6 Insurance as part of a self-managed superannuation fund s investment strategy By Julie Steed, Technical Services Manager

Transcription

1 IOOF AdviserConnect IOOF TechConnect Quarterly technical bulletin: Autumn Best interest duties life insurance in super By Martin Breckon, Technical Services Manager 6 Insurance as part of a self-managed superannuation fund s investment strategy By Julie Steed, Technical Services Manager 8 Salary sacrificing leave entitlements into super is this a real opportunity? By Damian Hearn, National Manager Technical Services Best interest duties life insurance in super By Martin Breckon, Technical Services Manager The best interest duty required under FoFA will apply from 1 July This will add a new level of complexity to the normal fiduciary duties currently required of financial advisers. Although ASIC has confirmed best interest duty does not imply a need for perfect advice, proper execution will set new parameters for advice industry best practice. When advisers begin working with best interest duty, and apply the safe harbour rule, they will also need to ask themselves the question Is this in the best interest of my client? This ultimate question may lead some advisers to change the way they deliver advice, and to recommend different strategies for their clients. Most importantly, this change may cause a shift away from looking just at the immediate funding efficiency need, to consider a wider and more complex range of issues. The IOOF TechConnect team, Damian Hearn, Pam Roberts, Julie Steed, Martin Breckon, Donald Lobo and William Truong provides a comprehensive range of technical support tools for professional financial advisers. 1

2 Why recommend placing life insurance in super? The reasons for placing life insurance cover within super are well understood. It is convenient, and premiums can be paid either by regular contributions or debiting a member s super account. Where cover is through group life there is auto-acceptance and lowercost premiums. Retail cover provides a more tailored solution, generally more comprehensive benefit definitions and a superior claims processing philosophy. Yet the main driver to choosing life cover through super is cost - the funding efficiency of pre-tax dollars, and when money is tight, the ability to debit a superannuation accumulation account for the cost of premiums. The following case study illustrates the pricing advantage: Case Study Bill Bill, age 40, earns $100,000 net of super. He is married with two children under 18. He is a non-smoker, and has placed all of his life insurance into his retail superannuation account, where his SG contributions are also directed. Bill s life cover consists of: death cover $1,000,000 TPD cover $1,000,000 income protection (indemnity) in super - benefits to age 65 with a 28 day waiting period His annual life cover premium is $3,510, made up as follows: death = $660 total and permanent disability = $1,350 income protection (Indemnity) = $1,500 Currently, Bill s account receives only the 9 per cent compulsory SG contributions as he cannot afford to make additional super contributions. He is aware that he needs to maximise his retirement savings, but balances this against his current cost of living and the understanding that his life insurance cover provides the necessary financial security for him and his family. Although Bill would have preferred own occupation TPD cover, he is uncomfortable with the any occupation TPD cover, and had also initially preferred agreed value income protection. He considered these trade-offs acceptable considering the funding efficiencies of including life cover within his super. Bill s marginal tax rate (MTR) (plus Medicare levy) is 38.5 per cent, so the 15 per cent maximum contributions tax rate provides a significant tax saving. With an annual insurance premium of $3,510, the pre-tax cost outside of super is: Cost of premium (1 (MTR + Medicare)) = $3, = $5,707 If Bill wished to maximise his retirement savings by conserving the value of his SG contributions, he could make additional contributions of $3,510 each year to cover the cost of his insurance premiums. For anyone with an MTR more than 19 per cent, life cover through super is quite compelling on a premium cost basis. Using Bill s $3,510 premium as an example, the value is quite straightforward as the following table shows: In super Outside of super Marginal tax rate + Medicare levy N/A 20.5% 34% 38.5% 46.5% Gross amount required $3,510 $4,415 $5,318 $5,707 $6,560 Tax levied N/A $905 $1,808 $2,197 $3,050 Cost of life insurance $3,510 $3,510 $3,510 $3,510 $3,510 2

