Finding sense (and dollars) in the transitional CGT relief elections: Part 1

Strategies

David Barrett
Friday 23 March 2018

Part 1: SMSFs using the proportionate method

The transitional capital gains tax (CGT) relief election associated with the 2017 super reform measures is a generous concession offered to super fund trustees. It protects assets which have appreciated in value prior to 1 July 2017 in the tax exempt pension/retirement phase from retrospective CGT, and the election removed the incentive for trustees to sell down and repurchase assets prior to 1 July 2017.

...although simple in concept, the operation of the CGT relief is very complex in practical application

However, although simple in concept, the operation of the CGT relief is very complex in practical application. The complexity exists due to the number of variables which may influence the decision to reset an asset’s cost base. Self managed superannuation funds (SMSFs) which used the proportionate method to calculate the fund’s exempt current pension income (ECPI) throughout 2016/17 can be especially challenging. The issues associated with SMSFs which used the segregated method are somewhat simpler, but there are a number of nuances nonetheless.

This article (Part 1) provides a framework for financial services professionals to analyse the impacts of cost base resetting for those SMSFs which used the proportionate method. Part 2 will cover those funds which used the segregated method.

Finding sense (and dollars) in the transitional CGT relief elections: Part 2

SMSFs using the proportionate method

Generally those SMSFs using the proportionate method throughout the pre-commencement period (9 November 2016 to 30 June 2017 inclusive) will have the option of resetting the cost base on all eligible assets owned by the fund throughout the pre-commencement period. To exercise the option, a transitional CGT election must be made, generally by 30 June 2018.

The cost base reset is a deemed sale and repurchase for CGT purposes. As a result of the deemed sale, additional assessable income may be taxable in the 2016/17 where the asset is in a capital gain position. However, a subsequent election can be made to defer that assessable income to the income year in which the eligible asset is actually sold. In addition, resetting the cost base of eligible assets in a capital loss position may be considered.


Table 1: Three decisions to consider

1 Reset the cost base of eligible assets in a capital gain position
2 Defer the assessable income (if any) from 1. above to the income year in which the asset is actually sold
3 Reset the cost base of eligible assets in a capital loss position

Case study: Annette and Paul

On 30 June 2017 Annette and Paul’s SMSF held $1 million of assets which supported Annette’s $500,000 transitional to retirement income stream (TRIS) and Paul’s $500,000 accumulation account. They are planning to retire on 1 July 2020.

As Annette’s TRIS will be subject to taxation on its earnings from 1 July 2017 due to the super reform measures, transitional CGT relief is available to the fund. The fund was using the proportionate method to calculate ECPI throughout 2016/17 and all assets were held throughout the pre-commencement period.

The SMSF’s assets and illustrative valuations as at 1 July 2018 and 1 July 2020 are shown in Table 2 below.


Table 2: Annette and Paul’s SMSF asset position

AssetCost baseValuation at 30 June 2017Unrealised CG 30 June 2017Illustrative valuation at 1 July 2018 (both still working)Illustrative valuation at 1 July 2020 (both retired)
1 375,000 500,000 125,000 550,000 600,000
2 250,000 300,000 50,000 330,000 400,000
3 165,000 200,000 35,000 220,000 300,000
Total: 790,000 1,000,000 210,000 1,100,000 1,300,000

Two of the three decisions listed in Table 1 above are relevant to Annette and Paul’s SMSF. The outcome of these decisions is dependent on the ECPI of the fund when the assets are ultimately sold, relative to the ECPI of the fund in 2016/17 (50 per cent). If the assets are sold prior to retirement, the ECPI of the fund is assumed to be zero per cent. A decrease in the ECPI favours resetting the cost base on assets in a capital gain position.

On the other hand, if the assets are sold after retirement when Annette and Paul have commenced account-based pensions (ABPs), the ECPI is assumed to be 100 per cent. An increase in the ECPI favours not resetting cost bases in 2016/17.

Diagram 1 below shows the capital gains tax (CGT) outcomes of the two decisions In relation to the timing of the sale of the assets, either pre-retirement on 1 July 2018 or post-retirement on 1 July 2020.


Diagram 1: Decision tree and outcomes (assets with CGs only)


If the assets are not sold prior to retirement, Scenario 1 ‘do nothing’ is the most attractive option as the total CGT liability is nil.

