Transitional rules to reset the cost base of assets that support pensions and TRIS in SMSFs using the proportionate method
Under the reforms to superannuation that come into effect from 1 July 2017 anyone that has an amount exceeding $1.6 million of superannuation in pension phase will need to withdraw the excess from pension phase. The Australian Taxation Office (ATO) Law Companion Guideline 2016/8 (LCG 2016/8)1 was released on 8 March 2017. It sets out transitional capital gains tax (CGT) relief available for funds that comply with the new transfer balance cap (TBC) and transition to retirement income streams (TRIS) reforms. Assets supporting income streams must be reallocated or reapportioned to accumulation phase before 1 July 2017, which may result in a capital gain on the dealing with the asset.
CGT relief is available up to midnight of 30 June 2017 to superannuation funds that need to:
- move assets to prepare for the TBC; or
- deal with the changes to the tax treatment of TRIS and pensions.
The LCG 2016/8 includes:
- how a superannuation fund makes the election to apply the relief;
- how the relief operates for both segregated and unsegregated funds;
- the effect of resetting an asset’s cost base (CB); and
- statements regarding the operation of the general anti-avoidance provisions contained in Pt IV of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
This paper considers the issues facing self-managed super funds (SMSFs) making the election to reset (increase) the CB of assets supporting pensions or the TRIS. The election is transitional, irrevocable and complex.
What is a pension?
A member contribution in the “accumulation” phase is preserved in their account until they satisfy a condition of release. Once the condition of release is satisfied a pension can be established with the account balance.
The pension is a tax-free income stream. The most common pensions are:
- an account-based pension; or
Under the current legislation, TRIS does not attract tax. However, From 1 July 2017 a fund loses the income
tax exemption for assets supporting the TRIS. Also, the account-based pension will be capped at $1.6 million (the Cap). That part of the pension that exceeds the Cap and is returned to the accumulation account will now be subject to income tax and CGT.
Proportionate vs segregated methods
There are two separate methods to obtain the CGT relief:
- proportionate method (unsegregated); and
- segregated method.
Exercising the CGT relief election is valuable for members either not wishing to remain in pension mode or who exceed their $1.6 million TBC limit.
Most SMSFs only have access to the proportionate method. In part, this is because most SMSFs have already applied the proportionate method to claim their pension exemption. This paper only considers the proportionate method. Situations where the SMSF trustee would not elect a CB reset include:
- where the asset’s market value (MV) is less than its CB (ie, there is capital loss if sold); and
- where the asset is likely to be sold before 30 June 2017 and the one-third CGT discount is more valuable than the CB reset.
How does the transitional CGT relief operate? The relief provisions can only apply to assets that were in the fund by 9 November 201613 and are still in the fund come midnight of 30 June 2017 (Pre-Commencement Period). However, SMSF trustees can only take advantage of this opportunity if they make the election before lodging their FY 2017 tax return. The provisions are contained in Subdiv 294B of the Income Tax (Transitional Provisions)Act 1997 (Cth) (IT(TP)A).
Calculating the proportionate method The proportionate method is set out in s 295–390 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). It can be applied to all of the SMSF’s assets or on an asset-by-asset basis.16 The SMSF first calculates the average balance and the days during the financial year that the average balances are held in the SMSF. It calculates the exempt portion of the SMSF’s taxable income as follows:
If a fund has 100% of pension assets, then the exemption from capital gains is 100%. Therefore, it is worthwhile to consider establishing a second SMSF fund and rolling out all non-pension assets (accumulation assets).
Four conditions to take advantage of the proportionate CGT CB reset election
The four conditions are set out in ss 294–115 to 294–120 of the IT(TP)A. They are:
- the exempt amount is above zero;
- the SMSF asset is held during Pre-Commencement Period;
- the SMSF has no segregated pension assets during the Pre-Commencement Period (this is usually the case for SMSFs); and
- the SMSF trustee makes the valid election before lodging the SMSF’s FY 2017 income tax return.