3 Best interest duty The challenge: With the introduction of best interest duty, a recommendation solely based on funding efficiency may not be sufficient. There are a number of questions to be considered: How to handle super funds that only offer one insurer s product, or a dealership with a limited approved product list (APL)? Will advisers also have to make recommendations based on the core purpose of the cover, product features, benefit definitions and research house ratings? Will advisers also need to consider the insurer s underwriting and claims payment philosophy? Obtaining life cover through super has a key implication when a claim is paid. For a benefit to be paid out from superannuation, it must meet a condition of release. Also, as it becomes a superannuation benefit, tax may be payable subject to a number of variables such as, to whom the benefit is paid, beneficiary age, type of benefit and the proportion of tax free to taxable components. The ASIC test for the application of the best interest duty is whether it is reasonable to believe that the advice would leave the client in a better position. In a better position may not always be monetary improvement, but may include protection from risks, preparedness for the future, or access to product features. However, improvements that are trivial or have no value to the client will not meet the test. Further a one size fits all advice model would be unlikely to meet the best interest duty, as it does not take into account the client s relevant circumstances. What are my best interest duty obligations from 1 July 2013? The Corporations Act Section 961B(1) states that advisers must act in the best interests of the client and s.961b(2) sets out a compliance safe harbour. It was intended that advisers can show they have met the best interest duty by meeting all of the elements of s. 961B(2), these are specific steps required to prove that best interests obligations have been satisfied. An adviser must: 1 identify the objectives, financial situation and needs of the client that were disclosed by the client through instructions 2 identify the subject matter of the advice sought by the client (whether explicitly or implicitly) 3 identify the objectives, financial situation and needs of the client that would reasonably be considered relevant to the advice sought on that subject matter (client s relevant circumstances) 4 if it is reasonably apparent that information relating to the client s relevant circumstances is incomplete or inaccurate, make reasonable inquiries to obtain complete and accurate information 5 assess whether the advice provider has the expertise required to provide the client with advice on the subject matter sought and, if not, decline to provide the advice 6 if it would be reasonable to consider recommending a financial product: a conduct a reasonable investigation into the financial products that might achieve the objectives and meet the needs of the client that would reasonably be considered relevant to advice on that subject matter b assess the information gathered in the investigation 7 base all judgements in advising the client on the client s relevant circumstances 8 take any other step that, at the time the advice is provided, would reasonably be regarded as being in the best interests of the client, given the client s relevant circumstances. ASIC has stated that in a better position may not always be monetary improvement, so therefore a recommendation based solely on pricing may be inadequate. SIC has further clarified a one size fits all advice model would be unlikely to meet the best interest duty as it does not take into account the client s relevant circumstance. For example, if a client needs $800,000 after tax to repay debt, $800,000 in life cover within super may not meet this need if lump sum tax is deducted. This means that advisers will need to consider a higher sum insured in super versus outside, to compensate for the tax. Without a specific defined need such as in this example, is it then sufficient to make a recommendation disclosing all of the requirements of superannuation dependency, tax dependency and subsequent benefit tax? These can be complex and confusing even disregarding the ongoing risk of further regulatory change. Also, can an ordinary client with a reasonable level of knowledge, understand all of the nuances and potential pitfalls, even when disclosed? ASIC stresses the importance of strategic advice and the need to formulate the strategy the advice is based on before recommending a financial product. According to ASIC advice providers are expected to make their own inquiries and research into the products they give advice on and not just rely on service providers such as research houses. So in the spirit of the legislation and of providing best practice advice, advisers need to understand the client s concerns, objectives and constraints and then recommend a strategy to satisfy the requirements of the best interest duty, and then deliver an outcome at a cost the client can afford. We will now consider this further with reference to the different types of life cover and the circumstances of Bill s case study covered earlier. 3

