SMSF strategy paper TB 95. Summary. In-specie transfers. Contents SMSF STRATEGY

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1 TB 95 SMSF strategy paper Issued on 26 September Summary Self managed superannuation funds (SMSFs) have enjoyed a rapid rise in popularity in recent years. Much of the excitement can be attributed to the unique opportunities that SMSFs can offer super fund members which are not available elsewhere. In this strategy paper we visit the SMSF specific strategies that can make investing in an SMSF such an attractive proposition. We also revisit some of the general superannuation strategies that are just as effective within an SMSF as they are in the wider superannuation market. These unique opportunities also contain plenty of traps for the unwary. As a result we have provided a number of helpful tips to help navigate your way through some of the more common problem areas of SMSFs. Contents Strategy Page In-specie transfers 1 Transferring listed securities or investment in a widely held unit trust to a SMSF 2 Investments in pension and accumulation Phase Jointly owning assets with a SMSF 4 Owning business real property in a SMSF 5 Acquiring farming property from a member 6 Other ways of accessing gearing 7 Life insurance policies in a SMSF 8 Tax deductions for the future liability to pay death and disability benefits 9 Adding amounts to pensions 10 Multiple pensions Estate planning 11 Recontribution strategy 12 Lump sum v pension death benefit payments 13 Benefit payments and defined benefits 14 3 Strategy Page SMSF investments and allocations to member account balances 20 Managing the fund after a relationship breakdown 20 Voting rights 21 Paying expenses of the SMSF 21 Bankruptcy 23 In-specie transfers Transferring investments as contributions to an SMSF can provide many advantages especially where a member has insufficient cash to make the contribution. Note: The Government proposes to ban offmarket transfers from 1 July This mainly impacts transfers of listed securities. The legislation to effect this measure is yet to be introduced into Parliament. Assets may be transferred to or from a superannuation fund providing the superannuation rules applying to contributions, acquiring an asset from a member or related party and paying superannuation benefits are met. Technical bulletins TB 84 Contributions and SMSFs and TB 80 Acquisition of an asset from a related party provide further information on in-specie contributions, contributions generally and the asset acquisition rules. This strategy paper looks at the particular strategies for in-specie transfers. In-specie contributions An in-specie contribution refers to a contribution made to the fund other than as cash. This involves the transfer of an investment to a fund for no consideration or for a price less than the market value of the investment. Reserving strategies 15 Members going overseas 17 When to bring children into an SMSF 18

2 Multiple contributions Even though a single asset may be transferred it can cover a number of contributions eg Julie & Bob own $350,000 worth of shares which they want to transfer in-specie to their SMSF. The transfer can be allocated as $150,000 non-concessional & $25,000 concessional contributions (if eligible) each for Bob & Julie. In-specie acquisitions An alternative to contributing an investment inspecie is for the fund to purchase the investment. This can free up cash to the member from the fund whilst retaining the investment within the superannuation environment. Using market valuations With the reduction in some asset values as a result of the global financial crisis it may be appropriate from a timing perspective to transfer assets inspecie at a current lower valuation so that: CGT may be minimised or avoided; Contributions caps are optimised; and Any increase in asset value is achieved in the concessionally taxed superannuation environment. Issues to consider with in-specie contributions: Advantages Disadvantages is paid the superannuation law requires the pensioner to notify the superannuation fund that the next payment they wish to receive from their account based pension is to be treated as a lump sum. This should be documented in the minutes of the superannuation fund to ensure that the superannuation law and Centrelink requirements are met. Under superannuation rules, the lump sum payment from the account based income stream satisfies the minimum pension requirements. Issues to be aware of include: potential CGT for the SMSF as the transfer involves a commutation of the pension for a lump sum payment which does not enjoy the exempt current pension income concession (impact on segregated / unsegregated structure?); and stamp duty due to a change in asset ownership. A lump sum payment from an income stream received on or after age 60 will be tax free. For someone between 55 and 59 (inclusive), the tax free component is received tax free and the taxable component within the low rate cap ($175, /13) is taxed at a nil rate. Consequently, a lump sum payment may be more tax advantageous than a pension payment between age 55 and 59 (inclusive) which has the taxable portion taxed at the MTR with a 15% tax offset. You should also consider the social security implications. In-specie transfer of contributions Lower asset value may help with contributions caps Any increase in asset value achieved in the tax effective super environment. Change of beneficial ownership may result in CGT liability Possible stamp duty Transferring listed securities or investment in a widely held unit trust to a SMSF SMSF TIP It may be worthwhile to consider holding shares or unit trust investments within a SMSF to avail of the fund s tax concessions. In-specie transfers via a pension Super laws do not allow pension payment to be made in-specie. However, a lump sum, unlike a pension, can be paid either as an amount of money or as an in-specie transfer of assets. Before paying a lump sum the fund s trust deed should ensure it is possible to pay lump sums from the pension. Conversion of a pension, in whole or in part, to a lump sum is referred to as a commutation of the pension. Before the lump sum A client may already own listed securities (eg listed shares, debentures or other securities) or an investment in a unit trust. Units in a widely held unit trust can be transferred to a SMSF. A widely held unit trust is a trust in which: an investor has a fixed entitlement to the income and capital of the trust; and the combined entitlements of less than 20 investors is not more than 75% of the income or capital of the trust. 2

3 The legislation permits a member, trustee, relative or other entity they control to transfer or sell listed securities and an investment in a widely held unit trust to the SMSF providing it is made on an arm s length basis. The benefit of the fund owning the listed securities or units is that: any income such as dividends and capital gains are taxed in the SMSF at concessional rates if the fund is in accumulation phase or tax free on assets used to pay a pension any capital gains on the sale of the listed securities or units are taxed at concessional rates or if the listed security or units are used to support pension assets, they are free from capital gains tax. any franking credits arising from the ownership of the listed securities or units can be applied against any tax payable by the fund and any excess credits is refunded to the SMSF. If the listed securities or units are sold to the fund then the cash acquired from the purchase can be used by the person or other entity for private or business purposes. In some cases, by transferring listed securities or units to a SMSF a client may qualify for a tax deduction or the government co-contribution. The transfer is considered to be a contribution to the fund and the relevant contribution caps should be considered. When transferring the listed securities or investment in a widely held unit trust to the SMSF, the adviser and their client need to consider: the income tax and capital gains tax implications of the transfer the appropriateness of the investment to the fund s investment strategy (particularly liquidity and diversification issues). Investments in pension and accumulation Phase Income and taxable capital gains earned by the fund on investments are tax free if they are used to support the payment of a pension. Therefore the best strategy is to ensure the investments remain in pension phase for as long as possible. You should also consider if the fund should use the segregated or unsegregated pension asset method. Trustees of superannuation funds can claim a tax exemption for any income and capital gains earned on investments used to provide income streams. There are two methods that can be used to calculate the exempt amount the segregated and unsegregated pension asset methods. Segregated pension asset method The segregated pension method requires that each fund investment be allocated to the accumulation and pension balances in the fund. This method allows a precise allocation of income and capital gains for the tax exempt and taxable components of the fund. The segregated pension asset method may be relatively expensive as it requires the investments to be allocated clearly between the accumulation and pension phases of the fund. This results in the equivalent of two sets of bank accounts being maintained for the fund. The accountant or administrator for the fund can assist the trustee to allocate the investments as appropriate. If the fund is in pension phase only, then the segregated pension asset method applies. Case study Merv (39) has received some listed shares as part of the float of an insurance company. Merv can transfer the listed shares to his SMSF, but he should consider the CGT consequences before doing so. If the SMSF does not purchase the shares from Merv, the value of the transfer is considered a non-concessional contribution. If Merv is an eligible person, he could make a personal deductible contribution. Note: The Government proposes to ban off-market transfers from 1 July This mainly impacts transfers of listed securities. The legislation to effect this measure is yet to be introduced into Parliament. Unsegregated pension asset method Under the unsegregated pension method the investments of the fund in accumulation and pension phase are pooled. Any tax exempt amount in the fund is calculated by an actuary who estimates the average amount of income and capital gains earned by the fund on the pensions being paid. This method is the more common of the two and is usually less costly than the segregated pension method. The reason is that there is no requirement to split investments between the accumulation and pension phases of the fund. If the commencement date for a pension is not 1 July (likely in most cases), then an unsegregated 3

