Using assets to pay superannuation benefits.
Self Managed Superannuation Fund (SMSF) trustees often ask whether they can use assets belonging to their SMSF to pay their members’ superannuation benefits. SMSFs trustees who contemplate doing this are trustees for SMSFs which are usually asset rich but cash poor.
The term used for a non-cash benefit payment is referred to as an “in specie benefit”. This is where, instead of paying an SMSF member their superannuation entitlement in “cash” using money, the benefit is paid by transferring an asset belonging to the SMSF, such as shares or a property to the member.
Until recently, there was confusion in the superannuation industry as to whether an SMSF trustee could make in-specie payments to members who were receiving superannuation income stream benefits (i.e. pensions and annuities).
Firstly, let’s look at the ATO’s definition of a superannuation income stream. The ATO has stated in Taxation Ruling 2013/5 (TR 2013/5) that an income stream is where a trustee has a liability to pay to a member a series of periodic payments that are related to each other over an identifiable period of time. Further, it states that the payments need not be periodic in the sense that they are always paid at the same, recurring intervals. A liability to make a single payment each year for a number of years can be just as satisfactory as a liability to pay a member a series of payments. However, a single payment made in one year will not satisfy a liability to pay a series of payment and thus will not satisfy as an income stream.
In 2013, the ATO issued publications that confirm that a lump sum superannuation benefit can be paid in-specie but an income stream superannuation benefit cannot. I will explain how the ATO has arrived at their decision soon, but before we proceed, we need to have an understanding of what is meant by the term “commutation”.
Commutation is not defined in any tax law or the superannuation law and therefore it takes its ordinary dictionary meaning in the context in which it appears. The Macquarie Dictionary gives the meaning of “commute” as “to change (one kind of payment) into or for another”.
Under the superannuation law, any superannuation benefit paid from an SMSF must be in accordance with the Payment Standards under the law. The definition of a “lump sum” under the law states that a lump sum includes an asset. Therefore, it would be reasonable to assume that the law can be interpreted as meaning a lump sum superannuation payment can be paid in the form of cash or in-specie. However, the superannuation law does not say anything about an income stream including an asset. As there is no equivalent definition for an income stream, the ATO has concluded that pension or annuity payments cannot be made in-specie and must be paid in cash. Of course, the ATO’s interpretation of the superannuation law on this issue has not been challenged in Courts so there is no case law to support this interpretation.
The ATO has produced some publications which it uses to support its view that only a lump sum payment can be made in-specie. Let’s take a look at some of these now.
Self Managed Superannuation Funds Determination (SMSFD) 2013/2 addresses whether a payment made as a result of a commutation of an account-based pension counts towards the minimum annual amount of pension required to be paid under the superannuation law. This publication not only confirms that it can count towards the minimum annual pension amount required to be paid under the superannuation law, but also at paragraph 9 that it will count even if it is paid in specie. Further, at paragraph 15 it states that the partial commutation payment is a lump sum for the purposes of the superannuation law.
So basically, the publication is confirming the ATO’s view that where a pension is commuted to a lump sum, the lump sum payment can be paid to the member either in specie or as a cash payment.
In TR 2013/5 the document states at paragraphs 110 and 119 that a member or a dependent beneficiary commutes their superannuation income stream if they consciously and validly exercise their right to exchange some or all of their entitlement to receive future superannuation income stream benefits for an entitlement to be paid as a lump sum.
In addition, under the income tax law, when an income stream is partially commuted, the member or a dependent beneficiary may make an election for the payment of the partial commutation not to be treated as a superannuation income stream benefit. If the election is made, the payment from the partial commutation is a superannuation lump sum for income tax purposes. If the election is not made the payment is a superannuation income stream benefit. By electing to treat the partial commutation as a lump sum, the lump sum payment will also be taxed as a lump sum payment. There are different tax treatments for superannuation income stream benefits and superannuation lump sum benefits, depending on the recipient’s age and components of the benefit.
