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

Strategies

Friday 23 March 2018

Part 2: SMSFs using the segregated method

The operation of the transitional capital gains tax (CGT) relief associated with the 2017 super reform measures differs depending on whether a superannuation fund was using the segregated or proportionate method to calculate its exempt current pension income (ECPI) in 2016/17.

This article (Part 2) looks at some of the advice considerations relating to the transitional CGT relief. It examines the position for self managed superannuation funds (SMSFs) that were using the segregated method to calculate ECPI as at 9 November 2016. The position for funds that were using the proportionate method is discussed in Part 1.

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

SMSFs using the segregated method

Broadly, there are two ways in which an SMSF will be segregated for tax purposes. For SMSFs that have both pension and accumulation accounts, the fund will be segregated if the trustee has allocated specific assets to support the pension accounts (‘segregated current pension assets’) and separate assets to support the accumulation accounts. Alternatively, if the SMSF is solely paying pensions, the Australian Taxation Office’s (ATO) view is that the fund is segregated by default, as all the fund’s assets are supporting the pension accounts and are segregated current pension assets.

Income from segregated current pension assets is generally tax exempt. Capital gains and losses from these assets are also disregarded.

The CGT relief available under the transitional rules is implemented by a notional sale and repurchase of the asset at its current market value. Where the relief is applied to a segregated current pension asset, the capital gain or loss that is realised as a result of the notional sale of the asset is also disregarded. This differs from SMSFs using the proportionate method where a portion of the net capital gain is taxable.

The transitional CGT relief effectively allows a superannuation fund to reset the cost base of an eligible asset to its market value on a particular date

The transitional CGT relief effectively allows a superannuation fund to reset the cost base of an eligible asset to its market value on a particular date. For SMSFs using the proportionate method, the relevant date for the cost base reset is 30 June 2017. Where the segregated method was used, the date the asset ceased to be a segregated current pension asset is the relevant date.

The relief applies to all eligible assets in a SMSF which used the proportionate method. For those SMSFs using the segregated method, the assets to which the relief applies depends on certain actions, if any, of the trustee during the pre-commencement period (ie 9 November 2016 to 30 June 2017, inclusive), as shown in Table 1 below.


Table 1: Action by segregated funds in pre-commencement period

ScenarioAction by trusteeAssets eligible for CGT relief*
1 Segregation maintained throughout pre-commencement period Assets transferred from exempt pension pool to taxed accumulation pool during pre-commencement period
2 Move to proportionate method at some time during the pre-commencement period All assets in exempt pension pool
3 Transition to retirement income stream (not in retirement phase) continues past 30 June 2017 All assets that supported the TTR pension

*Asset must be owned by the SMSF for the whole of the pre-commencement period.


Segregation maintained throughout pre-commencement period

Case study: Neil

Neil’s SMSF consisted solely of an account based pension at 9 November 2016 and was using the segregated method.

At 30 June 2017 Neil’s account based pension was worth $2 million. To avoid exceeding his transfer balance cap of $1.6 million Neil commuted $400,000 to an accumulation account. Neil moved specific assets with a value of $400,000 from his pension account to an accumulation account, creating two distinct pools of assets.

As the SMSF maintained segregation throughout the pre-commencement period, the CGT relief is available to those assets that were moved to a pool which supports the new accumulation account. The relief is not available for the $1.6 million of assets that continued to support Neil’s pension account.

The cost base reset is effective at the time the relevant asset ceased to be a segregated pension asset.

As the asset is treated as being sold whilst it was a segregated current pension asset, any realised capital gain or loss as a result of the cost base reset is disregarded. From this we can establish that in applying the CGT relief to segregated funds, it may be in the fund’s interests to:

  1. Reset the cost base on assets that are in a capital gain position*
  2. Don’t reset the cost base on assets that are in a capital loss position. As a capital loss from a segregated pension asset is disregarded, realising the loss provides no benefit to the fund.

* An exception to point 1 may occur where the asset is sold within 12 months of the reset date. Note that resetting the cost base on an asset also resets the date that is used to determine whether the fund is eligible for the one-third CGT discount. If assets are sold within 12 months of the reset date, further analysis may be required to determine if it is in the fund’s best interests to reset the cost base. Factors that may impact the decision include whether the gain or loss has accrued since the cost base reset and the fund’s ECPI percentage in 2017/18.