4 pension asset method is used for that particular year. Which method? If the SMSF is expected to earn considerable income or capital gains from some investments that are in pension phase the segregated pension asset method may prove the better of the two methods. The reason is that the income and any capital gains on investments allocated to the pension phase will be totally tax free. In comparison, if the unsegregated pensions method is used the investment earnings is averaged across the fund and apportioned depending on the member balances in accumulation and pension phase. In deciding on the most suitable method to use consideration should be given to any losses that are made by the fund. If the unsegregated pension assets method is used, any losses that are incurred by the fund can be carried forward to be offset against any future income of the fund. However, if the segregated pension asset method is used it is only capital losses that are made on investments in accumulation phase which can be carried forward. When does a pension exist? When working out the investments that are in pension phase consideration needs to be given to whether a pension is actually in existence. This may be a relatively simple matter when the pension is being paid. However, it needs to be understood when a pension has commenced or ceased. A pension commences at the time an agreement between the trustee and fund member indicates that the pension will commence from a particular date. There is no requirement for the fund to actually pay the pension to the person at the time of commencement as that depends on the particular rules relating to the payment. In some cases the pension may not be paid until the end of the financial year. A pension ceases if it is converted wholly to a lump sum or there is no one left who would be eligible to receive it. If only part of the pension has been converted to a lump sum, a reversion to the pension exists on the death of the original pensioner or a beneficiary is still to make the choice of whether to take a lump sum or pension on the death of a pensioner member then it is considered that the right to the pension continues. In these circumstances the investments will be considered as pension assets and any income and capital gains on them will be tax free. Strategies The strategies that arise from investments in the accumulation and pension phases of the fund are outlined below: Consider whether it is better for the fund to have its pension assets determined on a segregated or unsegregated pension basis. Depending on how the fund earns its income and realises capital gains there may be no real difference in the tax exempt amount. Therefore you should consider the cost of the actuarial certificate on an unsegregated basis compared to the additional accounting required if pension assets are determined on a segregated pension basis. It may be better to consider using the segregated method for investments which have higher levels of income such as interest and dividends or those where it is expected a capital gains will be realised over the next financial year. If possible, ensure that investments that are to be sold by the fund are made when they are in pension phase rather than accumulation phase. This should be done prior to any pensions ceasing in the fund. Joint Ventures and Partnerships SMSFs are able to enter into joint ventures to develop property or undertake an enterprise. However, depending on the manner in which the joint venture is structured, particularly if related parties are involved in the transaction, the value of the fund s investment may be included as in-house assets and may be subject to the relevant limit. Jointly owning assets with a SMSF SMSF TIP This strategy can be used by trustees who wish to take advantage of an investment opportunity but lack the resources to purchase the property outright. The trustees of a SMSF may have identified a good real estate investment. However the fund may not be able to purchase the whole of the property as it may not have enough cash to purchase it outright. Under the SIS Act the fund is unable to borrow (except under limited recourse borrowing 4

5 arrangements, see Technical bulletin 83) or place a mortgage over fund assets to obtain the property. The trustees may consider purchasing the property jointly with related parties (including members) as tenants in common or via an interposed trust or company. Rather than purchase the property directly it may be possible for the related parties and the fund to invest in a company or unit trust that would own the property. Before this takes place, tax advice should be obtained to ensure that the fund satisfies the special rules in the superannuation legislation that relate to interposed companies and trusts owning direct property. The advantage of the fund owning property is that: Any rent paid on the property to the fund is taxed at concessional rates. Capital gains that accrue after the asset is acquired by the fund is taxed at concessional rates if the asset is in accumulation phase and tax free if it is in pension phase. If the property is used for commercial purposes then the portion not owned by the superannuation fund can be acquired at some future time. This would also apply to the units or shares if the property was owned by a unit trust or company that satisfied the special rules of the superannuation legislation. Clients should seek specialist tax advice to ensure the tax and SIS Act implications of transferring or purchasing the property are properly investigated. This may not only include the impact on the fund but also the individuals or entities from whom the property has been acquired. If the members need to borrow funds to purchase their interest in the property, that property cannot be used as security for the loan. Another form of security, such as their own home, could be used. Case study ownership of asset as tenants in common Terry and Jan are trustees of the T & J Superannuation Fund. They wish to purchase a business property for $500,000 to expand their operations. They have $300,000 in cash and as conservative investors, they would prefer not to borrow. Their superannuation fund has at least $200,000 which is available for investment. They decide to purchase the property as tenants in common with the fund owning 40% of the property. As an alternative Terry and Jan may wish to mortgage other assets they have to purchase their share of the property. Terry and Jan s business can rent the proportion of the property owned by the SMSF. Rent is calculated on an arm s length basis. Owning business real property in a SMSF SMSF TIP A client may already own, or be considering the purchase of a business property. It may be worthwhile to transfer or hold the property within the SMSF. Business real property is any freehold or leasehold interest in real property (ie land or buildings) or an interest in Crown land. To qualify, the property must be used wholly and exclusively for business purposes. The business can be carried on by anyone, irrespective of whether they are a member or trustee of the fund. The benefit of the fund purchasing a business property is that: any rent paid by the tenant to the fund is taxed in the SMSF at concessional rates or tax free on assets used to pay a pension any capital gains on the sale of the property are taxed at concessional rates or if the property is used to support pension assets, it is free from capital gains tax. Any lease on the business property must be made on an arm s length basis. For example, if the business property is leased to a member, trustee, relative or other entity they control then a commercial lease must be put in place. If the property is used in the business of the member then they may be able to claim a tax deduction for the rent they pay to the fund. Under most commercial lease arrangements, the occupiers are liable for most expenses relating to the property. Any property or other asset that is owned by the fund is not permitted to be mortgaged or have a charge over it. By selling a business property owned by a member or the business to the fund, cash that has been built up in the fund can be used to purchase the property and any proceeds can be used privately or for purposes of the business. When transferring the property into the SMSF an adviser and their client must consider: the cost of stamp duty 5

