Friday 17 March 2017
Super reform transitional CGT relief Part 1
Part 1 – SMSFs using the segregated method on 9 November 2016
Somewhat unexpectedly the Government introduced transitional capital gains tax (CGT) relief in the superannuation reform bill first tabled in Parliament on 9 November 2016. The purpose of the CGT relief is to preserve the tax exempt status of unrealised capital gains on pension assets which will become subject to tax as a result of the superannuation reform measures commencing on 1 July 2017.
This article is for the benefit of financial services professionals only. It aims to help them understand the operation of the CGT relief, especially in relation to the self managed superannuation funds (SMSFs).
Part 1 (this article) examines the position of funds that were, on 9 November 2016, using the segregated method for the calculation of the fund’s exempt current pension income. Part 2 will examine the position of funds using the proportionate method on 9 November 2016.
The basic principles of the CGT relief
The CGT relief allows the cost base (for CGT purposes) of certain assets of a superannuation fund to be reset to the current market value of the asset.
Superannuation fund trustees may elect for the CGT relief to apply on an asset by asset basis. The election must be in approved form (yet to be determined), and must made by the time the superannuation fund trustee is required to lodge its 2016/17 tax return. It is irrevocable.
The election can only be made for assets held by the superannuation fund throughout the ‘pre-commencement period’. That period began at the beginning of 9 November 2016 and will end just prior to 1 July 2017. So the election is not available for assets sold prior to 1 July 2017 or purchased on or after 9 November 2016.
The election can only be made for assets held by the superannuation fund throughout the ‘pre-commencement period’
Importantly, it is stated in the object in the legislation that the CGT relief is provided only for capital gains that might arise as a result of individuals complying with the introduction of the $1.6 million transfer balance cap or the removal of the tax exemption which currently applies to transition to retirement income streams.
Identifying which assets the CGT relief can be applied to
For all superannuation funds, including SMSFs, the first step is determining which method was being used by the fund on 9 November 2016 to calculate its exempt current pension income (ECPI): the segregated method or the proportionate method.
Table 1 below shows which assets the trustee may apply the CGT relief to, based on the method used to calculate ECPI on 9 November 2016 and the subsequent events in relation to ECPI during the pre-commencement period.
Table 1: Which assets can the CGT relief be applied to?
|Super fund’s calculation of ECPI as at 9 November 2016:||Trustee may apply CGT relief to:|
|Uses segregated method - continues using segregated method throughout pre-commencement period||Any or all assets transferred during pre-commencement period from:
|Uses segregated method - switches to proportionate method prior to 1 July 2017||Any or all segregated current pension assets|
|Uses proportionate (non-segregated) method and 2016/17 ECPI > 0%||Any or all assets of the fund (which were not segregated current pension assets or segregated non-current assets during the pre-commencement period)|
Table 1 highlights that the CGT relief may be applied to a vastly different range of assets depending on the circumstances of the fund.
Case study - Harry
Harry’s $2.0 million account-based pension is the only superannuation interest of his SMSF. The fund’s liability to Harry is supported by six discrete assets, valued at $2.0 million in total. There are $460,000 of unrealised capital gains attributable to those assets. All the assets were purchased prior to 9 November 2016 and have been held for more than 12 months.
Harry is proposing to commute $400,000 from his account-based pension by 1 July 2017 to comply with the $1.6 million transfer balance cap. Because the SMSF’s liabilities relate solely to current pension liabilities, it is deemed to use the segregated method for calculating its ECPI (refer ATO Calculating ECPI QC 21546). So all six assets owned by the fund are currently held in the ‘segregated current pension asset’ pool (referred to below as the ‘exempt pool’).
Harry’s SMSF is represented in Diagram 1 below.
Diagram 1: Harry’s SMSF
The SMSF’s present asset position is represented in Table 2 below. There are six assets – five are in a capital gain position, and Asset 5 is currently in a $20,000 capital loss position.
Table 2: Harry’s SMSF assets - present position
|Asset||Cost base||Unrealised CG||Current value|
Two scenarios exist. Harry’s SMSF may:
- continue to use the segregated method for calculating ECPI throughout the pre-commencement period, or
- switch to using the proportionate method prior to 1 July 2017.
Scenario 1: Harry’s SMSF continues with the segregated method
When Harry partially commutes $400,000 from his account-based pension, the fund will establish a new accumulation account for Harry. For the fund to maintain the segregated approach throughout the pre-commencement period, it will need to support the new accumulation account with $400,000 of assets in a segregated non-current assets pool (‘taxable pool’).