However, as Neil has a total superannuation balance of more than $1.6 million and is receiving a pension, his SMSF will not be able to use the segregated method to calculate exempt income from 1 July 2017. His SMSF will be required to use the proportionate method from that point, meaning that all assets of the fund will become pooled and proportionately subject to tax in the future. While any gains relating to Neil’s accumulation assets will have been reset, any unrealised gains formally attributed to his pension assets have not been reset and may become proportionately subject to tax.


Move to the proportionate method prior to 1 July 2017

Given Neil’s SMSF is required to use the proportionate method from 2017/18 anyway, it may have switched to the proportionate method prior to 1 July 2017. If it had done this, the fund is able to apply the CGT relief to all eligible assets that were previously segregated current pension assets, so potentially all of the fund’s assets are eligible for relief.

If Neil’s SMSF elects to switch to the proportionate method at the time he commutes $400,000 from his account based pension (ie 30 June 2017), the cost base reset is available on his whole SMSF portfolio of $2 million. The effective date for the cost base reset is 30 June 2017.

Table 2 below shows the asset position for Neil’s SMSF prior to switching to the proportionate method. The fund has six assets – five have an unrealised capital gain and one has an unrealised capital loss.


Table 2: Neil’s SMSF asset position prior to switching to proportionate method

AssetCost baseUnrealised capital gainCurrent value
1 100,000 100,000 200,000
2 320,000 80,000 400,000
3 200,000 140,000 340,000
4 400,000 100,000 500,000
5 120,000 (20,000) 100,000
6 400,000 60,000 460,000
Total 1,540,000 460,000 2,000,000

If the cost base is reset on all the assets in Neil’s SMSF that have unrealised capital gains, but not for the asset with the unrealised capital loss, the cost base on his portfolio will increase from $1.54 million to $2.02 million. In doing this, the SMSF has realised $480,000 of capital gains that have accumulated prior to the cost base reset and will be exempt from tax.

The impact of switching to the proportionate method and resetting the cost base on the assets in a gain position is shown in Table 3 below.


Table 3: Neil’s SMSF asset position after switching to proportionate method

AssetCost baseReset cost baseNew cost baseUnrealised capital gainCurrent value
1 100,000 Y 200,000 0 200,000
2 320,000 Y 400,000 0 400,000
3 200,000 Y 340,000 0 340,000
4 400,000 Y 500,000 0 500,000
5 120,000 N 120,000 (20,000) 100,000
6 400,000 Y 460,000 0 460,000
Total 1,540,000 2,020,000 (20,000) 2,000,000

Impact of contributions made during the pre-commencement period

A further complication arises for SMSFs that were solely in pension phase at 9 November 2016 where a fund member made a contribution during the pre-commencement period.

Assume that Neil made a non-concessional contribution of $540,000 on 1 April 2017 to an accumulation account in his SMSF. Prior to the contribution, the fund was solely in pension phase.

At the time the contribution is made, Neil’s fund had two options:

  1. Maintain segregation by keeping the contribution and any subsequent earnings separate from the fund’s pension assets, or
  2. Adopt the proportionate method whereby all of the fund’s assets then supported both accumulation and pension accounts.

If the contribution was kept separate from the SMSF’s pension assets, then there is no change to the position outlined above. That is, Neil’s SMSF is still eligible to reset the cost base of all assets that were supporting his pension interest when the fund switches to the proportionate method on 30 June 2017.

However, if the contribution wasn’t segregated, the relevant date for applying the CGT relief becomes 1 April 2017 when the contribution is received. This is the case even if Neil doesn’t commute the $400,000 from his account based pension until 30 June 2017, as the trigger for applying the CGT relief is the date the assets ceased to be segregated pension assets on 1 April 2017.


Impact of switching to proportionate method on ECPI calculation

Where a fund switches between the segregated and proportionate methods during the financial year, the fund has two options for calculating its ECPI:

  1. Apply two separate ECPI calculations for the year.
    • For the first part of the year, the fund’s ECPI is calculated using the segregated method, meaning for Neil’s SMSF, all income derived in this period is exempt from tax.
    • For the remainder of the year, the fund’s ECPI is calculated using the proportionate method, based on the fund’s average pension liabilities in that period. An actuarial certificate is required to claim ECPI for this period.

    Note that the ATO expects SMSF trustees to calculate ECPI in line with this option if the fund switches from the segregated to proportionate method in 2017/18 or a later financial year.1

  2. Calculate ECPI on a proportionate basis for the whole year.
    • The ECPI is calculated using the fund’s average pension liabilities over the year, divided by the average fund balance over the year. An actuarial certificate is required to claim ECPI.

