Aggregation of multiple super interests (SMSFs only)

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1 For adviser use only, not for public distribution Recent super amendments 5 July 2007 A number of superannuation changes have either been made or proposed in recent weeks. Arguably the most important of these changes is that the aggregation rules will now apply to SMSFs only. This Technical Update provides an overview of the key amendments. CONTENTS Aggregation of multiple super interests (SMSFs only) Integrity rule for account based pensions Instalment warrants approved Employer ETPs and the transitional NCC cap Public offer funds new employer contributions Aggregation of multiple super interests (SMSFs only) Technical Update In previous regulations applying to most funds, the tax components of a client s non-pension interests were to be aggregated (as if they were a single interest) and used to determine the Tax Free and Taxable portion of each withdrawal. In effect, the regulations meant that if a client had separated their Tax Free and Taxable components into different (non-pension) accounts within the same fund, they would not be able to withdraw from their Tax Free 1 or Taxable monies separately. New regulations were made on 29 June 2007 which modify these provisions. The requirement to aggregate multiple non-pension interests within a fund will now apply to SMSFs only. The rationale for this change, as per the explanatory statement to the regulations, is because of the close-held nature and small membership of self managed superannuation funds. Accordingly, if a client has multiple accumulation interests in their SMSF, then any withdrawal 2 from one account from 1 July 2007 will be deemed to include both a Taxable and Tax Free component in the same proportion as these components make up of the total non-pension interests held by them at the time of the withdrawal. Similarly, if a pension is commenced from 1 July 2007, the pension will comprise a Taxable and Tax Free component based on the proportion that these components make up of the total non-pension interests held by the member at the commencement date. Any subsequent payment (including commutations and rollovers) from the pension will then comprise a Tax Free and Taxable component based on the proportion of these components as established at commencement. 1 Earnings would be included in the Taxable component of the interest. 2 A withdrawal includes a rollover to another complying super fund.

2 Example: Aggregation of SMSF interests Mike has two accumulation accounts in his SMSF with a balance of $100,000 each. At 1 August 2007, account 1 comprises 100% Taxable component, while account 2 comprises 100% Tax Free component 3. Under the aggregation rules, these two accounts will be deemed to form a single interest. As such, a withdrawal at 1 August 2007 from either account will be deemed to contain 50% Taxable component and 50% Tax Free component. Alternatively, if Mike wanted to commence one or more pension accounts in his SMSF (eg if he wanted to commence a pension with the proceeds of account 2 only - which is 100% Tax Free), under the aggregation rules the pension will be deemed to comprise 50% Tax Free and 50% Taxable. $200,000 50% Taxable $100,000 $100, % Taxable 100% Tax Free 50% Tax Free Account 1 Account 2 Deemed single account Note: Whilst not explicit in the law, where monies are drawn from one account but are deemed to comprise components from other accounts, we believe the SMSF administrator will need to adjust the components between the various accounts. As the drafting of the aggregation rules is quite ambiguous, a number of issues have been raised by industry with the ATO for clarification. For example, it is unclear whether the tax components of an income stream purchased directly with a contribution or rollover should be calculated taking into account the components of any other non-pension interests held by the client in the SMSF. From an estate planning perspective, separating certain types of contributions into different funds (or into separate accounts in a fund that is not an SMSF) could be considered by clients with larger benefits. This could allow them to commence separate pensions and receive predominantly the Taxable component from age 60 (which would otherwise enable them to preserve the Tax Free component and reduce the tax payable on death benefits received by non-dependant beneficiaries). This may not be worthwhile however, if your client (or their spouse) will use up the majority of their super assets before they die. 3 This could be made up of undeducted personal or spouse contributions, a CGT exempt contribution or other nonconcessional type contributions. Earnings would be allocated to the Taxable component but for the purposes of illustration we have assumed no earnings. Technical Update Page 2

3 Also, the longer term costs of undertaking a contribution separation strategy could actually outweigh any potential tax savings. For instance: - Clients may no longer enjoy the scale and fee linking benefits of having all their assets in the one fund, and - The size of any anti-detriment payment will reduce, as the calculation excludes the Tax Free component. Integrity rule for account based pensions Ordinarily, with account based pensions (including allocated pensions and term allocated pensions) earnings on the assets supporting the pension are tax-exempt. It is proposed that assets which are not included in the income stream account balance (eg they are held in reserve), will be ineligible for the tax concession available to segregated current pension assets. Any earnings or gains on assets which do not support current pension liabilities will be subject to tax at the rate of 15% in a complying superannuation fund. Funds will need to ensure that the market values of assets related to account-based pensions are reflected in the account balance used to determine minimum income. Market value is a defined term and broadly takes its ordinary meaning with some particular exceptions. We would expect that the ATO (and APRA) would provide further guidance on the meaning of market value for this purpose, perhaps via an update or confirmation of concepts in ATO Superannuation Circular 2003/1. In this circular, the general rule for purchase price and in-house asset purposes is that a value within the most recent 12 months would be reasonable. On this basis, it would seem that assets which don t have a formal market (for valuation/trading purposes) or are not regularly priced (eg investment property or artworks) should be valued at least annually. Instalment warrants approved Recently the ATO and APRA announced their view that investments in instalment warrants by a super fund constitute a borrowing for the purposes of section 67 of SIS. The ATO also stated that instalment warrants should be counted as an in-house asset for SMSFs under section 71 of SIS. However, the Government has now tabled legislation to allow super funds to invest in instalment warrants by introducing a new exemption to the prohibition on borrowing. This will enable a fund trustee to borrow money where: The borrowing is used to acquire an asset that is held on trust so that the fund trustee receives a beneficial interest and a right to acquire the legal ownership of the asset (or any replacement) through the payment of instalments, The lender s recourse against the fund trustee in the event of default on the borrowing and related fees, or the exercise of rights by the fund trustee, is limited to rights relating to the asset, and The asset (or any replacement) must be one which the fund trustee is permitted to acquire and hold directly. Technical Update Page 3