6 the income tax and capital gains tax implications associated with the transfer or sale the appropriateness of the investment to the fund s investment strategy (particularly liquidity and diversification issues). Case study Nigel and Helen are trustees of the Idyllic Superannuation Fund. They own a commercial property which has no mortgage and is rented to an arm s length party. They have decided to transfer/sell the property to their SMSF as any rent received from the tenant is taxed in the fund at concessional rates. Prior to the transfer, Nigel and Helen would need to obtain advice on the stamp duty and capital gains tax consequences. Also, they should decide how the value is treated as a contribution to the fund, for example, they may be able to claim a tax deduction for part of the transfer or have it treated as some other type of contribution. It is important to remember that if the transfer/sale of the property to the fund is a contribution, then the limits on concessional and non-concessional contributions should be considered. Alternatively the fund may have cash available to purchase the commercial property outright from the members. Acquiring farming property from a member Transfer family assets through the generations by having the SMSF acquire the family farm. Furthermore, the farm s rent and any capital gains upon sale are taxed at concessional rates within the fund. Superannuation legislation prohibits a SMSF from acquiring an asset from a member or related party, unless one of the exceptions applies. One of the exceptions is the acquisition of business real property which includes farming property. A SMSF can acquire a farming property from a member or other party related to the SMSF if it meets the definition of business real property at the time of acquisition. Business real property is property used wholly and exclusively in one or more businesses which are carried on by the member, related party or any other persons. A farming property is still considered to be wholly and exclusively used for business purposes even where up to two hectares of it are used for private and domestic purposes. A farming property is used in a business when it is used to carry on a primary production business. Primary production includes: the cultivation of land (eg. fruit growing) maintaining animals for the purpose of selling them or their bodily produce (eg. cattle breeding or poultry farming) fishing operations forest operations (eg. planting and felling trees) Whether a person is carrying on a business is determined on a case by case basis after considering a number of key factors. These include: Does the activity have a significant commercial purpose? Is there an intention to make a profit and will the activity be profitable? Is there repetition and regularity of the activity? How much time does the taxpayer spend on the activity? Are business records kept separate from personal records? What is the size of the operation and the capital investment involved? Is the business carried on in a similar manner to other like businesses? Are activities planned, organised and carried on in a businesslike manner? Does a business plan exist? Primary focus is given to the first two dot points in assessing whether a person is carrying on a primary production business. These require the activity to be carried on for a commercial purpose and to be commercially viable. If the activity is not commercially viable, for example, during the initial stages, then it must be clear that the intention is to make a profit. This would exist, for example, where there are plans to purchase additional land or animals or develop the enterprise further. Whether a business of primary production is commercially viable is often dependant on the size and scale of the activity. The size of the land and the number of animals needs to be sufficient to sustain a commercial enterprise. The larger the scale of the activity the more likely it will be that a business is being carried on. The smaller the scale of the activity the more important the other indicators become when deciding whether a business of primary production is being carried 6

7 on. Commercial viability will of course vary depending on the type of primary production. Warning: There are no hard and fast rules for determining whether activities constitute the carrying on a business of primary production. It is determined on the individual facts of each case. Clients who wish to transfer the ownership of their farming property to an SMSF should consider whether the property meets the definition of business real property at the time of transfer. This means a business of primary production must be carried on the property which is determined by the individual facts of each case. Following are some very broad guidelines for identifying whether a business is being carried on, for some types of primary production. Cattle Breeding As a general indication, it is expected that a commercial breeder would have at least 20 to 30 head of cattle with 40 to 50 hectares of grazing land for the breeder s activities to constitute the carrying on of a business. Smaller scale activities may constitute carrying on a business if there is a clear intention to make a profit, for example, there are plans to increase the number of cattle over a few years. Fruit Growing If the fruit growing activities are conducted in a business like manner and the level of the activity is commercially viable, the activities accordingly constitute a business of primary production. The scale of the activities may be small but still result in more produce than is required for the taxpayer's own domestic needs. Where this is so and there is also an intention to profit from the activities and a reasonable expectation of doing so, a business may be carried on despite the scale. Horse Breeding The quality and number of horses kept by a person is a good indication as to whether horse breeding is commercially viable as a business. As a general guideline, it is expected that a commercial breeder would have at least six commercial brood mares. However consideration would be made to any plans to further increase the number of mares. Other ways of accessing gearing As a general rule superannuation funds are permitted to borrow directly only in limited circumstances. While this may restrict a fund to the benefits of gearing there are a number of alternative ways an SMSF can access gearing. All types of superannuation funds, including SMSFs, are not generally permitted to borrow. However, there are some exceptions which allow borrowing in very limited situations. The rules allow a fund to borrow up to 10% of the market value of its total assets for various periods to pay member s benefits (90 days), settle investment transactions (7 days) or pay the superannuation surcharge (90 days). In addition, it is also possible for the fund to obtain a loan for purposes of a limited recourse borrowing arrangement. Technical Bulletin TB83 provides information on the rules for limited recourse borrowing arrangements. An SMSF can indirectly access gearing in various forms. The fund can invest in private and public companies and trusts as well as a range of other types of investments. The amount the fund can invest depends on its investment strategy and the impact of the superannuation legislation on the particular investment. Public company shares and units in publicly listed unit trusts An SMSF can invest in any companies that are listed on an approved stock exchange throughout the world. The investments on those exchanges can consist of securities such as options, bonds and other derivative type products. The fund can purchase units in public trusts listed on the stock exchange. Many publicly listed companies and trusts borrow to run their businesses because at certain levels the cost of borrowing is lower than the cost of other capital they may require to operate. By investing in listed shares and units an SMSF can benefit from the underlying gearing of the company or trust. Private company and trust investments In the case of private companies and trusts it is possible for an SMSF to gain access to gearing in the same way as investing in a listed company or trust. It should be noted that there may be limits on the fund purchasing shares or units in private companies or trusts which are controlled by the fund and parties related to it. 7

8 Private company shares SMSFs can purchase private company shares. However, depending on the holdings of related shareholders there may be a limit to the value of the shares the fund can purchase and continue to hold in the company. Where related parties, including the SMSF, control a company the value of the shares is included in the value of the fund s inhouse assets. The maximum value of in-house assets that the fund can hold is limited to no more than 5% of the total market value of all the funds investments. Control of a private company is where related parties have the right to more than 50% of the voting rights in the company OR where related parties sufficiently influence the directors. Where there is no control of a private company, there is no restriction on a SMSF owning shares in the company if permitted by the fund s investment strategy. A similar rule applies to SMSFs which purchase units in a unit trust. That is, if the unit trust is controlled by related parties, any units held by the superannuation fund are included in the value of the fund s in-house assets. If related parties do not control the unit trust, then there is no restriction on the value of units held by the SMSF. Control of a unit trust is where: Related parties have the right to more than 50% of the capital or income of the trust, OR The trust deed of the unit trust allows related parties to appoint or replace the trustee of the trust, OR The trustee(s) of the trust act in accordance with the directions, instructions or wishes of related parties. A related party includes a member of the fund, a relative of a member or any company or trust they control either individually or as a group. Syndicates Syndicates can take a number of forms and usually relate to property investments. The syndicate usually consists of a small group of investors who pool their money to purchase a property which may be leased or developed depending on the terms of the syndicate agreement. Any syndicate should be examined to determine the underlying investment vehicle used. The syndicate may consist of shares in a company which owns the relevant investment, units in a unit trust or the investment may be owned jointly or as tenants in common. Where the superannuation fund owns shares in a company or units in a unit trust as part of the syndicate structure the value of the shares or units held by the fund would depend on whether related parties control the company or trust. If the property is owned as tenants in common, the proportion of the property owned by the superannuation fund is not relevant as if the property is commercial property it can be leased to anyone, including related parties, and will not be an in-house asset of the fund. If it is a domestic residence owned by the syndicate as tenants in common, it is possible to be leased to arm s length parties. However, if it is leased to a related party then it is treated as an in-house asset of the fund. Life insurance policies in a SMSF SMSF TIP This strategy is recommended for people who: have one or more life insurance policies wish to hold the policies within superannuation can receive tax concessions on super contributions to reduce the effective cost of the premium. Under legislative changes from 7 August 2012, when developing or reviewing the fund s investment strategy, the trustee should consider insurance for fund members. Trustees should document (in the investment strategy) the decision to obtain or not obtain insurance and the reasons for doing so. The requirement for SMSF trustees to consider insurance may provide opportunities to recommend cover for the SMSF. Term life insurance cover can be held directly by an individual or within a superannuation fund. Premiums are not tax deductible to individuals. If the cover is held in a superannuation fund, the cost of cover is paid from available money in the fund or from contributions received on behalf of the member. The cost of the premium paid for life cover is generally tax deductible to the superannuation fund. A superannuation fund is prohibited from purchasing assets (with some exclusions) from a member, trustees, relative or any entity that they control. Insurance policies owned by a fund member or a relative cannot be transferred to the fund. The strategy requires the client to cease ownership of the term insurance policy in their own name and have the superannuation fund commence a new policy with the same life insurance company. The 8

