Summary: the need to recalculate
On 8 December 2010, the NTLG Superannuation Technical Sub-Group discussed the application of the 'proportioning rule' that applies when a pension has been ended and then later recommenced by a member of an SMSF. The relevant law is in section 307-125 of the Income Tax Assessment Act 1997 (Tax Act).
The Group put this situation to the ATO:
- The member of an SMSF converts their superannuation pension back into accumulation phase. (Usually, this is done to avoid 'drawing down' any more of the superannuation entitlements and to allow the SMSF to avoid realising any large losses.)
- Consequently, the SMSF loses the pension asset exemption on those assets, which were being used to support the payment of the member's pension.
- The member does not make any contributions to the SMSF while it is back in accumulation phase.
- However, in that period, the SMSF may have received some income and other earnings.
- The member decides to start a new pension.
In response, the ATO confirmed that the SMSF trustee must recalculate the tax-free and taxable portions of a member's superannuation interest of the new pension which is to be paid.
What's the current law?
The Tax Act [i] ensures that the tax free component and taxable component of a superannuation benefit are calculated by:
- first, determining the proportions of the value of the superannuation interest that those components represent; and
- next, applying those proportions to the benefit.
The Tax Act [ii] then deals with apportioning each superannuation benefit payment. For example:
- Assume that the SMSF is to pay a superannuation lump sum of $100.
- Just before the benefit is paid, the value of the superannuation interest from which the lump sum will be paid was $1,000.
- Of that $1,000, the tax free component is $200 and the taxable component is $800.
- Then, when the lump sum is paid, those same proportions are applied to the lump sum. So — for the lump sum — the tax free component is $20 and the taxable component is $80.
The effect of these provisions is that the SMSF can't just:
- pay out all of the taxable component; and
- then fund the remaining payments from the tax free component.
(But for these provisions, that would be a nifty way to reduce the tax payable on any later death benefit – because those death benefits would be paid from tax free components and would be subject to less tax when paid to the beneficiary.)
In the above scenario, the biggest compliance challenge facing the SMSF trustee is how to calculate the tax-free and taxable components of the member's superannuation interest, at the time the new pension starts.
The question is whether:
- the trustee of the SMSF calculate the tax free and taxable components of the pension without regard to the original proportions calculated with the original pension; or
- the trustee needs to include these proportions when applying the proportioning rule for the new pension.
What does the ATO say?
The ATO's National Tax Liaison Group minutes record the ATO's response as follows:
- If a member of an SMSF fully commutes their pension, then the trustee must recalculate the tax-free and the taxable component of any new benefit subsequently paid from the fund, in accordance with the Tax Act.
- This requirement arises because the full commutation of the pension changes the member's superannuation interest in the SMSF from one that was supporting a superannuation income stream to a new accumulation interest.
Under a literal interpretation the trustee(s) of the SMSF are required to completely recalculate the tax-free and taxable proportions at the start of the new pension, without regard to those proportions that were applied to the original pension.
Under a more flexible interpretation the taxpayer must return to the original tax-free and taxable components that were calculated at the commencement of the first pension, and these proportions need to be taken into account when determining the proportioning rule of the new pension.
As set out above, the ATO prefers the literal interpretation.
More information from Maddocks
For more information, contact Maddocks on (03) 9288 0555 and ask for a member of the Maddocks Superannuation or Tax and Revenue Team.
More Cleardocs information on related topics
You can read earlier ClearLaw articles on a wide range of SMSF topics here.
More Cleardocs information on SMSFs
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- SMSF Death Benefit Nomination - binding or non binding
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[i] Section 307-125(1)
[ii] Section 307-125(2)