4 In addition, the in-house asset rules will be amended so that an investment in a related trust that is part of an instalment warrant arrangement which meets the above requirements will only be an inhouse asset where the underlying asset itself would be an in-house asset of the fund if it were held directly. Comment: While the amendments proposed by the Government are an important win for SMSFs, it should be remembered that any investments in instalment warrants must comply with other investment rules, including consistency with the fund s investment strategy. Employer ETPs and the transitional NCC cap The ATO has issued an interpretative decision (ATO ID 2007/131) which states that certain components of employer ETPs paid into a client s superannuation account between 10 May 2006 and 30 June 2007 will count towards their transitional NCC cap of $1 million. The amounts that count toward the transitional NCC cap are those that are not included in the assessable income of the superannuation fund (ie the pre-july 1983 component and invalidity component, if applicable). Note: If the employer ETP is a CGT exempt component ETP and the client has elected to use their CGT cap (by providing an ATO approved notice to the fund before 31 July 2007), the amount covered by the notice counts towards their CGT cap and not their NCC cap. The law makes it quite clear that the Tax Free components of employer Directed Termination Payments (DTPs) 4 made from 1 July 2007 do not count towards a client s NCC cap. Accordingly, it had not been expected that a different approach would apply during the transitional phase and there was no specific announcement to this effect. Unfortunately, it is not clear whether the ATO could or would use their discretion to disregard these contributions if a client inadvertently exceeded the $1 million cap because of the inclusion of the pre-july 1983 and invalidity components from an employer ETP. Ideally, it would be better if the law was changed to allow affected clients to elect to withdraw these amounts from their super account in much the same way as applies where clients have requested the ATO for a Transitional Release Authority where excess NCCs were made between 10 May 2006 and 6 December For more information, refer to our Technical Update issued on 8 May Public offer funds new employer contributions To give effect to its announcement in the May 2007 Federal Budget, the SIS regulations have been amended to prevent public offer funds from requiring a new employer to become a standard employer sponsor in order to make contributions for an existing member. 4 These are eligible transitional employer termination payments that a person can direct their employer to contribute to their superannuation account if they meet the contribution tests in the SIS law. The employer does not have to withhold tax from a DTP. The DTP will usually contain a Taxable component wholly made up of an untaxed element. This is assessable to the fund at the rate of 15% (as applied to employer ETPs). Technical Update Page 4

5 The new regulation is intended to ensure that public offer funds allow employees to choose to remain in the same fund when they change employment, rather than having their employer contributions returned or paid to another fund if their new employer refuses to be a standard employer sponsor of the fund. Note: This does not affect corporate funds or Government sector schemes that are not offered to the public. References: Income Tax Assessment Amendment Regulations 2007 (No. 2), Select Legislative Instrument 2007 No. 90. Income Tax Assessment Amendment Regulations 2007 (No. 6), Select Legislative Instrument 2007 No Tax Laws Amendment (2007 Measures (No. 4) Bill ATO ID 2007/131 Superannuation - Excess Non-Concessional Contributions Tax: roll over of an employer eligible termination payment between 10 May 2006 and 30 June Superannuation Industry (Supervision) Amendment Regulations 2007 (No. 3), Legislative Instrument 2007 No For further information please contact your MLC Alliances representative in your state. NSW (02) VIC/TAS (03) QLD (07) WA/SA (08) This document was prepared by MLC Limited ABN without taking into account any particular person's objectives, financial situation or needs. It is solely for use of financial advisers and it is not intended for distribution to investors. It is not guaranteed as accurate or complete and should not be relied upon as such. MLC Limited does not accept any responsibility for the opinions, comments and analysis contained in this document, all of which are intended to be of a general nature. Accordingly, reliance should not be placed by anyone on this document as the basis for making any investment, financial or other decision. Investors should, before acting on this information, consider the appropriateness of this information having regard to their personal objectives, financial situation or needs. We recommend investors obtain financial advice specific to their situation before making any financial investment or insurance decision. MLC Limited, Miller Street, North Sydney NSW 2060, is a member of the National Australia Bank Group of companies. Technical Update Page 5