SMSFs and how the CGT rules work when a pension is in play — Part 1
Many SMSF advisers approach capital gains tax (CGT) questions that arise for SMSFs with a simple rule of thumb in mind: namely, capital gains made by a fund in connection with a CGT event happening are subject to an effective 10 per cent rate of tax (i.e. where the asset has been held for more than 12 months), or potentially nil tax if the asset is covered by the pension exemption.
Though such an approach can provide useful top-level thinking about how net capital gains are taxed in an SMSF, it important to recognise its limitations. In particular, the above is an oversimplification of how tax law operates. Indeed, tax agents and tax advisers (including registered tax agents and registered tax financial advisers) need to provide accurate advice and treatment, so the above general rule of thumb should not be relied on as a substitute for appropriate tax advice.
This article outlines key aspects of how the CGT rules apply to SMSFs. (All legislative references are to the Income Tax Assessment Act 1997 (Cth) unless otherwise stated.)
CGT is the primary taxing code for SMSFs
For SMSFs, the distinction between items of a revenue or capital nature is less controversial. Broadly, s 295-85 provides that the CGT rules are the primary code for determining the tax treatment of gains or losses generated on the disposal of an asset by an SMSF.
This is a major “paradigm” shift for most tax advisers to come to grips with, as the usual tax rules apply very differently to SMSFs as explained below. Broadly, most gains on the sale of assets in an SMSF are on capital account even for assets (e.g. shares) where there is substantial trading activity by the fund or where the fund trustee has an intention to derive a gain on resale of the asset. For most other taxpayers, this would clearly be on revenue account.
For many different types of resident taxpayers, working out the income tax consequences of a CGT event occurring can be a complex exercise, because unless a specific exclusion applies, the relevant gain that arises must first be analysed as ordinary concepts income under s 6‑5 separately to the analysis under s 6‑10. Though gains from asset disposals that come home to such taxpayers due to a “mere realisation” will generally be treated on capital account, consideration will always need to be given whether the gain was actually on revenue account. For example, receipts from ordinary business operations or commercial transactions carrying out a profit-making scheme generally constitute ordinary income for a non-SMSF taxpayer notwithstanding the statutory income consequences of any relevant CGT event (FC of T v. The Myer Emporium Ltd  163 CLR 199; TR 92/3). In that case, the anti-overlap rule in s 118-20(1) will need to be applied to address any potential double taxation of the gain.
Fortunately, this kind of two-pronged analysis based on the revenue/capital distinction is generally not required for superannuation funds, as s 295‑85 provides that the CGT rules are the primary code for determining the tax treatment of gains or losses derived by an SMSF trustee in relation to a CGT event happening.
For instance, in relation to an SMSF disposing of shares, even where there is a substantial pattern of trading activity, or where the fund trustee had a clear intention of maximising profit on resale of the shares, the disposal would nonetheless be on capital account.
NB: The exclusivity of the CGT code for SMSFs is subject to very limited exceptions, e.g. assets that form part of trading stock acquired prior to 7.30pm on 10 May 2011.
The relevant CGT event and asset
Due to the primacy of the CGT code, it is also important to identify the relevant CGT event that applies.
As with any other taxpayer, multiple CGT events can occur based on the same set of facts, and the CGT event that applies is the one that is most specific to the situation under s 102‑25.
NB: This article focuses on CGT events in respect of fund assets and does not consider the CGT rules in relation to member interests in the fund as distinct CGT assets. However, in broad terms, s 118‑305 provides that any capital gain or loss made from a CGT event happening in relation to a member’s interest in the fund is disregarded.
Calculation of net capital gain
Once the relevant CGT event is identified, and assuming the gain is not disregarded as a segregated pension asset, the SMSF trustee will need to calculate the net capital gain that arises under s 102‑5 as part of ascertaining its assessable income for the relevant financial year.
In broad terms, a fund must work out the relevant net capital gain by taking the capital gain that arises under the particular CGT event and applying the following reduction steps:
- Step 1 – Applying current year capital losses to reduce the gain;
- Step 2 – Applying any carried forward net capital losses (as calculated under s 102‑10); and
- Step 3 – Applying the one-third (1/3) general CGT discount percentage that is available to superannuation funds where the asset has been held for a period greater than 12 months.
An SMSF is typically entitled to a one-third (1/3) discount on a capital gain provided the asset was held for at least 12 months at the time of the CGT event happening: ss 115-25 and 115-100(b).
Note that the one-third discount is not available if the transitional CGT cost base reset relief had been used for FY2017 in respect of an asset unless a further period of 12 months had elapsed since the cost base reset (with a deemed acquisition date of immediately before 1 July 2017 or at some time between 9 November 2017 to 30 June 2017 inclusive).
Also note that in applying the above method statement, the ATO generally does not accept that the small business CGT concessions in Div 152 can apply to an asset disposed of by an SMSF, so no further reductions are available after Step 3.
Exempt income — the unsegregated method
The unsegregated method is the most commonly used method for SMSFs claiming exempt income under the “exempt current pension income’ (i.e. ECPI) exemption.
If a fund is paying one or more (retirement phase) pensions in the relevant income year of the CGT event, and the fund is using the unsegregated method in s 295‑390 to calculate its exempt income, the net capital gain will broadly be exempt to the extent that the fund’s assets are used to support current (retirement phase) pension liabilities.
This exemption applies prior to the fund combining its ordinary and statutory income to ascertain its assessable income, and thus also prior to any calculation of the fund’s taxable income.
The unsegregated method is based on the proportion of average value of current pension liabilities of the fund compared to the average of the fund’s superannuation liabilities as determined in accordance with the following formula in s 295-390(3):
Average value of current pension liabilities
Average value of superannuation liabilities
- Average value of current pension liabilities is the average value for the income year of the fund’s current liabilities (contingent or not) in respect of retirement phase superannuation income stream benefits of the fund at any time in that year. This does not include liabilities for which segregated current pension assets are held.
- Average value of superannuation liabilities is the average value for the income year of the fund’s current and future liabilities (contingent or not) in respect of superannuation benefits in respect of which contributions have, or were liable to have, been made. This does not include liabilities for which segregated current pension assets or segregated non‑current assets are held.
Note that an actuarial certificate is required to certify the exempt percentage that is used to support the fund’s claim of exempt income in the fund’s annual tax/statutory return.
Daniel Butler, director, and William Fettes, senior associate, DBA Lawyers