Thursday 06 April 2017
Super reform transitional CGT relief - Part 2
Part 2 – SMSFs using the proportionate method on 9 November 2016
The application of the super reform transitional CGT relief for superannuation funds that use the proportionate method to calculate their exempt current pension income (ECPI) potentially involves a greater range of issues than apply to those funds using the segregated method.
This article, Part 2 in the series, examines the position of superannuation funds that were, on 9 November 2016, using the proportionate method. The position of those funds using the segregated method as at 9 November 2016 is discussed in Part 1.
The information in this article is provided for the benefit of financial services professionals only. It is intended to help financial services professionals understand the operation of the CGT relief, especially in relation to self managed superannuation funds (SMSFs).
Identifying which assets the CGT relief can be applied to
The basic principles of the CGT relief were described in Part 1.
The relief is available only to those assets owned by the superannuation fund throughout the ‘pre-commencement period’. But the range of applicable assets may be narrowed further.
For all superannuation funds, including SMSFs, the first step in understanding which assets the relief may be applied to is to determine which method was being used by the fund on 9 November 2016 to calculate ECPI. Table 1 below shows which assets the trustee may apply the CGT relief to.
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)|
This article focuses in the last row of Table 1 – funds using the proportionate method.
Case study - Harry and Sally
Harry and Sally’s SMSF is comprised of an accumulation interest of $1.0 million in Sally’s name and an account-based pension valued at $2.0 million in Harry’s name. The fund’s liabilities are supported by nine discrete assets, valued at $3.0 million in total, with $760,000 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.
The fund is using the proportionate method to calculate ECPI throughout 2016/17. The ratio of current pension liabilities to total liabilities means the fund’s ECPI is approximately 67 per cent.
Harry and Sally’s SMSF is represented in Diagram 1 below.
Diagram 1: Harry and Sally’s SMSF
Their SMSF’s present asset position is represented in Table 2 below. There are nine assets – six assets are in a capital gain position, and three assets are in a capital loss position.
Table 2: Harry and Sally’s SMSF assets - present position
|Asset||Cost base||Unrealised CG||Current value|
Harry is proposing to commute $400,000 from his account-based pension to an accumulation account prior 1 July 2017 to comply with the $1.6 million transfer balance cap.
CGT relief available on all assets in Harry and Sally’s SMSF
Table 1 above shows that where a fund has at least one pension liability and uses the proportionate method throughout the pre-commencement period, it may apply the CGT relief to all of the fund's assets which were not treated as segregated during the pre-commencement period.
The rationale behind the CGT relief is the relevant assets will be exposed to a greater rate of tax due to a decrease in the ECPI resulting from the partial commutation of Harry’s pension. The option to reset the cost base preserves the taxable position of the unrealised capital gains at that point.
So for Harry and Sally’s SMSF, as the partial commutation of Harry’s 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 nine assets in the fund.
But there’s a catch…
However, for each asset that the CGT relief is applied to, the trustee must calculate the amount of assessable income that would be subject to tax if the asset had been sold for its current market value at that time.
That amount of assessable income is either taxable in the 2016/17, or at the trustee’s election, deferred until a later year when the asset is realised. This second election, like the first election to reset the cost base, is:
- made by the trustee on an asset by asset basis
- must be in approved form
- submitted by the same deadline as the first election
Assuming that the trustee would not elect to reset the cost base on those assets in a capital loss position (Assets 5, 8 and 9), the impact of making the CGT election to reset the cost base is illustrated in Table 3 below.
Table 3: Cost base reset results in assessable income
|Asset||Cost base||Unrealised CG||Current value||Reset cost base?||Updated cost base||Assessable income|
Taking Asset 1 as an example, the election to reset the cost base will result in a deemed gross capital gain of $100,000. As the fund has held the asset for more than 12 months, the one-third CGT discount will apply, reducing the gross capital gain to $66,667. In addition, as the fund’s ECPI is 67 per cent, only one-third of this amount is taxable, that is $22,222. So the CGT liability would be $3,333 (15 per cent of $22,222) in the 2016/17 income year if the second CGT election for deferral is not made.