So the fund will be required to transfer $400,000 of assets from the exempt pool to the taxable pool. Which assets the trustee chooses to transfer between the pools may be driven by a number of factors, including:
- the size of the accumulation account liability created (in this case $400,000)
- the investment return fundamentals of the assets, including consideration of liquidity requirements needed to fund pension payments, income expectations and capital growth expectations
- the level of unrealised capital gains that may be removed as a result of the CGT relief cost base reset
If we assume that Asset 2 is transferred to the taxable pool, then because this asset’s value ($400,000) matches the fund’s accumulation interest liability, no further assets need to be transferred. The trustee may elect to reset the cost base on Asset 2 to its current value of $400,000. Harry’s SMSF position after these changes is represented in Diagram 2.
Diagram 2: Harry’s SMSF after partial commutation and transfer of Asset 2
Harry’s superannuation pension interest is supported by the exempt pool of assets, which retains the unrealised capital gains of $380,000. If this pool of assets was sold prior to 1 July 2017, no tax would be payable on any capital gain.
Harry’s accumulation interest in the fund is supported by the taxable pool, which comprises Asset 2 with nil unrealised capital gains if the trustee elects to use the CGT relief to reset the cost base.
Restriction on use of the segregated method from 1 July 2017
However, Harry’s SMSF cannot continue with this structure from 1 July 2017. An SMSF or a small APRA fund (SAF) will not be able to use the segregated method for calculation of its ECPI from 1 July 2017 where the following criteria are met:
- there is at least one pension account in the fund
- a fund member (who has an account balance in the fund ) has a total superannuation balance at the previous 30 June that exceeds $1.6 million, and
- that fund member has a superannuation pension, whether or not within the SMSF or SAF.
This restriction is an integrity measure intended to prevent the movement of assets between the taxable and exempt pools for the purposes of avoiding CGT. Unfortunately this integrity measure means that Harry’s SMSF will be exposed to capital gains taxation from 1 July 2017 where it has maintained the segregated approach up until 1 July 2017, as described above. The position of Harry’s from 1 July 2017 is represented in Diagram 3.
Diagram 3: Harry’s SMSF position from 1 July 2017
One impact of the proportionate approach applying to the fund from 1 July 2017 is the unrealised gains of $380,000, formally attributable to those assets in the exempt pool, will become partially subject to tax based on the ECPI of the fund, which will be approximately 80 per cent. If those assets were sold down on 1 July 2017, 20 per cent of the capital gain will be taxable, resulting in $7,600 of tax payable (assuming the one third CGT discount applies).
However, another option is available for Harry’s SMSF.
Scenario 2: Harry’s SMSF switches to the proportionate method prior to 1 July 2017
Table 1 above shows that where a fund was using the segregated method on 9 November 2016 and switches to the proportionate method prior to 1 July 2017, the CGT relief may be applied to any or all of the relevant assets which were in the exempt pool immediately prior to the switch. The rationale is that these assets were previously exempt from taxation and will be subject to proportionate taxation from the time of the switch, so the cost base reset preserves the tax exempt status of unrealised capital gains to that point.
So for Harry’s SMSF, where a $400,000 partial commutation of his $2.0 million account based pension occurs in compliance with the introduction of the transfer balance cap, the trustee may elect to reset the cost base on all six assets formerly in the exempt pool. Assuming that the trustee would not elect to reset the cost base of Asset 5 which is presently in a capital loss position, the impact of switching to the proportionate approach and applying the CGT relief to the remaining assets is illustrated in Table 3 below.
Table 3: Harry’s SMSF assets – after switching to proportionate method
|Asset||Original Cost base||New Cost base||Unrealised CG||Current value|
The fund’s position is represented in Diagram 4.
Diagram 4: Harry’s SMSF position (pre-1 July switch to proportionate approach)
Selling all the assets in the fund on 1 July 2017 will not result in any CGT liability, but a capital loss will be generated which may be carried forward to future income years.
Those funds which were using the segregated method on 9 November 2016 may find that adopting the proportionate approach to the calculation of ECPI prior to 1 July 2017 will allow application of the CGT relief to a wider range of assets than continuing with the segregated approach until 1 July 2017.
Applying the CGT relief to the wider range of assets may have a positive impact on the CGT position of the fund...
Applying the CGT relief to the wider range of assets may have a positive impact on the CGT position of the fund from 1 July 2017, when it may be required to adopt the proportionate approach anyway.
Part 2 of this article series considers the position of funds using the proportionate method on 9 November 2016.Read Part 2: SMSFs using the proportionate method on 9 November 2016
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