Now that’s quite a lot to take in and I must admit, sometimes I have to read ATO publications more than once to really understand what they are actually saying. What the above publications are trying to explain is that there are two definitions of a “lump sum”. One under the superannuation law and one under the income tax law.
For the purposes of the superannuation law, a lump sum takes its ordinary meaning and includes a payment made by way of an asset transfer (i.e. an in specie payment). Therefore, a partial or full commutation of an income stream will be a lump sum as per the ordinary meaning of commutation and can be made in specie as per the inclusive meaning of lump sum in the superannuation law.
On the other hand, under the income tax law, the recipient of a partial commutation of an income stream must make an election under the income tax law if the amount is to be taxed as a lump sum and not as an income stream benefit.
Therefore, any payment that does not arise from a partial or full commutation is not a lump sum payment, under the superannuation law, and cannot be paid in specie. If the pension recipient elects, under the income tax law, to have the payment treated as a superannuation lump sum, then it will be taxed as a lump sum benefit instead of an income stream benefit.
Please also keep in mind that an in specie lump sum benefit cannot be made for benefits accessed under the superannuation law for severe financial hardship, compassionate grounds or payments to temporary residents. These benefits must be paid in cash.
Before proceeding to pay your SMSF member their lump sum superannuation entitlements as an in specie payment, you need to ensure that the payment of in specie benefit is permitted under your SMSF’s Trust Deed. The trust deed outlines the specific actions the trustees can take in paying an entitlement. You will also need to consider other implications such as capital gains tax and stamp duty for the SMSF and implications of Centrelink entitlements and income tax payable by the recipient. You will also need to ensure that the account-based pension is not a non-commutable income stream such as restrictions imposed on transition to retirement income streams.
Examples of in-specie lump sum superannuation payment
Example 1 [in-specie lump sum payment]: Alan and Emily are members and trustees of their SMSF. They have total accumulated superannuation savings of $800,000 which consists of a residential property valued at $500,000, $250,000 listed shares and $50,000 cash. Alan is now aged 66 and decides to retire. The amount of retirement benefit that Alan is entitled from his SMSF is $550,000. Alan and Emily have always planned to sell their existing home in the City and move closer to the beach once they retired. They would like to move into the residential property owned by their SMSF as it would be an ideal home to live in once retired. Alan and Emily as trustees of their SMSF paid Alan his lump sum retirement benefit consisting of the residential property $500,000 (in specie) and cash of $50,000. As there has been a change of legal ownership of the residential property, the SMSF will pay tax on any capital gains from the in specie transfer of the property from the SMSF to Alan.
Example 2 [partial commutation of a pension]: Alan decides to retire and requests his SMSF to pay his retirement benefit as an account-based pension. Alan commenced his pension on 1 July. As Alan is aged 66 the minimum pension that his SMSF is required to pay in that financial year is, say, $20,625 ($550,000 multiplied by 3.75%). Next financial year, Alan decides he would like to partially commute his pension. The minimum amount of pension the SMSF is required to pay Alan is calculated by multiplying the balance of his pension account by 5%. Assume the balance of Alan’s pension account is $529,000 x 5% = $26,450 and a total of $16,450 pension instalments have already been paid to Alan during the financial year. Alan decides to partially commute his pension and withdraws a lump sum of $80,000. As per SMSFD 2013/2, the partial commutation payment is a lump sum and counts towards the minimum pension amounts regardless of whether the payment is made in cash or in specie. If Alan wishes for the payment to be treated as a lump sum, he can make an election under the taxation law. It does not matter if the payment is later taxed as either a pension payment or a lump sum commutation in the hands of the recipient. As long as at least the minimum amount of pension is paid from the SMSF and is appropriately documented the SMSF will not lose the tax exemption associated with paying an income stream. The SMSF paid Alan’s lump sum payment of $80,000 by an in specie transfer of listed shares owned by the SMSF.