As the population ages and more SMSF members enter pension phase, accountants and advisers will need to grow their knowledge of how to structure and maximise the tax benefits of having members in pension phase. This article looks at the ins and outs of segregation and exactly when a SMSF does and does not need to pay for an actuarial certificate.
Under ITAA 1997, a superannuation fund can be operated in one of two ways for taxation purposes - segregated or unsegregated. If you wish to structure an SMSF using segregated accounts, consult Section 295-385 of the Tax Act. Section 295-390 defines unsegregated current pension assets.
The assets of a fund are segregated, in accordance with ITAA 1997, if they are solely backing the payment of a pension or solely backing an accumulation account.
Any segregated accounts within a SMSF need to be completely excluded from the calculation of the exempt percentage (EP) as any income derived from these assets will either be completely exempt from tax (if they support a pension) or completely taxable (if they are segregated for members in accumulation).
If the SMSF's situation is black and white, in other words, all assets are segregated so that they are either solely backing a pension or solely backing accumulation, an actuarial certificate is an unnecessary expense and is not required.
An accountant should be able to arrive at an exempt current pension income calculation by using the equation provided in ATAA 1997 Sec 295-390:
TAX EXEMPT PROPORTION = AVERAGE VALUE OF CURRENT PENSION LIABILITIES
AVERAGE VALUE OF SUPERANNUATION LIABILITIES
The "average value of current pension liabilities" refers to the average value for the particular income year of the fund's current liabilities for income stream payments that fall due in that year. And, we repeat, this does not include income from assets that are segregated for the payment of pensions.
The "average value of superannuation liabilities" is the average value for the specific income year of the fund's current and future liabilities related to super benefits for which contributions were or were liable to have been made. Liabilities for which segregated assets are held by the fund are not included in this amount.
The segregation model
So, how do you make sure that a SMSF's situation is black and white? What will the ATO view as a properly segregated fund or asset? Unfortunately, there are more grey areas in relation to segregation than there are black and white facts.
However, if you want to take your clients down the path of structuring assets in a segregated manner, be mindful of the following:
- In previous discussions about segregation, the ATO has made it clear that it would not allow partial segregation of an asset, even something as straightforward and easy to divide as a bank account. In other words, a whole asset needs to be completely segregated and used for either the specific purpose of supporting an income stream or for the specific purpose of supporting an accumulation balance. The prevailing view of the ATO seems to be that it cannot have a foot in each camp.
In practice this means that the SMSF needs to almost keep a separate set of books for each member's account, think of two SMSF within one SMSF. You basically end up operating multiple funds within the one fund and this can end up being much more administratively expensive than the cost of an Actuarial Certificate for maintaining unsegregated assets. What we are talking about here is two bank accounts and two share broker accounts etc.
- The structure used is completely up to the trustee. The fund's trustee has complete discretion as to how assets are held when one or more member is in pension phase. This discretion comes with a big responsibility as the trustee needs to ensure that segregated assets that form a pool within the fund's overall portfolio are still in line with the fund's overall investment strategy.
It makes sense to segregate assets that are liquid (like cash and shares) or capable of producing regular income for the purposes of supporting pension payments whereas less liquid assets (like property) with higher potential for capital growth may be better suited to support an accumulation account. This structure can, however, alter the risk profile of a particular member's account and needs to be clearly articulated in the fund's overall investment strategy.
- You will need a paper trail. If you wish to satisfy the ATO that you have a properly segregated structure for taxation purposes, it is essential to keep records explaining how assets are segregated. This can take the form of a simple minute to record that 20,000 NAB shares have been segregated to support the payment of Bob's income stream from 30 march 2014.
Finally, any SMSF electing to use asset segregation may also need to demonstrate that it has not done so purely for the purposes of dodging tax. One often cited example of a strategy that may ring alarm bells at the ATO is the decision to segregate an investment property for the payment of a non-taxable pension, just before its sale which ends up generating a large capital gain. If you choose to use such a strategy, you will need to be able to demonstrate how it is in line with the fund's overall investment strategy.
Of course, the main advantage of segregating assets can be the tax benefits so it is a bit of a tightrope walk. All income earned on segregated pension assets will be exempt from tax, that includes capital gains made from shares or property investments.
So, the first answer to our headline question is, if the assets of a SMSF are completely segregated, you will not need to worry about an actuarial certificate to determine the exempt current pension income that can be claimed. The calculation is straightforward and the paperwork should speak for itself.
It is, however, true to say that in most cases, subject to the segregated assets exemption, an actuarial certificate will be needed to claim the deduction for exempt current pension income, if a fund has a combination of accumulation and pension assets in the one pool.
When you don't need an actuarial certificate
It may seem like a no-brainer, but if all SMSF members are in accumulation phase, or, if all members are in pension phase and no new contributions during the year have been received, the fund doesn't need an actuarial certificate. In the first instance, with all members in accumulation, all income is taxable. In the second, with all members in pension phase, all income is tax exempt.
A single-member SMSF may also be able to spare the expense of an actuarial certificate in certain circumstances. For instance, If the member has been drawing a transition to retirement income stream (TRIS) but has an opening pension balance and a zero accumulation balance for the particular income year, and all new contributions go to a separate bank account, the fund won't need an AC.
Another way to avoid obtaining an AC is that when contributions are used to start new pensions the same day they are received. That means no monies have remained in an accumulation date for even a single day. Documentation must be robust for any fund employing this strategy. Correct pension start dates are critical.