9 owner of the new policy is the trustee of the superannuation fund. This strategy depends on whether the insurer s processes and policies will permit the superannuation fund to commence a new policy on the same terms as the policy previously held by the member. This would also allow continuity of cover. If the insurer is not prepared to issue a policy on the same terms then the strategy may not be worthwhile as the member may have to undertake further medical tests. This may result in an increase in premiums and/or lower coverage. The option to re-issue an insurance policy to a new owner is not offered by all insurers. Advisers should check with individual insurance companies on their procedures before recommending the strategy. The holding of a term life insurance policy within superannuation provides the following benefits: The ability to pay tax free lump sums to tax dependants. The ability for certain dependants to receive a death benefit income stream. A person may be able to salary sacrifice, make personal deductible contributions, receive cocontributions, etc Clients can manage their cash flows by using super money to pay the premiums. As part of this strategy it is necessary to consider the taxation of death benefits to dependants and non-dependants and the effect of a member having a binding death benefit nomination. If binding nominations are used within the SMSF, the person nominated must be a SIS dependant or the person s estate. If there is no valid nomination the trustee will distribute benefits according to the governing rules of the fund. This may be trustee discretion or a payment directly to the deceased s estate. Case study Alan is self-employed and has a term insurance policy with an annual premium of $550. He is eligible to claim a tax deduction for his personal contributions. It has been recommended that Alan cease the policy in his name and commence a term policy in his SMSF. Following the change, Alan s premium for his insurance cover is effectively made as a contribution to superannuation. As Alan is self employed, he can claim a tax deduction for contributions to superannuation, effectively making the cost of his life insurance premium tax deductible. Tax deductions for future liability to pay death and disability benefits SMSFs can claim tax deductions for premiums for death and disability insurance. Where the trustees decide not to claim a deduction for the premiums, a deduction may be available to the fund for the future liability to pay death and disability benefits. This is available from the time the death or disability benefit has been paid and may provide a greater benefit to the fund than claiming a tax deduction for death and disability premiums on a year by year basis. Insurance premiums paid by a superannuation fund on policies for death, terminal medical conditions, total and permanent disablement (TPD) and temporary disability are tax deductible to the fund at the time the premium is paid. The amount of the deduction available depends on the type of policy. For example, if the policy is a whole of life policy then the deduction to the fund is equal to 30% of the premium or if the policy is an endowment policy the premium is equal to 10% of the premium. In all other cases the deductibility depends on the proportion of the policy used to pay for the death, disability or terminal medical condition under the policy. As an alternative, where the fund trustees do not wish to claim a tax deduction for the death, disability or terminal illness benefit they may claim a deduction for the future liability to pay benefits when the relevant benefit has commenced to be paid. To claim this deduction the fund must make an election that no deduction will be claimed for premiums paid to provide the relevant death, disability or terminal illness benefits. Also, there is no requirement for the superannuation fund to hold an insurance policy to cover the particular events. The benefit of claiming the tax deduction for the future liability is that the amount of the deduction at the time of the relevant payment may be greater than the deduction available for insurance premiums claimed on a year by year basis. 9

10 The amount of the future liability to pay benefits is calculated using the formula: Where: Benefit amount x Future service days Total service days Benefit amount is lump sum or purchase price of annuity Future service days is the number of days from date of termination of fund membership to the member s last retirement day (the last retirement day is usually age 65) Total service days is the sum of future service days plus the member s eligible service days (eligible service days is the total of the periods or periods of fund membership or employment to which the benefit amount relates). Case study David (50) is married to Celeste with two children who are dependants for tax purposes. David has been a member of his SMSF for 20 years and dies in an accident. His balance in the SMSF at the time of his death is $1million and Celeste is to receive a death benefit lump sum. There are 5,478 days between the date of termination of fund membership (age 50) to age 65. There are 12,783 days in the total service period (age 30 to 65). The future liability tax deduction is: $1million x 5,478/12,783 = $428,538 If the SMSF has a taxable income of $28,000 in the year in which the death benefit payment is made, a carry forward loss of $400,538 is created. The carry forward loss can be used to offset future assessable income of the fund which includes amounts such as taxable contributions, capital gains and other investment income. The payment of the $1million lump sum death benefit to Celeste, who is a death benefits dependant for tax purposes, is tax free. However, if the lump sum payment was made to a child over 18 who was a non-dependant for tax purposes then there would be additional tax to pay, based on the components. Detailed information on payment requirements may be found in Technical Bulletins TB 37 Superannuation death benefits. Adding amounts to pensions Commence a death benefit pension prior to the fund receiving insurance proceeds. This may result in a greater tax free proportion depending on the circumstances. There is a method of adding the proceeds of a life insurance policy to a death benefit pension without changing the proportions that apply to the pension. On the commencement of a pension the superannuation rules require that the tax free and taxable portions of the benefit are calculated. This is determined by using the balance of the member s accumulation interests in the fund and working out what proportion of that balance relates to tax free and taxable amounts. The percentages are then applied to any amount paid from the relevant pension to calculate the amount that will be taxable and that which will be tax free. These percentages continue to be applied to any pension or lump sum withdrawal from the pension until it ceases, that is, until the balance supporting the pension runs out or it is commuted to a lump sum or to commence another pension. A death benefit pension is taxable if the deceased or the dependant receiving the pension is under age 60 at the time of death. The pension will be taxable in that case until the dependant receiving the death benefit pension reaches age 60. A death benefit pension paid to a child under age 18 is required to be commuted to a lump sum and paid by the time he or she reaches age 25 (unless disabled). These payments are tax free. If the pensioner is age 60 or over, the taxable and tax free components are also relevant on their death if a lump sum benefit is paid to a non-dependant for taxation purposes. In this situation any lump sum is split into its taxable and tax free components and tax may be payable by the non-dependant. If a dependant is to receive a death benefit pension (with taxable component) at some stage it may be worthwhile to consider commencing the pension prior to receiving any insurance proceeds. While the superannuation rules prohibit contributions and roll-overs of benefits to be added to a pension once it has commenced it is permissible to add income to the capital value of the pension. This means that any income on investments used to support the pension, transfers from reserves and the proceeds from insurance policies can be added to the capital value of the pension after it has commenced. The main advantage of adding these amounts is that there will be no change to the taxable and tax 10