This process is repeated for each asset the first election is applied to. Table 3 below shows that there would be approximately $206,000 of assessable income resulting from making the election on the six assets in a capital gain position. Approximately $31,000 of CGT will be payable.
Impact of the second CGT election
The deferral election allows the trustee to disregard the assessable income in the 2016/17 income year. That amount ($22,222 in relation to Asset 1) must be recorded, carried forward and brought to account in the income year in which the asset is ultimately realised. The assessable income carried forward will be subject to tax at the superannuation fund’s tax rate (currently 15 per cent) in that year.
Assuming no change in the superannuation tax rate, $3,333 of tax will payable whether or not the second election is made – the second election will only impact on the timing of the payment of that tax.
Any capital gains accrued subsequent to the cost base reset will be subject to CGT based on the fund’s circumstances at the time of sale. Resetting the cost base causes the 12 month qualification period for the CGT discount to restart, and the ECPI of the fund in the year of realisation will be applicable.
Making the first election is not a trivial decision
A consequence of the first election in Harry and Sally’s situation is a tax liability may be crystallised. So some consideration of the pros and cons of making the election is warranted.
Assume that Asset 1 will be sold in the 2020/21 for $300,000. Assume also that by this time not only has Harry commuted $400,000 to a new accumulation account in the fund, but Sally has used her accumulation interest in the fund to commence an account-based pension. Based on current balances, their SMSF will have approximately $2.6 million of current pension liabilities, and $3.0 million of total liabilities (including Harry’s accumulation account), so the fund’s ECPI will be approximately 87 per cent.
CGT position if first election was made
Sale of Asset 1 will have two CGT impacts. Firstly, the amount being carried forward ($22,222) will be taxable in 2020/21, so a CGT liability of $3,333 will result.
Secondly, a gross capital gain of $100,000 will be realised. As mentioned above, resetting the cost base also resets the 12 month qualification period for the CGT discount, which will have been met by 2020/21. The gross capital gain of $100,000 will be reduced by the one-third CGT discount and the fund’s 87 per cent ECPI, meaning that only $8,667 is non-exempt income, taxable at 15 per cent. So the tax liability on the capital gain accrued since the cost base was reset would be $1,300.
In total there will be $4,633 of CGT payable in relation to Asset 1 in the 2020/21 income year.
CGT position if first election was not made
If the fund does not apply the CGT relief, the cost base will remain at $100,000, so a gross capital gain of $200,000 would be realised in 2020/21. Applying the one-third CGT discount and the fund’s 87 per cent ECPI, results in $17,333 of non-exempt income which is taxable at 15 per cent.
So the total CGT liability would be $2,600.
Future direction of ECPI may influence making the first election
The ECPI in Harry and Sally’s SMSF has increased from approximately 67 per cent in 2016/17 to 87 per cent in 2020/21. Making the first election has crystallised the CGT liability on the first $100,000 of capital gains on Asset 1 based on the 67 per cent ECPI. If the election is not made, that same $100,000 of capital gains will be 87 per cent exempt in the 2020/21 income year.
So, as shown above, making the election will be detrimental to the tax position of Harry and Sally’s SMSF.
More broadly, the decision process in making the first election should consider the future direction of the fund’s ECPI with respect to the timing of the sale of the asset for which the election is being contemplated. Although financial services professionals do not have a crystal ball to view future events, some future events such as the transfer of Sally’s accumulation account to an account-based pension are possibly foreseeable enough to drive the decision making process.
Those funds which were using the proportionate method to calculate ECPI on 9 November 2016 may require greater consideration before making any CGT cost base reset elections. The future direction of ECPI relative to the timing of the sale of assets will be an important consideration.
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