    In relation to this option, the ATO has stated:

    "we do not intend to specifically review ECPI calculations in the 2016/17 income year (and prior) regarding calculations made on the basis of fund assets being unsegregated for the entire income year, despite the fund being 100% in pension phase for part of the year."2

Table 4 below illustrates the impact of these two different calculations on Neil’s SMSF, assuming that the fund has the following income:

  • Other income of $100,000, of which $40,000 is derived in the period from 1 July 2016 to 31 March 2017 and $60,000 is derived in the period from 1 April 2017 to 30 June 2017
  • Realised capital gains relating to the cost base reset of $480,000 (reduced to $320,000 after applying the one-third CGT discount)

With option 1, all income from 1 July 2016 to 31 March 2017 is exempt from tax. From 1 April 2017 to 30 June 2017, the ECPI of the fund is 78.7 per cent. This means 21.3 per cent, or $12,756, of the income received is subject to tax.

Using option 2, the fund’s ECPI over the whole year is 93.7 per cent, meaning 6.3 per cent, or $26,489, of the assessable income is taxable. This results in a tax liability that is $2,060 more than if ECPI was calculated using option 1.

It should be noted that option 2 may not always result in a higher tax liability – it depends on factors such as the timing of the switch to the proportionate method, the distribution of income over the year and the capital gains realised as a result of the cost base reset. However, it is important for financial services professionals to be aware of the different calculation methods as this may impact on the advice provided to clients in relation to the transitional CGT relief.


Table 4: Calculation of ECPI for Neil’s SMSF

PeriodECPI methodECPIAssessable income before ECPI exemptionTaxable income
Option 1: Part year approach
1 July 2016 – 31 March 2017 Segregated 100% $320,000 capital gain
$40,000 other income
Nil
1 April 2017 – 30 June 2017 Proportionate 78.7% $60,000 other income $12,756
Option 2: Full year approach
1 July 2016 – 30 June 2017 Proportionate 93.7% $320,000 capital gain
$100,000 other income
$26,489

Transition to retirement pensions

The transitional CGT relief is also available for segregated funds in respect of non-retirement phase transition to retirement pensions, regardless of whether the pension was commuted prior to 1 July 2017 or continued into the 2017/18 financial year.

Where the TTR pension was commuted prior to 1 July 2017, the CGT relief is applied according to whether the fund maintained segregation or switched to the proportionate method during the pre-commencement period. However, where the TTR pension was retained and continued to be paid until at least 1 July 2017, the CGT relief is available to any eligible assets that were supporting the TTR pension. In this scenario, the asset is deemed to have been sold immediately before 1 July 2017 and repurchased at the start of 1 July 2017.


Case study: Tim

Tim’s SMSF consisted of a non-retirement phase TTR pension and an accumulation account. The fund was segregated as it had set aside specific assets to support the pension account.

At 30 June 2017, Tim’s TTR pension was valued at $600,000 and his accumulation account was valued at $100,000. The assets supporting his pension account had unrealised capital gains of $100,000.

If Tim continued his TTR pension until at least 1 July 2017, the SMSF is eligible to reset the cost base on the $600,000 of assets supporting his pension. The $100,000 capital gain that is realised as a result of applying the CGT relief will be exempt from tax as it relates to a segregated pension asset.

From 1 July 2017, Tim’s SMSF will cease to have segregated current pension assets and all income and net capital gains will be taxable.


Conclusion

The application of the transitional CGT relief is relatively straightforward for funds that were using the segregated method to calculate ECPI in the 2016/17 financial year.

As a general rule, trustees of segregated funds should consider resetting the cost base of eligible assets with unrealised capital gains...

As a general rule, trustees of segregated funds should consider resetting the cost base of eligible assets with unrealised capital gains (unless the asset will be sold within 12 months), but not resetting the cost base for assets with unrealised capital losses.

Financial services professionals should also be aware of the different approaches to calculating ECPI for funds switching between the segregated and proportionate methods, as the method used may ultimately impact the fund’s 2016/17 tax liability.

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1 Australian Taxation Office, Requirements for claiming the tax exemption (QC 21546), accessed online 19 March 2018

2 Australian Taxation Office, Requirements for claiming the tax exemption (QC 21546), accessed online 19 March 2018

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