However, if Scenario 1 is adopted, and the assets are sold down prior to retirement, a large CGT liability results ($31,000). A better outcome is achieved by resetting the cost base of the assets and deferring the assessable income (Scenario 3) where the CGT liability is $20,500. Note that Scenario 2 provides a similar outcome, but Scenario 3 is preferred because of the deferral of the $10,500 CGT liability from 2016/17 until the assets are actually sold.

In Annette and Paul’s case, an important parameter in the decision to make the transitional CGT election is the likelihood of holding the eligible assets until retirement. The time remaining before retirement (slightly more than 2 years for Annette and Paul) is therefore a crucial issue – the longer the timeframe, the lower the likelihood, in general.

Also crucial is the number and type of assets held by the fund. A diversified portfolio involving a large number of assets may be more likely to result in asset sales prior to retirement than in Annette and Paul’s situation where there are only three assets.


Capital losses complicate the picture

Consider now a different case study involving Harry and Sally. They have a SMSF which on 30 June 2017 held $3 million of assets supporting their respective interests. Harry’s interest was an ABP valued at $2 million, and Sally had an accumulation account valued at $1 million. Harry commuted $400,000 from his pension to comply with the super reform measures (the $1.6 million transfer balance cap) on 30 June 2017.

Harry and Sally’s SMSF uses the proportionate method to calculate its ECPI. In 2016/17 the ECPI was 67 per cent ($2,000,000 / $3,000,000), and will decline to approximately 53 per cent ($1,600,000 / $3,000,000) in 2017/18.

Harry and Sally’s SMSF assets as at 30 June 2017 and illustrative valuations as at 1 July 2022 are shown in Table 3 below.

Table 3: Harry and Sally’s SMSF asset position

AssetCost baseUnrealised capital gain (loss)30 June 2017 valuationUpdated cost base (if reset)Illustrative valuation at 1 July 2022*
1 1,130,000 770,000 770,000 1,900,000 2,424,000
2 440,000 160,000 600,000 600,000 766,000
3 670,000 (170,000) 500,000 500,000 638,000
Total: 2,240,000 760,000 3,000,000 3,000,000 3,828,000

*Five per cent per annum growth


Similar analysis as shown above for Annette and Paul’s SMSF would apply to Harry and Sally’s SMSF assets that are in a capital gain position (assets 1 and 2). However, the potential to reset the cost base on asset 3 requires more analysis. For each of the three scenarios in Annette and Paul’s case (‘do nothing’, ‘reset, no deferral’ and ‘reset + deferral’), there is an additional decision to reset (or not) the cost base of asset 3.

This means there are three decisions (as shown in Table 1 above) with six possible scenarios - see Diagram 2 below. The CGT impact of each scenario has been calculated based on the asset valuations assumed as at 1 July 2022 depending on whether or not Sally has retired and starts an ABP with the funds in her accumulation account ($1 million). If Sally starts an ABP, the fund’s ECPI is assumed to increase from 53 per cent to 87 per cent ($2,600,000 / $3,000,000).

Diagram 2: Decision tree (CG assets + CL assets)


The total CGT paid in relation to assets 1, 2 and 3 under each of these six scenarios is shown in Table 4 below.


Table 4: Total CGT outcomes for six scenarios based on Sally’s retirement

ScenarioReset assets with capital gainsDefer assessable income from cost base resetReset assets with capital lossesTotal CGT paid if assets sold and Sally hasn’t retired (ECPI 53%)Total CGT paid if assets sold and Sally is retired (ECPI 87%)
1 No - No 75,000 21,000
4 No - Yes 75,000 21,000
2 Yes No No 62,000 39,000
5 Yes No Yes 64,000 36,000
3 Yes Yes No 58,000 35,000
6 Yes Yes Yes 44,000 16,000

Broadly, Table 5 shows that it is in Harry and Sally’s best interest to reset the cost bases on those assets in a capital gain position if the assets are sold in a year where the ECPI of the is lower (that is, prior to Sally retiring) than the ECPI in 2016/17. If the ECPI in the year of sale is higher (because Sally has retired), it may be detrimental to reset the cost bases in 2016/17.