If the four conditions are satisfied then at the 12th stroke of midnight 30 June 2017, for CGT purposes, the SMSF is deemed to have:
- sold the asset; and
- immediately purchased back the asset at the asset’s MV (the CGT asset’s CB is reset to the asset’s MV as at midnight of 30 June 2017).
“The deemed repurchase results in the fund becoming the owner of the asset ‘again’ at the repurchase time, for
the purposes of the CGT regime.”20 The “repurchase time” or acquisition date is midnight of 30 June 2017.
The legislation provides two ways to implement the proportionate approach.
Method 1: paying the tax for the accumulation portion in the FY 2017
The non-exempt portion or (accumulated portion) is added to taxable income for FY 2017. Using this approach:
An SMSF has $6 million in assets of which $4 million is in pension phase. The CB of the assets is $500,000. The assets have been held for over 12 months. The trustee has elected for CGT relief.
Step 1: calculate the amount of the SMSF that is tax exempt
The two-third is the pension amount which receives the new CB with no CGT consequences. The remaining one-third is the accumulation amount and is subject to CGT.
Step 2: determine the notional capital gain (NCG) on 30 June 2017
= MV — CB
= 6,000,000 – 500,000 = $5.5 million
Step 3: calculate the capital gain that is exempt from CGT
= 1/3 x capital gain
= (1/3 x $6,000,000) – (1/3 x $500,000) = $1.83 million
Step 4: the CGT for FY 2017
CGT in FY 2017
= $1.84 million x [15% x (1 – 1/3)]
= $184,000 with a CB of $6 million
If the SMSF trustee does not elect to apply the CGT relief it means that they suffer CGT of $5.5 million x [15% x (1 – 1/3)] = $550,000.
Method 2: defer notional tax on accumulation assets until they are sold
An SMSF trustee can defer the accumulation NCG until that asset is eventually disposed of.22 Deferring an otherwise upfront tax payment is usually highly beneficial to the member.23 If the SMSF trustee elects to defer the NCG then the non-exempt portion is not included in the SMSF’s assessable income until the asset is disposed of.
The Smith Super Fund purchased 1000 listed shares on 1 July 2006 for $40,000 (this means that the shares’ CB is $40,000). These shares are now worth $170,000.
The shares are sold in 6 years’ time. A deferment can be used if the SMSF trustee defers the gain on the non-exempt portion of the fund until the event occurs.
Unrealised capital gain
= 170,000 – 70,000
= 100,000 x (1 – 1/3)
The SMSF trustee has an opportunity to reset the CB of these shares to their market value. As 50% of the fund is in pension mode for FY 2017, the capital gain is:
= $66,667 x 50%
= $33,333.50 NCG arises in FY 2017.
It may be argued that there is an obligation to inform all trustees of SMSFs under the accountant’s care of this
opportunity. Beware, a client may have recently started a pension without the accountant’s knowledge. It may be
prudent to send information to all SMSF clients. To follow is some wording that an accountant may wish to base their letter upon.
Accountant’s sample letter to client
I am writing to all SMSF clients. If you have a pension or transition to retirement income stream (TRIS) (or had the right to set one up), then before midnight 30 June 2017 consider whether you need to elect to change the cost base of some of the assets. This generally has a favourable tax result as it may reduce the capital gain that you pay when you eventually sell that asset.
The issues are complex. If you instruct us, then we would be happy to review your Super fund on an asset-by-asset
basis. This is to determine whether an election should be made for some of the assets. Each election is irrevocable. Once the election is made, it cannot be reversed.
Part IVA of the ITAA 1936
As with any tax benefit strategy, Pt IVA of the ITAA 1936 is always a consideration. CB resetting is an ideal
opportunity to reduce CGT on assets and save the 10% CGT. Therefore, consider whether it is a “scheme” that helps the SMSF member minimise potential future CGT exposure. Advisors must not artificially manipulate clients’ circumstances to meet the CGT relief provisions.
Adjunct Professor Dr Brett Davies
National Tax Partner, Legal Consolidated Barristers and Solicitors
The author wishes to acknowledge the research undertaken by Legal Consolidated Barristers & Solicitors’ Intern, Natalie Connor, LLB, BCom, law and commerce graduate from The University of Western Australia.