’t require much analysis to realise the inequality of that approach.
Any regulatory factors need to be periodically updated for changed economic factors or they will be inappropriate. For the old legacy Section 1.06(6) pensions, there are Schedule 1B commutation amount limits. These were predicated on factors applicable to times of higher inflation and returns. They are too low for current times. The prescribed way superannuation must be valued under family law legislation for matrimonial property pool purposes is in a similar situation. You get (for PSS, CSS and Military Schemes) a family law value which is different to how the trustees will implement a split on their scheme factors.
The main purpose of this article and the focus for the rest of the commentary is how unfair the taxation regulation of overseas retirement money is for Australian residents. There are two major ways a lump sum moved to Australia is treated. These will be illustrated by considering a 401K transfer from the USA to Australia and QROPS transfer from the UK. Similar issues occur with transfers from other countries, but noting that the Trans-Tasman Agreement with NZ is totally different.
US retirement funds usually are not accepted by the ATO as meeting the foreign superannuation fund requirements and so are treated as a foreign trust. They are assessed under Subsection 99B(1) of the ITAA 1936. This means that in the year of receipt, the whole distribution is assessable other than the amount of capital contributed. The person may have been an Australian tax resident for only a year or two but taxed on total gains over many years. It gets worse! The US fund will impose a withholding tax on the whole distribution, but the ATO will only grant a partial tax credit. Having a benefit accumulated over many years assessed against a single tax year pushes the applicable marginal tax rate up massively. It is not unusual for a person to lose as much of the transfer on larger amounts as they keep. That is not fair.
Two strategies are utilised to try and ameliorate this unfairness. The first is, if the US fund will allow it, to make several payments in different tax years to limit the top marginal tax rate applicable. The second strategy is to consider paying the entitlement as a pension. The pension can be a term pension of more than 10 years in roughly equal amounts besides lifetime annuities.
US DTA Article 18(1) states that “subject to the provisions of Article 19 (Government remunerations), pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State”. There are similar clauses for social security pensions and life office annuities. There is a deductible amount. This strategy may reduce the overall tax impost as lower marginal tax rates apply and the withholding tax problem is avoided.
For a UK pension fund, the commissioner generally accepts the UK fund as a foreign superannuation fund for the purposes of Subdivision 305-13 of the ITAA 1997. The UK fund needs to meet the sole purpose test, i.e. have no other benefit payment options other than retirement invalidity death etc. Otherwise, it is not a superannuation fund for Australian income tax purposes and can’t be a foreign super fund. The UK funds are assessable under Section 305-60 if within six months of tax residency, or otherwise under Section 305-70 of the ITAA 1997.
For lump sum payments from a foreign superannuation fund, applicable earnings after six months tax residency is worked out as follows:
- The amount vested just before start day plus contributions made by or in respect of the member during the period after the start date plus transfers from any other foreign super fund after the start date.
- Deduct the above from total amount vested in the member when the lump sum was paid to Australia before any deductions for foreign tax.
- Multiply the resulting amount by the proportion of Australian residency days since the start date divided by total days.
- Add all previously exempt fund earnings.
The amount cannot be less than zero. The balance of the benefit is not assessable income. The commissioner does not have the discretion to extend the tax-free six-month period — even if the taxpayer was not able to transfer in this period through no fault of their own.
According to Section 305-80 of ITAA 1997, a taxpayer who is transferring their foreign super benefits directly to an Australian complying fund can elect to have the Australian super fund pay the tax on the applicable fund earnings if the taxpayer no longer has an interest in the overseas fund immediately after the payment. The advantage is the 15 per cent super fund rate may be less than the taxpayer’s marginal tax rate.
The unfairness with the UK transfers occurs because the commissioner has moved the currency transaction to time of receipt but does not use a similar basis for the growth or assessable component. The commissioner’s view on the application of Subsection 960-50(1) of ITAA in relation to foreign currency translation to Australian dollars is expressed in ATO ID2015/7 for foreign super funds. It states that the applicable fund earnings amount should be calculated by deducting the Australian dollar equivalent of the amount vested in the foreign fund just before the day the taxpayer first became an Australian resident, from the amount received from the foreign fund. The amount should be translated using the exchange rate applicable on the day of receipt of the relevant lump sum in Australia, i.e. a single translation rate. This is different to how the commissioner treated currency conversions a couple of years ago and how defined benefit growth is assessed.
Many UK entitlements are expressed as defined benefits. Such an entitlement is funded by both capital and investment earnings. In times of low returns, more capital is required and vice versa. Currently, if one subtracts the current cash equivalent transfer value from one from some years ago, it overstates the growth component. The commissioner changed the currency exchange rules because the ATO didn’t like the growth component being reduced by exchange rate changes. They only want the actual exchange rate used. The problem is, the commissioner is not being even-handed in applying the same logic to how the growth component is calculated.
It is good that there is an emphasis on what is in the client’s best interest. The issue will not be comprehensively addressed unless the deficiencies in legislation and its implementation is included in the mix.
Brian Bendzulla, managing director, NetActuary