Consequences when the minimum pension amount is not met
Where a retirement phase account-based pension (ABP) does not meet the relevant pension standards there are consequences for the fund and the member.
These consequences include reducing the fund’s claim for exempt current pension income (ECPI) and changing the mix of tax components of the pension interest. There will also be transfer balance account (TBA) implications.
A transition to retirement income stream (TRIS) that fails to satisfy the relevant rules, for example, not paying the minimum pension or exceeding the 10 per cent maximum pension will also have implications. A TRIS is not a retirement phase pension until a full condition of release is satisfied and consequently a breach of the relevant rules does not affect the fund’s claim to ECPI, however, all pension payments will be treated as lump sum benefit payments. Given a TRIS is generally commenced using preserved benefits, this will cause the SMSF trustee(s) to breach the preservation standards and consequently all payments will be fully assessable to the member and taxed at their marginal tax rate (MTR), unless the Tax Commissioner exercises discretion not to.
Approach to SMSF admin when paying pensions
When you have SMSF clients paying pensions, consider the approach to the fund’s administration, accounting and reporting. The traditional annual in arrears approach is unlikely to detect an underpayment of the minimum pension before 30 June, compared to a more regular, for example monthly or quarterly, processing approach. Specialised SMSF administration and accounting platforms have the functionality to help SMSF clients, their advisers, administrators or accountants, with the use of data feeds to record and monitor pension payments to reduce the chance of a breach of the relevant pension standards.
Tax Commissioner’s GPA
We understand that a shortfall to the required minimum pension can still happen, which inevitability is not identified until after year end. There is an option for SMSF trustees and their advisers to consider when this happens.
The Tax Commissioner’s General Powers of Administration (GPA) exception was introduced by the ATO to allow an SMSF to effectively continue a pension and importantly, where the pension is a retirement phase pension, claim ECPI in certain circumstances, even when the minimum pension payment was not met.
The Tax Commissioner may allow a pension to be treated as continuing, even where there is a shortfall in the required minimum pension amount where all of the following conditions are satisfied:
1. The SMSF trustee(s) failed to pay the minimum pension amount in that income year because of either:
- an honest mistake made by the trustee(s) resulting in a small underpayment of the minimum pension amount; or
- matters outside the control of the trustee
2. Where the pension was in the retirement phase, the entitlement to claim ECPI would have continued but for the trustee failing to pay the minimum payment amount
3. Upon the trustee becoming aware that the minimum payment amount was not met for an income year, the trustee makes a catch-up payment as soon as practicable in the following (current) income year; or treats a payment (intended prior year payment) made in the current income year, as being made in that prior income year
4. Had the trustee made the catch-up payment in the prior income year, the minimum pension standards would have been met
5. The trustee treats the catch-up payment, for all other purposes, as if it were made in the prior income year.
Rather than apply to the ATO, an SMSF trustee can self-assess entitlement to the exception where all the following apply:
1. Failure to meet the minimum pension requirements was an honest mistake or was outside the control of the trustees
2. The underpayment is only small
3. All the other conditions, listed above, have been met; and
4. The trustee(s) has not previously applied the exception for failing to meet the minimum pension payment requirements.
What is a ‘small underpayment’?
The ATO outlines on their website1 that “the Commissioner considers a small underpayment to be one that does not exceed one-twelfth of the minimum pension payment in the relevant income year”.
It further states that where a pension commenced part way through the income year, the one-twelfth amount is based on the annualised minimum pension and not the pro-rata minimum pension amount. This would generally provide a higher qualifying amount.
Where the shortfall amount exceeds one-twelfth of the annual minimum pension this does not mean that the ATO will not exercise discretion and apply the exception. However, the SMSF trustee(s) cannot self-assess their entitlement to the exception. They, or their agent, will have to make an application to the ATO outlining the circumstances that affected the SMSF trustee’s ability to make the minimum pension payment for the income year. The ATO will then consider the facts, circumstances and reasons for the shortfall and whether the exception should be applied.
An SMSF who has previously self-assessed their entitlement to the exception, will also need to make an application to the ATO, even where the shortfall meets the one-twelfth test. Again, the ATO will consider the SMSF’s application on its own merits.
Whilst there is no benchmark set of circumstances that where met, would mean a favourable outcome from an application to the ATO, based on the ATO website examples1, it would be important, for a fortuitous outcome, for the SMSF to be able to demonstrate that the SMSF had:
- a good compliance history of meeting the minimum pension payment requirement
- the liquid funds available to make the required payment to meet the minimum pension amount
- a consistent pattern of payment of pension amounts, even where payments were not made regularly, for example, the SMSF always made the minimum pension payment annually in June of each year
- not met the minimum pension due to either circumstances outside of their control or there was an honest mistake made that caused the shortfall.