11 free proportions calculated at the time the pension commenced. This may result in a greater tax free proportion depending on the circumstances. Case Study John (45) has a wife, Dianne (43) who has recently passed away. He is to receive a death benefit from Dianne s superannuation fund of $1.4 million. The amount of the death benefit will consist of the balance in Dianne s account in the superannuation fund of $400,000 ($100,000 is tax free and $300,000 is taxable) and the proceeds of an insurance policy of $1million which is a taxable component. As John wishes to receive some money prior to receipt of the proceeds of the life insurance policy he decides to commence a death benefit account based pension with that balance in the accumulation account at that time of $400,000. This will mean that due to the operation of the proportioning rule that 25% ($100,000/$400,000) of it will be tax free and 75% ($300,000/$400,000) of it will be taxable. When the proceeds of the insurance policy of $1million are received by the fund they are added to the balance of the pension and do not change the taxable and tax free proportion. As an alternative if John was to commence the death benefit account based pension after receipt of the proceeds of the insurance policy into the accumulation account, the taxable proportion of the pension will be greater. If the death benefit pension is to commence with the balance in the accumulation account plus the insurance proceeds the taxable amount of the pension will be $1.3million (92.86%) and the tax free amount will be $100,000 (7.14%). (Reference ATO NTLG Superannuation Technical Minutes March 2010 Agenda Item 6.11) Multiple pensions Estate planning Effective use of the proportional rule for calculating the taxable and tax free portions of a pension can ensure death benefits paid to non-dependants have the greatest tax free proportion. The proportioning rule does not allow taxable and tax free components to be separated when a benefit is withdrawn from the fund. When a lump sum or pension payment is made from a fund, the tax free and taxable components are calculated at the time of payment. In the accumulation phase, this proportion changes on a daily basis as contributions are made and investment earnings are added and deducted from the account balance. In the pension phase, the proportion is calculated at the time the pension commences and does not change for the life of the pension. If a member consolidates all superannuation benefits into a single account they have little to no control over the tax effectiveness of benefits they receive or their beneficiaries. Separating accounts into taxable and tax free components will have no effect as multiple accumulation accounts in an SMSF form a single superannuation interest. Each pension, such as an account based pension, in an SMSF has its own taxable and tax free components just like the accumulation balance in the fund. Therefore, a person moving into the pension phase may have the opportunity to commence multiple pensions which will consist of their own taxable and tax free elements. This may provide tax advantages for members under age 60 and also allow members of the fund more flexibility when choosing which beneficiary should receive a death benefit with the greatest tax free component. Case Study 1 Joe (58) has retired and the balance in his SMSF is $300,000 (all taxable component). He also has $200,000 in the bank that he would like to contribute to the SMSF as a non-concessional contribution before starting an income stream. He would like to draw an annual income of $32,000. If Joe makes the non-concessional contribution to the fund, the capital amount used to commence the pension will be split proportionately according to the taxable and tax free components. These proportions will apply to each pension payment or lump sum withdrawal while the pension remains in existence. The tax free proportion of the pension is $200,000/$500,000 = 40% The taxable proportion of the pension is $300,000/$500,000 = 60% If Joe was to draw a pension of $32,000 for the year the taxable and tax free proportions of the pension would be Taxable proportion Tax free proportion 60% x $32,000 = $19,200 40% x $32,000 = $12,800 11

12 Possible Alternative If Joe was to commence an income stream with the balance in the fund of $300,000 (100% taxable) prior to making the non-concessional contribution and then another income stream after contributing the non-concessional contribution of $200,000 (100% tax free), he could reduce his taxable income by $10,200. Pension 1 minimum payment $9,000 (100% taxable)* Pension 2 remaining payment $23,000 (100% tax free) *Note: the minimum pension payable for Joe for the 2012/2013 financial year is equal to 3% of the pension account balance. Case Study 2 When Joe dies he would like to leave 60% ($300,000) of his benefit to his wife Sara and 40% ($200,000) to his adult daughter Natalie. If Joe had one income stream, Sara would receive her benefit tax free ($300,000), but Natalie would pay tax of 16.5% on the taxable portion of any amount she received. 60% x $200,000 x 16.5% = $19,800 However, if Joe had two pensions with different tax components he could allocate his death benefit more tax effectively by leaving the taxable pension to Sara who will receive the benefit tax-free regardless of the tax components. Part or all of the tax free pension could then be left to Natalie saving her $19,800 in lump sum tax. Recontribution strategy A recontribution strategy enables a member to increase the tax free component of their superannuation benefit. It allows greater tax effectiveness of taxable superannuation income streams and has potential estate planning benefits. The recontribution strategy involves making a lump sum withdrawal from superannuation and then contributing the amount withdrawn (or part thereof) back into superannuation. The aim of this strategy is to increase the tax free component of a member s superannuation benefit. When using the re-contribution strategy with an SMSF, there are a few considerations: the lump sum must actually be paid from the SMSF the proportional drawdown rules apply to the withdrawal any amount recontributed to the fund is subject to the concessional or nonconcessional contribution caps, as appropriate the amount in the accumulation phase within an SMSF is treated as a single amount for purposes of the proportional rules. The benefit must actually be paid from the SMSF To constitute a payment from the SMSF, a benefit must actually be paid from the SMSF. The issue of a cheque or promissory note that is subsequently endorsed back to the SMSF does not constitute a payment from the SMSF. The cheque must be negotiated via a bank account to establish the payment has been made. It is possible to make a payment from the fund as an in-specie transfer of assets. If the recontribution strategy requires a lump sum inspecie payment, the actual title of the asset must be transferred to the member. Any capital gains tax and stamp duty implications would need to be taken into consideration. If the SMSF has sufficient cash assets, using these cash assets to fund the recontribution strategy could avoid any capital gains tax or stamp duty implications associated with an inspecie benefit payment and subsequent inspecie contribution. For additional information on benefit payments refer to Technical Bulletin 90 Benefit payments from an SMSF. The proportional drawdown rules apply to the withdrawal When a lump sum is withdrawn from superannuation, the proportional drawdown rules apply. These rules require that the tax free / taxable proportion of the lump sum superannuation withdrawal is calculated by reference to the underlying accumulation superannuation interest. 12

13 An SMSF has a single accumulation interest An SMSF has only one accumulation interest for a member. However, each pension paid for a member of an SMSF is counted as a separate interest. Consider whether any benefit can be gained by commencing a superannuation pension with the member s existing superannuation benefits prior to making the recontribution to the SMSF. Case study Amy (57) is a member of a SMSF. Her member interest in the SMSF is $400,000 (all taxable). She has retired and will perform the recontribution strategy prior to commencing a pension. Her available low rate threshold is $100,000 (due to a prior withdrawal). Amy withdraws $100,000 from the SMSF and commences a pension with the remaining $300,000 (100% taxable). Amy recontributes the $100,000 back into the SMSF as a non-concessional contribution and commences a second pension (100% tax free). Amy draws the minimum pension payment from the taxable pension and draws the remainder of her income needs from the tax free pension. Recontribution and anti-detriment payments An issue often raised when performing the recontribution strategy is the potential to reduce an anti-detriment payment. Anti-detriment payments are additional amounts paid after the death of a fund member that are able to provide a tax deduction to the superannuation fund in certain circumstances. Anti-detriment payments are an issue only if the SMSF actually pays anti-detriment payments or the benefits will be rolled over prior to a member s death into another superannuation fund that pays anti-detriment payments. For additional information, refer to Technical Bulletin 56 Recontribution strategy and Technical Bulletin 24 Anti-detriment Payments. In addition, an anti-detriments calculator TC 06 is available to calculate the amount of the anti-detriment payment. Lump sum v pension death benefit payments A death benefit can be paid as a lump sum or pension. The death benefit strategy to be used depends on a number of factors such as the age of the recipient and the deceased at the time of the member s death, the taxation of the benefit and whether the assets in the SMSF are liquid enough to pay the required benefit. Benefits paid to dependants for superannuation purposes are to be cashed as soon as practicable on the death of a member. A benefit is cashed when a lump sum(s) or income stream(s) or a combination of both commences to be paid to the dependant or to the member s estate. Only the following dependants can receive a death benefit pension. A spouse A child under age 18 A child at least 18 and under 25 that was financially dependent on the deceased A child with a qualifying disability Any other personal financially dependent on the deceased Any other person in an interedepency relationship with the deceased When paying benefits from an SMSF it should be ensured that any benefit can be paid as required by the fund s trust deed. This may require that the benefit is paid in cash, in-specie or as a combination of both. While it is possible to pay lump sum benefits in cash and in-specie, income streams paid from pensions must be made in cash. This can create an issue where the investments of the SMSF provide cashflow which is inadequate to pay pensions or are lumpy and it is difficult to sell part of the investment to enable the lump sum or pension to be paid as required. Case study The XYZ Superannuation Fund owns a commercial property which constitutes about 90% of the value of the fund. Due to a flat rental market the rent received by the fund has not increased for the past two years, however, the expenses of maintaining the property have increased substantially. This has resulted in a reduced amount of cashflow for the fund to be able to pay other costs including the pension required by the members. This means that the pensions paid to members are decreased to the minimum amounts under the legislation or the 13

