With the new Regulations making the commutation of legacy income streams more accessible from 7 December 2024, there’s a critical concern with the initial drafting of the formulas for calculating Division 296 tax: The difference in the TSB valuation of a complying pension at 30 June preceding an income year and at the end of the following income year, where the pension in commuted in that income year, can increase a member’s total superannuation balance (TSB) due to the allocation of the pension reserve to the member upon commutation. This, in turn, can inflate ‘earnings’ for Division 296 purposes as the drafted rules specified that only allocations from a reserve which were assessed as a concessional contribution would be excluded from earnings.

Consider this scenario:

• As at 30 June 2025, an SMSF has one male member, aged 70, with a non-reversionary, non-indexed lifetime pension (TBA special value: $1.6 million), reserves backing the pension liability ($2 million), and an accumulation balance of $2 million.

• For Division 296, the calculation at 30 June 2025 is $2 million (accumulation) + $1.09 million (family law value for the lifetime pension, based on the prescribed factors) = a TSB of $3.09 million.

• A year later, for simplicity assume $100,000 was withdrawn via a pension payment, and there were no earnings, the TSB at 30 June 2026 would be $2 million (accumulation) + $1.06 million (family law value for the lifetime pension) = $3.06 million. Adjusted TSB is $3.06 million + $100,000 (add back the pension payment) = $3.16 million. Division 296 earnings are then calculated $3.16 million – $3.09 million = $0.07 million. The exact numbers work out as $69,000 in Division 296 earnings.

The numbers change dramatically if the member commutes their pension in 2025-26, taking advantage of the new legacy pension commutation rules:

• The lifetime pension is commuted in full, and the $2 million reserve is transferred to accumulation for the member. The member receives a TBA debit for $1.6 million. The member decides to start a new account-based pension (ABP) with $1.6 million, the maximum allowed under their personal transfer balance cap and leaves $400,000 in accumulation phase. For consistency let’s assume they take a $100,000 pension payment prior to 30 June 2026 making 30 June balance of $1.5 million.

• At 30 June 2025 their TSB remains $3.09 million as calculated previously.

• At 30 June 2026 their TSB is now $2.4 million (accumulation) + $1.5 million (ABP) = TSB of $3.9 million.

• The adjusted TSB is $3.9 million + $0.1 million = $4.0 million, and ‘earnings’ for Division 296 purposes are then calculated as $4.0 million – $3.09 million = a staggering $910,000 compared to $69,000 where the legacy pension is not exited – the artificial inflation in Division 296 earnings is clear.

Why does this happen?

The method for calculating TSB for legacy pensions is not tied to the market value of assets supporting the pension liability. Currently the TSB for a lifetime pension is generally the original TBA credit (special value) of the pension. This is proposed to change to be based on a valuation using family law factors as part of the introduction of Division 296.

In most cases both the special value, and the family law valuation, is lower than the amount being held in reserve to support the pension liability.

However, when the pension is commuted in full and the reserve is allocated to the member’s superannuation interest, this can result in a substantial jump in TSB for the member, driving up Division 296 earnings for that year.

This is likely to occur in any financial year (during the 5-year legacy pension exit period) where a defined benefit pension is commuted, and the monies are retained in superannuation.

In practice it is not only allocations from a reserve upon commutation which will lead to inflated Division 296 earnings. Any amounts allocated from a reserve to a member, which are not assessed against the member’s concessional contributions cap, won’t be included in ‘contributions’ and so would lead to inflated Division 296 earnings. This would include:

• amounts allocated using the ‘fair and reasonable’ reserve allocation rules

• amounts allocated to a member from a reserve due to the commutation of a complying lifetime, life expectancy pension, or flexi pension

• amounts allocated from a pension reserve to a member who was previously the recipient of a defined benefit pension funded from that reserve

What’s the solution?

The adjusted TSB calculated at year end adds back on withdrawals and minuses off contributions made during the income year. However, ‘contributions’ do not currently include allocations from a reserve which are not counted against a member’s concessional contribution cap. This oversight means ‘cap free’ reserve allocations directly inflate Division 296 earnings in the year of commutation.

The Division 296 legislation was drafted prior to the new Regulations for commutation of legacy pensions, and so it is highly likely that the legislation will need to be updated to account for this. For example, reserve allocations which do not meet one of the cap free exceptions, are now assessed against a member’s non-concessional contribution cap and not concessional contribution cap.

A solution to fix the issue of inflated Division 296 earnings upon commutation of a defined benefit pension could involve amending the Division 296 TSB adjustment rules to include in the definition of ‘contributions’ allocations from a reserve to a member which are not assessed against a contribution cap, less the TSB immediately prior to commutation value of any defined benefit pensions which ceased or were commuted in the year resulting in a reserve allocation.

This would ensure the end of year TSB was only reduced by the part of a reserve allocation not already represented in the TSB for the member at the start of the income year.

Continuing the scenario…

Taking the scenario above where the member commutes their pension in 2025-26, let’s assume this is done on 1 July 2025, taking advantage of the new legacy pension commutation rules:

• At 30 June 2025 their TSB remains $3.09 million.

• At 30 June 2026 their TSB remains $2.4 million (accumulation) + $1.5 million (ABP) = TSB of $3.9 million.

• The year end adjusted TSB is now calculated allowing for the proposed solution above as $3.9 million + $0.1 million pension payment – ($2 million reserve allocation – $1.09 million TSB) = $3.09 million, and ‘earnings’ for Division 296 purposes are then calculated as $3.09 million – $3.09 million = $0 – no earnings, the artificial inflation in Division 296 earnings is removed!

Advisers are seeking urgent clarity

The unintended consequences of the current proposed rules will leave many clients facing an administrative and financial scramble. Members with large balances will be penalised for commuting their legacy pensions, and allocating fund reserves, under the five-year exit measure for legacy pensions. They may incur material Division 296 tax on what is effectively capital of the fund, not earnings.

The Division 296 rules need to be fixed to remove the inflation of ‘earnings’ for clients who commute defined benefit pensions and allocate reserves, and to allow advisers and clients sufficient time to make decisions in light of the new rules the introduction of Division 296 should be deferred to 1 July 2026.

One thing is clear: the legacy pension rules highlight the need for a more considered approach and, arguably, for deferral of Division 296’s commencement. Time is needed for a legislative framework that deals fairly with the unique nuances of legacy pensions, so trustees and advisers can act with confidence.