The examples provided by the ATO on their website1, can be referenced as an indication of when the ATO would likely or not exercise discretion and apply the exception. For example, scenarios where the ATO is unlikely to apply the exception are where the shortfall is due to the SMSF trustee paying the pension:
- by cheque which is subsequently dishonoured due to insufficient funds in the SMSF’s bank account
- pays the pension by cheque prior to 30 June but does not have available sufficient funds in its bank account. The member does not deposit the cheque until there are sufficient funds available, which is after 30 June
- pays the pension via an electronic fund transfer on 30 June, which falls on a weekend. The payment is processed by the SMSF’s bank on the next business day which is after 30 and credited to the member’s bank account. The ATO considers the payment made on the date the funds are received into the member’s bank account.
Successful application of the shortfall exception – still work to be done
Where the SMSF meets all conditions to self-assess the application of the exception or the ATO provides a favourable response to an application, there is still some work to be done.
First, the catch-up pension payment made in the following income year needs to be brought to account in the prior income year, the income year the shortfall occurred. This would require a journal entry to debit the member’s pension interest, deducting the amount and crediting a liability account, for example, “Pension amount owing”, that will be disclosed on the SMSF’s Statement of Financial Position.
Second, ensure that the catch-up payment made in the following income year is debited (offset) against the liability account, the “Pension amount owing” liability account. This will offset the amount accrued in the prior income year and importantly, not include it as a pension payment for the income year in which it was actually paid – watch out for whether this could result in another pension shortfall.
Thirdly, when reviewing whether the SMSF has met the minimum pension for an income year, make sure you do not include a pension shortfall catch-up payment that had been accrued in the prior income year where the SMSF was successful in applying the exception. As noted in the previous point, this could result in the SMSF not meeting the minimum pension payment in another income year due to the catch-up payment being counted in the wrong income year.
What happens if the SMSF has multiple pensions?
Where an SMSF is paying more than one pension to one or more members, the minimum pension payment requirements must be satisfied for each pension. Where the trustee fails to meet the minimum pension payments for one or more pensions, the conditions for the exception must be considered with respect to each pension.
Clarification will be required from the SMSF trustee(s) as to the correct allocation of pension payments made during the income year, particularly where a single pension payment is to be split between members or multiple pensions for the same member. The pension that has the minimum pension shortfall will be the one that fails the pension standards and has the subsequent consequences.
The SMSF trustee(s) may also consider the consequences for the member, where a pension is deemed to cease due to the failure to pay the minimum pension, including:
- The need to submit appropriate transfer balance account reporting; and
- The “locked” in tax components of each pension; and
- The Centrelink treatment, assets and income test, for each pension.
What about a TRIS – can the SMSF trustee apply the exception?
The ATO website1 notes that the exception currently applies to all account-based income streams, including a TRIS. A TRIS commenced in an SMSF will be based upon an account-based pension.
The loss of the ECPI claim is not relevant for an SMSF trustee in respect to a TRIS not in retirement phase, however, as previously noted, there can be severe tax consequences for the member, including:
- all payments being treated as lump sum benefit payments
- a breach of the preservation standards
- all payments for the income year taxed at the member’s marginal tax rate.
In this scenario, there will be no reference to the tax components of each payment from the TRIS. The entire amount of the payments will be assessable to the member, with no reference to the tax-free component of each payment and no application of the 15% pension tax offset.
Whilst the SMSF trustee can seek to apply the exception in respect of a shortfall to the minimum required TRIS payment, it cannot apply the exception in the scenario where the 10% maximum threshold has been exceeded.
What about other pensions?
Again, the ATO website states that the exception applies to “all account-based income streams”1. Given that a market linked pension (MLP) is also an account-based income stream, with payments based on the account balance of the MLP, it would appear that the exception could be applied to a shortfall on the minimum MLP pension amount, where all the conditions are met. However, based on the ATO’s comment around a TRIS maximum, it would be expected that the exception could not be utilised where the MLP maximum has been exceeded.
For other defined benefit legacy pensions, it would appear that the exception could not apply.
Ultimately, responsibility lies with the SMSF trustee(s) to ensure minimum pension payments are made each year in accordance with the SIS Regulations. However, it is good to know that should a situation arise, outside the trustee’s control, which leads to a shortfall to the minimum pension payment requirement for an account-based income stream, there is an option available that can avoid a nasty tax outcome for both SMSF trustee(s) and the member.
Mark Ellem, head of education, Accurium