14 investments are sold in part or wholly to obtain sufficient cash flow. It may be possible to sell part or all of the commercial property to the members which would provide sufficient cashflow to the fund. This should occur while the fund is in pension phase to ensure there is no CGT liability on the full or partial sale of the property. If the sale was to occur while the fund was in accumulation phase there is a potential CGT liability for the fund. The main issue here is that if the property is sold to the member of the fund that any rent received by the member personally will be taxable income and taxed at ordinary personal rates. The advantage of having the property in the pension phase is that the rental income earned by the fund is tax free if the property is used to support the pension and if the pensioner is age 60 or over, the pension will be tax free. It is also possible that the pension payable to could be reduced or commuted back to accumulation phase until the fund has sufficient cash flow to recommence pensions in the future. Note that only the spouse can commute and rollover a death benefit. This may create an issue for fund members where they are relying on the payment of the pension to cover personal living expenses. Asset protection One benefit of having a pension paid from an SMSF is that the investments which support the pension in the SMSF are protected from creditors. The benefit of retaining the investment in the SMSF is discussed under the title Bankruptcy. This may be particularly beneficial for small business people who may be in relatively high risk businesses. In the case of a spouse who commences a death benefit pension, if that pension is commuted after the death benefits period (generally the later of 6 months after death or 3 months after grant of probate or letters of administration) then it can be rolled over to the spouse s account balance in the SMSF or rolled over to another superannuation fund. Where this occurs, the commuted value of the pension is added to the spouse s balance in the fund and is dealt with as if it were his or her benefit. The amount rolled over consists of a non-preserved component. In situations where the death benefit is paid from the SMSF as a lump sum any amount that may be paid back to superannuation is a contribution and subject to the concessional and non-concessional contribution caps. The future withdrawal of these recontributed amounts is subject to a condition of release being met by the member. Centrelink issues lump sums v pensions The Centrelink treatment of death benefit lump sums and pensions differ. A lump sum received from a superannuation fund on the death of a member is not included as income for purposes of the income test. However, depending on how the lump sum is used it may be included for purposes of the assets test as a financial asset and deemed for income test purposes (for example, funds placed in a bank account or term deposit). Where a death benefit pension is paid, the account balance of the pension is asset tested. In addition, the annual pension received less the deductible amount is assessed under the income test (a nil assessment if the amount is negative). Taxation issues in the SMSF Where possible, it may be better to commence a pension in an SMSF rather than pay a lump sum as investments that are used to support a pension and are sold while in pension phase are not subject to CGT. In comparison, if a lump sum is payable from the fund a CGT liability may arise on the sale of the investment. Once the assets supporting the pension have been converted to cash while in pension phase the pension can be commuted and paid as a lump sum to the dependant. Death benefit lump sums and pensions are taxed in different ways where the deceased and their dependant for taxation purposes are both under age 60. If a lump sum is paid to the dependant the whole of the payment will be tax free. However, if a death benefit pension is paid the taxable component of the pension is added to assessable income and is eligible for a 15% tax offset. Benefit payments and defined benefits SMSFs that existed prior to 31 December 2005 were able to pay complying lifetime and life expectancy pensions. The advantages provided by these pensions has now diminished and there are a number of strategies which now permit the pensions to provide lump sums to pensioners. Generally, SMSFs were permitted to commence defined benefit lifetime and life expectancy pensions until 11 May 2004 and in some cases by 31 December These pensions are actuarially valued and were previously used for Reasonable 14

15 Benefit Limit (RBL), social security and estate planning purposes. With the abolition of the RBLs in July 2007, defined benefit pensions have outlived their useful life for these purposes. However, they continue to be effective for social security and estate planning reasons. For social security purposes, lifetime and life expectancy pensions commenced before 20 September 2004 continue to be assets test exempt and those commenced from 20 September 2004 and before 20 September 2007 are 50% assets test exempt. The main advantage of retaining a lifetime or life expectancy pension for estate planning purposes is that any balance remaining in the fund after the pension has ceased, usually after the death of the pensioner or reversionary pensioner, falls into the reserves of the fund for future distribution to members. The reason the residual amount falls into the fund reserves is that the pensioner or reversionary pensioner is entitled only to the payment of the pension from the balance in the fund. Once that right has ceased any amount remaining is transferred in accordance with the fund s trust deed. The transfer is usually to the reserve and then used for purposes specified in the fund s trust deed such as transfers to other members, payment of fund expenses and so on. In some cases a client may wish to access part of the balance of the lifetime or life expectancy pension. This is usually not available as these pensions are only able to be commuted in very limited circumstances, for example, to commence another defined benefit pension. If the lifetime or life expectancy pension is commuted to a term allocated pension, the actuary will make a calculation which splits the amount supporting the pension into two components that part which is providing the current pension and another part which is considered to be a reserve component. The amount providing the current pension must be rolled over to commence a term allocated pension, however, the amount that is identified as the reserve component can also be included in the amount to commence the term allocated pension or be paid as a lump sum to the pensioner or returned to accumulation phase in the fund. If the allocation from the reserve component is in the form of a pension, no amount counts towards the concessional contribution caps. If the allocation from the reserve component is not in the form of a pension, that amount counts towards the concessional contributions caps. The main advantage of this strategy is to release a lump sum amount from a lifetime or life expectancy pension. The main disadvantage is that the estate planning benefit of having the residual amount of the pension on the death of the pensioner or reversionary pensioner will not occur. Any amount that results from the subsequent term allocated pension must be paid as a lump sum on the pensioner s death or on the death of the reversionary pensioner. (Reference the ATO NTLG Superannuation Technical sub-group minutes 3 December 2008 Agenda Item 6.5) Reserving strategies The creation of reserve accounts can be an effective strategy. A reserve can be used to fund anti-detriment payments, to time contributions above the contribution caps, to smooth investment returns, and to facilitate the transfer of assets between family generations. What is a reserve? A reserve is an account or accounts established within a superannuation fund where an amount is set aside to provide for future expenses and payments. They do not form part of an individual member s account balance, instead they are recognised as a separate account within the fund. Amounts credited to a reserve can originate from a number of sources including the investment earnings of the fund, revaluation of fund assets, insurance proceeds and residual amounts from lifetime and life expectancy pensions. Superannuation legislation allows fund trustees to maintain reserve accounts provided it is permitted by the governing rules of the fund (i.e. trust deed). If a reserve account is created, the trustees must develop a reserving strategy to indicate how the reserves of the fund are to be used. There is no guidance in the legislation on the form the reserve should take. This allows the strategy to be suitably specific or broad in nature, as required. When formulating a reserving strategy, areas for consideration may include: the purpose of the reserve account; an investment strategy for amounts credited to the reserve; and how amounts in the reserve will be used by the fund and fund members. 15

