SMSFs and how the CGT rules work when a pension is in play — Part 2
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.
Exempt income — the segregated method
The segregated method is the other method available to SMSFs for claiming exempt income or ECPI. The segregated method involves the investments of the fund funding pensions being used solely to provide pensions (these assets are known as segregated current pension assets) and other assets (such as assets in accumulation phase).
Active segregation is not that common and a considerable number of SMSFs are segregated as a result of being deemed segregated (i.e. where 100 per cent of fund assets are funding pension liabilities).
Active segregation depends on appropriate record keeping. For example, it would be best practice to have trustee resolutions recording:
- the specific assets that have been specifically identified as funding the pension liabilities; or
- the specific assets that are not funding pension liabilities, .e.g an SMSF may have all of its assets funding a pension apart from certain assets which are not funding a pension. It may be easier to record the non-pension assets (e.g. cash in a separate bank account) rather than the pension assets which may be far more comprehensive (e.g. a diversified portfolio of investments).
Importantly, if a CGT event happens in relation to a CGT asset of an SMSF that is also a segregated current pension asset under s 295-385, any capital gain (or loss) is disregarded under s 118-320. Thus, any resulting net capital gain or capital loss is disregarded and is not reflected in the method statement analysis under s 102-5 discussed above.
We do not consider the segregated method in any further detail here as this method of claiming exempt income is rarely applied in practice, particularly since 1 July 2017 due to the additional restrictions that apply under s 295-387 where an SMSF with disregarded small fund assets; where at least one member has at least a total superannuation balance of at least $1.6 million, this method is not available.
Taxable income and tax payable
Broadly, for an SMSF that is covered by the unsegregated method of claiming ECPI, any net capital gain that arises under the method statement in s 102-5 (i.e. non-exempt proportion) is included in the fund’s assessable income for the relevant income year under s 6-10 as statutory income. Noting that the exempt portion is excluded from statutory income.
After the fund ascertains its assessable income (i.e. its ordinary income under s 6-5 and its statutory income under s 6-10), the fund’s taxable income can be calculated.
Naturally, tax advisers need to be aware they check that the correct amount or proportion of deductions have been claimed where an SMSF claims a pension exemption. In particular, to the extent expenditure is incurred in gaining or producing exempt income, it is not deductible under s 8-1. Section 8-1(2) expressly provides:
(2) However, you cannot deduct a loss or outgoing under this section to the extent that:
(c) it is incurred in relation to gaining or producing your *exempt income…; or
For example, where an expense is incurred by an SMSF which is 60 per cent exempt under the unsegregated method in s 295-390, only 40 per cent of the expense is deductible. Thus, expenditure that is incurred partly in gaining or producing exempt income and partly in gaining or producing assessable income must be appropriately apportioned. The ATO provides some guidance in TR 93/17 in this regard.
Also, an interesting modification rule applies in relation to the treatment of contributions in determining what is deductible to an SMSF. Broadly, s 295-95(1) modifies the deduction provisions for “contributions” made to complying superannuation funds since “all contributions” are treated as if they are included in the fund’s assessable income for the purposes of working out the amount of any deductions (e.g. non-concessional contributions [NCCs] are treated as assessable for calculating deductions). Thus, this modification rule can provide an SMSF a greater deduction if it receives significant NCCs in a financial year, as even though NCCs are not included in assessable income, s 295-95(1) deems them to be assessable.
Tax advisers should carefully review deduction claims as the ATO has previously noted that some tax agents claim a pension exemption for their SMSF clients without adjusting the amount of deductions claimed. This suggests that there are numerous tax agents that may not be aware of how this aspect of the pension exemption applies to SMSFs.
Applying the method statement to calculate tax payable:
Under s 295-10(1), the following method is used for calculating the tax payable by the fund:
Step 1. For a superannuation fund, work out the no-TFN contributions income. Apply the applicable rates as set out in the Income Tax Rates Act 1986 to that income.
Step 2. Work out the entity’s assessable income and deductions, taking account of the special rules in this division. The special rules modify some provisions of this act. They also include amounts in assessable income, allow deductions and exempt amounts from income tax.
Step 3. Work out the entity’s taxable income as if its trustee:
(a) were an Australian resident (except where paragraph [b] applies); or
Step 4. Work out the low tax component and non-arm’s length component of the taxable income of a complying superannuation fund…
Step 5. Apply the applicable rates as set out in the Income Tax Rates Act 1986 to the components, or to the taxable income of a non-complying superannuation fund…
Step 6. Subtract the entity’s tax offsets from the Step 5 amount or, for a superannuation fund, from the sum of the fund’s Step 1 and Step 5 amounts.
Thus, in broad terms, any non-exempt portion of the net capital gain would be subject to the usual rate of tax that applies to complying superannuation funds (i.e. 15 per cent). People who say net capital gains are taxed at a 10 per cent tax rate are assuming the one-third CGT discount applies. However, the correct tax rate is 15 per cent of the discounted net capital gain (which is 15 per cent).
Let’s now work through a practical example
To help illustrate the above rules, we now consider the following example:
- An SMSF makes a $220,000 capital gain on the sale of shares which have been held for more than 12 months.
- The SMSF regularly trades in shares and has always had the intent of acquiring shares to resell at a profit.
- The SMSF is 60 per cent in (exempt) pension phase for the 2020 financial year and this percentage is certified by the fund’s actuary.
- The sale contract relating to the sale of shares is entered into on 31 January 2020.
- The SMSF has $10,000 in carried forward capital losses from prior financial years.
- Assume there is no other income for FY2020 and we will ignore deductions or offsets/franking credits for the sake of simplicity.
The net capital gain for the disposal of shares is calculated as follows:
Apply relevant capital losses: $220,000 less $10,000 = $210,000
Apply the general one-third CGT discount: $210,000 x 1/3 = $70,000
The amount at Step 3 of the method statement in s 102-5 is therefore: $210,000 – $70,000 = $140,000
The non-exempt proportion (i.e. 100% – 60% ECPI = 40%) of the fund’s net capital gain is included in the fund’s assessable income as follows:
$140,000 x 40% = $56,000
Thus, $56,000 of statutory income from the disposal of the shares will be included in the SMSF’s assessable income for FY2020 and taxed at the usual 15 per cent rate of tax. This results in a tax liability on the disposal of shares as follows:
$56,000 x 15% = $8,400
- The CGT regime is the primary code for taxing complying superannuation funds, and the fact that the SMSF trustee regularly trades in shares and has always had the intent of acquiring shares to resell at a profit is irrelevant.
- The SMSF would need to carefully consider the deductions that can be claimed given the SMSF’s exempt portion is 60 per cent. Broadly, only around 40 per cent of general expenses would be deductible under s 8(1). Further, NCCs are treated as assessable income under s 295-95(1) in determining the proportion that can be claimed as a deduction.
How the CGT rules interact with the pension exemption is quite interesting and, at times, somewhat complex. As can be seen from the above, tax advisers should carefully review the legislative schema rather than relying on general rules of thumb. There are many SMSF advisers that are not aware of the technical tax detail outlined above. Conversely, there are many tax agents who similarly appear ignorant given the ATO’s publications.
Daniel Butler, director, and William Fettes, senior associate, DBA Lawyers. You can read Part 1 of this article here.