However, Scenario 6 is attractive whether or not Sally is retired when the assets are sold. This is the case because the capital loss of $170,000 in 2016/17 is assumed to be carried forward and used to offset the deferred assessable income of $204,600 (election 2) from the deemed sale of assets 1 and 2 ($930,000 gross capital gains, reduced by the 1/3rd CGT discount and 67 per cent ECPI in 2016/17). When capital losses are used to offset the deferred assessable income that results from the transitional CGT relief elections, the use of those capital losses is maximised relative to other alternative uses of the capital losses, and can reduce the fund’s tax liability by $15 per $100 of capital loss.

To illustrate, consider Harry and Sally’s position. Scenario 2 involves resetting the cost base of assets 1 and 2 (assets in a capital gain position), and results in CGT of $30,690 payable in relation to 2016/17. Scenario 5 involves also electing to also reset the cost base on asset 3 (asset in a capital loss position). The capital loss reduces the tax payable in 2016/17 by $5,610 – the value of the capital losses is $3.30 per $100 of capital loss.


Table 5: Harry and Sally, Scenarios 2, 5 and 6

Scenario 2 ‘reset CG, no deferral’
CGT in 2016/17
Gross gain
930,000
Deferred gain
Less loss
Gain/(loss)
930,000
Less 1/3 discount
(310,000)
Discounted gain
620,000
ECPI 67%
(415,400)
Taxable gain
204,600
Tax @ 15%
30,690
Scenario 5 ‘reset CG & CL, no deferral’
CGT in 2016/17
Gross gain
930,000
Deferred gain
Less loss
(170,000)
Gain/(loss)
760,000
Less 1/3 discount
(255,333)
Discounted gain
506,667
ECPI 67%
(339,467)
Taxable gain
167,200
Tax @ 15%
25,080
Scenario 6‘ reset CG & CL + deferral’
CGT in 2016/17
Gross gain
930,000
Deferred gain
Less loss
Gain/(loss)
930,000
Less 1/3 discount
(310,000)
Discounted gain
620,000
ECPI 67%
(415,400)
Taxable gain
204,600
Tax @ 15%
Nill
Scenario 6‘ reset CG & CL + deferral’
CGT on deferred income in year assets 1 and 2 sold
Gross gain
Deferred gain
204,600
Less loss
(170,000)
Gain/(loss)
34,600
Less 1/3 discount
Discounted gain
34,600
ECPI 67%
Taxable gain
34,600
Tax @ 15%
5,190

Scenario 6 involves resetting the cost bases on all assets, and deferring the assessable income caused by the resetting of the cost bases of assets 1 and 2. The $204,600 of assessable income that was taxable in Scenario 2 is not taxable in 2016/17 in Scenario 6.

As a consequence, the capital loss which results from resetting the cost base of asset 3 is carried forward to the next income year because there is no capital gain in 2016/17 to offset, so there is a net capital loss position.

If this capital loss continues to be carried forward (because there are no other capital gains realised in the interim) until the income year in which assets 1 and 2 are sold, then the capital loss may be used to offset the deferred assessable income ($204,600) from 2016/17. The capital loss of $170,000 reduces the $204,600 to only $34,600 of assessable income, and only $5,190 of CGT is payable.

This is a saving of $25,500 compared to the tax paid in 2016/17 in Scenario 2, and $19,890 compared to Scenario 5.


Summary

In general, the decision to reset the cost base of assets in a capital gain position is driven by whether the fund’s ECPI when the assets are ultimately sold is likely to be higher or lower than the ECPI in 2016/17. If higher, it may be detrimental to reset, but if lower, if may be advantageous to reset. Large increases in ECPI are generally a consequence of the retirement of a member and the subsequent commencement of an ABP, so the timing of the sale of assets with respect to retirement of members are two crucial variables in the cost base reset decision.

...the decision to reset the cost base of assets in a capital gain position is driven by whether the fund’s ECPI when the assets are ultimately sold is likely to be higher or lower than the ECPI in 2016/17

Capital losses can be used to offset the deferred assessable income that is a consequence of the transitional CGT relief elections for SMSFs which used the proportionate method throughout 2016/17. It is attractive to do this as it reduces the amount of CGT that might otherwise be payable if the capital losses were not used in this way.

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