16 What are the benefits of a reserve? There are many uses for reserves. Some of these benefits may include: Anti-detriment payments Flexible timing of contributions over financial years Preventing the sale of lumpy assets to pay benefits Intergenerational transfer of assets Paying off loans raised by the fund for purposes of limited recourse borrowing arrangements Anti detriment reserve A superannuation fund can increase a member s lump sum death benefit to reflect the contributions tax paid by the fund provided certain conditions are met. This increased payment is commonly referred to as an anti-detriment payment. Where an anti-detriment payment has been made by the fund a tax deduction may be claimed based on the amount of the increased payment. The challenge for SMSFs is that the increased death benefit payment must be obtained from sources other than from members accounts. To enable the anti-detriment payment to be made, the trustees may use amounts credited to a reserve account to fund the anti-detriment payment. For additional information anti-detriment payments refer to Technical Bulletin 24 Anti-detriment Payments. In addition, an anti-detriments calculator TC 06 is available to calculate the amount of the anti-detriment payment. Contribution reserve An SMSF may use a contribution reserve for the purpose of enabling contributions in excess of the concessional and non-concessional caps to be made to the fund. The use of the reserve in these circumstances is limited as the contribution must be made in June of the financial year and then transferred to the member s account by 28 July of the next financial year. Also, it is possible to use this strategy a limited number of times as it may result in excess contributions in the second and subsequent years. A contribution reserve can be useful where an employer or a person wishes to claim a concessional contribution of up to their concessional contributions cap for the current financial year and the next financial year. reserve in June of the financial year. By 28 July in the next financial year the contribution is allocated to the members account and it will count towards the member s cap for the financial year in which it is allocated, not the year in which the contribution is made to the fund. Case Study Matthew (45) is self-employed and eligible to claim a personal superannuation contribution. His taxable income is high this financial year and he wishes to make the maximum concessional contribution to the fund. He makes a contribution of $50,000 in June and claims a deduction for the amount in his tax return for this contribution and claims the deduction in the financial year in which it was made. An amount of $25,000 of Matthew s contribution is credited to his account in the SMSF and the remaining $25,000 is credited to a reserve. It is credited to Matthew s account by 28 July in the next financial year. To claim a deduction for the contribution, the notice of intent must be provided to the SMSF prior to the lodgement of his income tax return (or 30 June of the next year, whichever occurs first). Investment reserve Investment reserves have long been used to smooth investment returns. When investment returns are high, a portion of the return is credited to the member s account and the balance is allocated to an investment reserve. This reserve can be used to increase future amounts credited to member s accounts when investment returns for the year are low or negative. Case Study The Park Bench SMSF achieves an actual investment return for the year of 10%. The trustees of the fund decide to credit 5% of this return to the account balances of all members, with the remainder allocated to a reserve. The following year the Park Bench SMSF achieves an investment return of 1%. The trustees of the fund decide to use part of the investment reserve to increase the amount credited to all members to 4%. Part of the contribution is credited to the member s account and the remainder is credited to the 16

17 Intergenerational transfer of assets Reserves are not allocated to individual member s accounts so do not form part of member s death benefits. The reserve account can therefore be retained in the fund and transferred to future generations over time. Case Study Harold has $2 million in his SMSF including $150,000 in a reserve account. He would like the proceeds of his fund to go to his adult son Luke who is not a member of the fund. When Harold dies, the reserve account does not have to be paid out to Luke as a death benefit. Instead, Luke can become a member of the fund and the reserve account can be allocated to him over time. Provided the allocations are fair and reasonable and are less than 5% of Luke s interest in the fund they can be transferred without being assessed against the concessional contribution cap. The above example not only saves Luke 15% in lump sum benefit tax, it also has the potential to prevent the sale of lumpy assets in the fund to pay the benefit. Paying off loans raised by the fund for purposes of limited recourse borrowing arrangements Limited recourse borrowing arrangements involve the superannuation fund borrowing for purposes of acquiring an investment which is held in a holding trust until it is sold or the loan is paid off and the investment transferred to the fund. Amounts credited to the reserve can be used to pay off the loan and reduce or extinguish the outstanding loan for purposes of the limited recourse borrowing arrangement. Case Study The Andrew Smith Superannuation Fund has borrowed $100,000 for purposes of purchasing a property under a limited recourse borrowing arrangement. The fund has paid interest on the amount borrowed and has built up a significant reserve of $70,000 from the fund s income over the years. The trustees decide to use $50,000 of the amount credited to the reserve to reduce the amount of the outstanding loan. Members going overseas If a trustee of an SMSF is going overseas for an extended period, someone who remains in Australia can be granted an Enduring Power of Attorney to be a trustee of the fund in their place. This will allow the central management and control of the SMSF to be in Australia and if the fund is complying it will be taxed at concessional rates. If a member of an SMSF goes overseas, care should be taken to ensure that the SMSF continues to be taxed at concessional tax rates. To be taxed concessionally an SMSF that complies with the superannuation legislation must be an Australian superannuation fund. This requires the fund to satisfy a central management and control test as well as an active member test. An SMSF that does not meet the requirements as an Australian superannuation fund is taxed as a non-complying fund for tax purposes and the fund s income is taxed at 45%. Income of the fund includes the value of the fund s assets at the commencement of the year less any non-deductible contributions made to the fund since 30 June Central management and control test The central management and control of an SMSF must ordinarily be in Australia. Central management and control relates to who makes the high level decisions of the fund and where these decisions are made. High level decisions include: the investment strategy of the fund the use of fund reserves (where relevant) how the assets of the fund are used to fund member benefits. If there is an equal amount of decision makers in Australia and overseas, the central management and control is taken to ordinarily be in Australia. Where the central management and control of the SMSF is temporarily outside of Australia, the central management and control test may be satisfied where: the central management and control of the fund remains outside Australian for a period of not more than 2 years; or based on the circumstances, the central management and control is deemed to ordinarily be in Australia (this may apply to 17