As pension documents take time to generate and our documents cost $165, Click here to read how to commence a pension in a SMSF, note for this method to work, there should not be many contributions during the year. Assuming that there are quarterly concessional contributions, the fund will end up with five pensions on 30th June, four new ones and one from 1st July. All these pensions can be consolidated by commuting all the five pensions on 30th June and commencing one pension with all the five pensions on 1st July. This strategy is also known as rebooting pensions.
All advisors have to be very careful at the time of merging pensions as each pension has taxable and tax free component. And once you commute a pension, the pension liquidates to the members accumulation account and the new one pension commences from this accumulation account. To understand the whole concept properly, we strongly recommend that you come to our seminar on 8th April 2014, Tuesday at Crown Plaza at Norwest Sydney. We have put more seats in the room and at the time of writing this article, there were three seats left. To book, click here.
There are also times when a fund, if in pension phase, may be entitled to claim exempt current pension income but may be better off not making such a claim. If the benefit being derived from the ECPI is not as great as the cost of obtaining the actuarial certificate, there really is no point paying for an AC.
Take the example of a two-person fund. Member A has an accumulation balance of $200,000 and member B's accumulation balance is $300,000. Member B starts a pension on 1 April 2014 and the unsegregated assets method is followed. The fund has assessable investment income of $5000 and the actuary gives a provisional exempt percentage of 10.8%.
The exempt income would be 10.8% of $5000 or $540. The fund's potential tax saving at 15% would be $81 but if the cost of an actuarial certificate is $97.50 (and that's one of the least expensive available), there is no advantage to obtaining an AC.
The other time a fund that is eligible to claim ECPI but may be better off not doing so is if it has incurred losses which it would like to carry forward.
What about money in reserve accounts?
This is a contentious issue and the subject of ongoing debate within the SMSf industry. Our view is that a reserve account is always in accumulation. So if, for example, a contribution is received into a reserve account during a particular income year and allocated to any particular member, Income on this reserve account is taxable for the amount of time it remains in that reserve account, even if the fund members are in pension phase.
Why actuarial certificates are worth the cost
We've just outlined a raft of reasons why a SMSF can avoid going to the expense of acquiring an actuarial certificate. However, the reality is that significantly more SMSFs should be using the services of actuaries to claim ECPI.
It's been estimated that 35% of SMSFs are currently in pension phase and it is anybody's guess, how of these funds also have member balances in accumulation account. ATO is concerned on how exempt current pension income (ECPI) deduction is being claimed by advisors and has alerted trustees about incorrect claims.
Among other things, ATO has found that trustees do not obtain AC and when they do, the claim is incorrect as incorrect information was sent to the consulting Actuary.
Applying for an AC from within the accounting software
Another problem, which we have seen is a more recent one and it is about applying for an AC from within the accounting package. There are some major issues here:
- Since "Average" pension liabilities is the numerator in the calculation and total "Average" liabilities of the fund the denominator, the calculations are very date sensitive, which means if a wrong date is entered in the software for a large contribution, it can skew the resulting exempt income percentage.
- Assumptions used by various Actuaries are different, for example, some actuaries use 85% of the concessional contributions made during the year which are not moved to pension phase to be in accumulation phase whilst others include the full 100%.
- As you do not have to pay for the certificate until you like the exempt income percentage provided by the various actuaries on these softwares. We encourage you to apply in all the four or five actuaries which the software offers. As even a difference of 1% for a $1000,000 income fund could mean a saving of income tax of $1500 for your client.
- We find it quite amusing that all 4 or 5 actuaries give different results, even if the same data is supplied to them. Sometimes we wonder if these exempt percentages are correct as a better percentage will stand to increase the Actuaries revenue, enticing them to flex their assumptions to a point where the auditor may have an objection to its computation.
- Paragraph 128 of GS 009 auditing standard actually requires auditors to check these exempt percentages. We wonder how many auditors actually check these percentages. Or to be exact, in ATO's own words, how many auditors even know how to check these exempt percentages claimed by funds. If you are an auditor and if you see all these things coming at you and you are worried about them, this can only mean that you are going in the wrong way, please learn how all this works or stop auditing these funds.
- Mid year pension commencements are a mine field of its own. Assume that concessional $1M is contributed into the fund on 1st January of the year and pension commenced on the same day. For about half the year, $850,000 is a pension liability and $150,000 which is owed to ATO for tax is not a pension liability and cannot be in the numerator in your calculation but in the denominator in the computation. Further, some time in the future, the ATO will assess excess concessional contribution tax which the member may want the fund to pay. Which means that there could be further amounts which are not pension liabilities but fund liabilities.
As you can see claiming ECPI is not easy and it is not a surprise that the ATO is worried about its misuse. In reality, only about five percent of SMSFs are using ACs, which is also a cause of concern for ATO. Do your SMSF clients a big favour and check out by clicking here the benefit of using an actuary to maximise the deductions that can be claimed from ECPI for $97.50.
Dividend washing allows an entity to obtain multiple franking credit entitlements from the same underlying economic interest. In practice it involves selling shares shortly after becoming entitled to receive a fully franked distribution from those shares. Shortly after, the investor purchases a new and "substantially identical" interest that also provides an entitlement to another fully franked distribution.
The government estimates that revenue lost from the practice of dividend washing is around $20m annually. If you wish to make comment on the draft legislation, you may do so 
Obviously everyone is a little disappointed. Then 8,000 Accountants start cheering "Give him another chance, give him another chance." 
However, any fund receiving any type of contribution from an employer, whether Super Guarantee contributions or salary sacrifice payments will need to be ready for the changes. Likewise, in order to receive rollovers from industry or retail funds, SMSFs will need to be ready for the introduction of SuperStream.