18 a temporary period where members are absent from Australia for up to 2 years). Alternatively, the central management and control remains in Australia where: the decision makers temporarily return to Australia and the central management and control activities are exercised at this time a person who is in Australia holds a valid enduring power of attorney and is appointed as a trustee (or director of a corporate trustee) of the SMSF in place of the trustee who is overseas. the SMSF becomes a Small APRA Fund (SAF). An individual trustee appointing their legal personal representative as trustee (using a power of attorney) and removing the member as trustee must be in accordance with the SMSF trust deed. Similarly, the replacement of a corporate trustee must be done in accordance with the constitution (if any) of the corporate trustee. Active member test The active member test applies where a member who is a foreign resident makes contributions to the SMSF. The active member test requires that Australian resident members for whom contributions have been made: hold at least 50% of the total market value of the fund s assets of all active member accounts; or are entitled to at least 50% of the amounts payable to all active members if they voluntarily ceased to be members. An active member of an SMSF is one who: is a contributor to the fund (for this purpose it includes rolling a benefit into the superannuation fund); or *had contributions made to the SMSF on their behalf. *Where a foreign resident is not a contributor of the fund, if someone makes a contribution on their behalf in respect of a period that they were an Australian resident, then they are not an active member. A member can continue to contribute, or have contributions made for their benefit, whilst they remain an Australian resident for taxation purposes. Short term, temporary stays overseas does not generally result in the loss of Australian residency. If a foreign resident wishes to contribute or rollover existing benefits into their SMSF, they must ensure that they satisfy the active member test. Where the active member test cannot be satisfied, the foreign resident should not be a contributor to the SMSF. Alternatively, they may wish to contribute to a retail superannuation fund. Are there any resident members of the SMSF that are not active members? If they were to become a contributor to the fund (the amount of contribution is not relevant) could this allow the foreign resident to also be a contributor of the fund whilst satisfying the active member test? When to bring children into an SMSF SMSF Strategy Prior to bringing family members into an SMSF, there are some issues and strategies for consideration to ensure the smooth operation of the fund. The maximum number of members in an SMSF is 4. This may present a problem for larger families with 3 or more children. In these cases, a number of SMSFs could be considered. A minor (someone under age 18) is considered to be under a legal disability and so cannot be a trustee (or director of a corporate trustee) of a SMSF. A legal personal representative (eg parent or guardian) of a minor can act as a trustee on behalf of the minor. Where a parent acts as trustee on behalf of the minor, they may also be a member of that fund. In this case, the parent is a trustee in their own right and on behalf of the minor. Having children as members of an SMSF may be an issue because each child may have a small balance in the fund. Also, the children may be perceived as wielding too much power due to the de facto control they exert as fund trustees. These issues may not present a huge barrier and the best result could be to admit the children as fund members. 18

19 Co-contribution One reason for having children as members of an SMSF could be the access to the co-contribution, if eligible. The benefit for the child will build up in the fund and they may have a choice of how the amount is to be invested. If the child is under 18 they may have child contributions made to the fund by a parent or relative or someone else. Also, where the child is working they may be able to make salary sacrifice, or personal deductible contributions to the fund. Choice of Fund Under the choice of fund legislation, a child may be entitled to nominate a fund to which they belong. This can allow them to aggregate all superannuation contributions in the one fund, such as the family SMSF, rather than have contributions spread over a number of funds. The benefit may be that the cost of administering the child s superannuation benefit may be reduced as there is only one fund involved and they may have greater investment choice and flexibility. Voting rights of members An issue of concern to parents who are trustee/members of the SMSF is that allowing a child to become a member he or she may have influence in the operation of the fund. The reason is that each trustee or director of the trustee company may each be entitled to one vote under the rules of the fund. This may allow the children to effectively control the fund and give them more than a reasonable say in how the fund is to be invested and administered. If this is the case a number of methods can be used to provide members of the fund with reasonable control. Reasonable levels of control can be achieved by the trustees being allowed to have voting rights which are proportionate to their balance in the fund. Another way could be to require all trustees to have a unanimous vote in favour of a resolution on particular matters relating to the operation of the fund. Death benefits and child members Where a parent who is a member of the fund has passed away and the child becomes entitled to a pension, he or she can join the fund at the time the pension commences to be paid. There is no need for the child to be a member of the fund before the payment of the death benefit. the child is at least 18 and under 25 and was financially dependent on the deceased member the child has a qualifying disability. As a minor does not have legal capacity to be a trustee of the fund, the child s parent or legal personal representative will act as a trustee until the child reaches age 18. Children and the intergenerational transfer of assets It is possible to retain assets in a SMSF through the generations. This can be done by the retaining assets that have been acquired by one generation remaining in the fund after those members have left or are receiving pensions. The next generation may be able to manage the asset as appropriate. Before this can be done, careful planning is required to ensure benefits can be paid to the retiring generation at the appropriate time. Case study Steve and Judi are in their mid 50s and have built up substantial assets in their SMSF over many years. The fund currently consists of a property which they farm, shares in the family company as well as listed securities, bonds, fixed deposits, insurance and a range of other investments. Their son and daughter-in-law are currently working the farm as Steve and Judi have other interests they are pursuing. Steve and Judi would like to retire in about 5 or 10 years time once they reach age 60. The son and daughter-in-law who are not fund members realise the potential benefits of retaining the farm and family company shares in the fund as a number of CGT issues will not arise if Steve and Judi retire and decide to receive a lump sum. The same issues may not arise if they decide to take a pension and use the income from relevant fund assets to support the pension. As there is currently 5 or 10 years until Steve and Judi retire it is decided that the son and daughterin-law become members of the fund and during that time contribute as much as possible. This should create a pool of assets to pay any retirement benefit that may become due. Also, it will enable assets to be built up in the fund so that by the time Steve and Judi retire their benefits can be paid in cash or in-specie without the need to transfer the farm or the family company shares out of the fund. Death benefit pensions can only commence if: the child is under age 18 19

20 SMSF investments and allocations to member account balances SMSF TIP Don t confuse an SMSFs assets with those you actually own. SMSFs members need to understand the link between the account balance in their SMSF and the fund s investments. This is particularly common where clients have sold in the fund or made an inspecie transfer of investments they previously owned to the fund. Many clients think that if they transfer their investments to the fund they or their dependants have a right to receive those investments when it comes time for payment of a benefit. This is generally not the case as the fund investments can be used to pay expenses of the fund including any benefits payable to any member or their dependants. When an investment is transferred to a fund it is recorded as a fund asset for accounting purposes. On the other side of the balance sheet (these days referred to as a statement of financial position) the value of the investment is recorded in one or more of the member s accounts. If the value of the fund investments changes due to market fluctuations, for example, it is usual to reflect the increase or decrease in the member s accounts at the time the fund accounts are prepared. Case study Leila and David are members of a SMSF. Leila s balance is $400,000 and David s balance is $200,000. They are nearing retirement and Leila decides to transfer some of her listed shares valued at $100,000 to the fund. This is to be done as an in-specie transfer. The value of the shares is recorded in Leila s account in the fund as a nonconcessional contribution. The position in the fund before and after the transfer of the shares is: Before the transfer of shares Member balance Leila $400,000 David $200,000 Investments Value of fund investments $600,000 After the transfer of shares Member balance Leila $500,000 David $200,000 Investments Value of fund investments $700,000 The shares Leila has transferred to the fund are included in the pool of fund investments available to pay any of the member s benefits or other expenses of the fund. The investments no longer belong to Leila. However, as a result of the transfer Leila s balance in the fund has increased by $100,000 which is equal to the value of the shares she transferred to the fund. In some cases, the trust deed of an SMSF may permit the trustee to allocate certain fund investments to a particular member. Specialist advice should be obtained in these cases before the trustee decides to link particular investments with a fund member. Managing the fund after a relationship breakdown SMSF TIP Don t let a relationship breakdown impact the effectiveness of your SMSF. Superannuation can be split on the breakdown of a relationship. The laws apply to married and de facto couples (same or opposite sex). Detailed information on the measure is located in Technical Bulletin TB39 Superannuation and relationship breakdown. This strategy paper considers the particular issues for SMSFs. Trustees As all members of a SMSF must be trustees, consideration should be given as to whether it is viable to have an ex-spouse as a trustee within the fund. An ex-spouse may create difficulties in the operation of the fund especially for fund investment decisions. It may be appropriate for the transfer of the benefits of the ex spouse to another fund. If so, it is important to ensure that the spouse who is leaving the fund also ceases as a trustee of the fund. Arrangements should be put in place to meet 20

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