4 Death cover Any death benefit paid from a super fund must be paid either to a superannuation dependent or the deceased s legal personal representative. To who this payment is directed can be assured by the use of a binding nomination. A superannuation dependent may either be a tax dependent or a non tax dependent, which will define the potential benefit tax liability. Some of the factors to consider here are: the differences between superannuation and tax dependants taxable and tax free components of a superannuation death benefit non tax dependants and the possibility of an untaxed element occurring in the taxable component the different treatment of adult children and minor children eligibility for death benefit pensions and tax anti-detriment benefits, what they are, who is eligible and tax treatment. Case study Bill death cover In Bill s circumstances, maintaining his death cover within superannuation can be justified. Also, certainty of payment to his spouse can be assured with a valid binding death benefit nomination. The nomination determines to whom the benefit is paid, but not how it is paid for example, as either a pension, lump sum or combination of both. It is important to regularly review Bill s circumstances, and amend the strategy if necessary as his circumstances change. For example, if Bill s spouse were to pre-decease him, to consider the implications of a death benefit possibly paid to adult children. Total and permanent disability Total and permanent disability (TPD) insurance is usually sold as an additional benefit in addition to term death cover either inside or outside of superannuation. Outside of superannuation the benefit is usually tax free as long as it is paid to the life insured or a defined relative. Within superannuation, any TPD benefit paid will be taxed as part of the member s total superannuation benefit. Despite the possibility of benefit tax, TPD cover within super has advantages. However, where super fund membership is linked to an employment arrangement, it is important to check whether continuation options are available to allow cover to continue on termination of employment. A further consideration is that, while a person may be eligible to receive a TPD benefit under the terms of their insurance cover, for that benefit to be paid from a super fund, the member must also meet the definition of permanent incapacity under SIS. The tax treatment of a lump sum payment will be as a disability superannuation benefit. Outside of superannuation individuals generally cannot obtain a personal tax deduction for TPD insurance premiums. However, a key advantage is that the benefit is tax free unless paid to someone other the life insured or a defined relative. The TPD challenge Should you recommend TPD cover inside or out of superannuation. This will depend on criteria relevant to your client s circumstances and objectives: The purpose of the cover: Is the funding sensitive to timing for example for business succession or key person purposes? Is it solely a pricing decision and to what degree is the premium deductible? What is tax payable on the payment proceeds, and is there a need to gross up the sum insured? Does the client need the policy to be portable? Is own occupation cover preferred to any occupation requirements? Case study Bill TPD As Bill would have preferred an own occupation TPD definition, in light of best interest duty, it may be worth considering this further. Should a client like Bill want to maximise the tax deduction on their TPD premium as well having the comfort of an own occupation definition, there are product solutions to address this. Under IOOF s Superlink TPD insurance cover, a client may have the same sum insured owned by the superannuation fund (any occupation) and self-owned (own occupation). The benefits of splitting TPD ownership are: potential superannuation definition complications are avoided full tax deductibility for the portion of the premium paying for any occupation cover only a portion of the premium (the cost difference between the any occupation definition and own occupation definition is non-deductible. This presents a suitable tailored for the client solution, which goes beyond cost alone. Income protection Within superannuation, payments made by an insurer with respect to income protection cover must be kept separate from your client s other benefits and can only be paid as an income stream subject to the member s marginal tax rate. No tax offsets are available. 4

5 When income protection cover is held within superannuation, although premiums can be deducted from your client s account, the payment of temporary incapacity benefits must be paid directly to the member, rather than credited to their superannuation account. Premiums are tax deductible for cover held both inside and outside of super. Your client can package non-superannuation income protection premiums paid by their employer as a fringe benefit, but this packaged benefit is made exempt from fringe benefit tax by the otherwise deductible rule in Commonwealth Fringe Benefits Tax Assessment Act 1986 section 24. There are Centrelink issues to be considered when long term income protection benefits or a negotiated lump sum is received. However, benefits originating from a superannuation fund receive more favourable treatment. Bringing it all together With the introduction of best interest duty, what should we do with a client who currently has adequate cover within super? How do we proactively ensure we comply with our best interest duty obligations and retain the client in the new regime? Case study Bill Bill s adviser reviews his circumstances, objectives and constraints, and recommends a strategy involving improved product features to reduce risk and to enhance his savings potential. Cover Inside super Outside super Death $1,000,000 $660* TPD $1,000,000 (any occupation) $1,120* TPD $1,000,000 (own occupation) $230 Income Protection Premier 28 day waiting $950* period 2 years benefits (Indemnity) Income Protection Standard 2 year waiting $630* period benefits to age 65 (Indemnity) Total premium $2,410 $1,180 * 100% deductible Bill s adviser has proactively complied with his best interest duty, and through innovative use of professional knowledge recommended a solution of improved features which: Increases the superannuation contributions towards Bill s retirement savings by $1,100 each year by reducing the amount deducted for life cover premiums from his super account. Ensures who will receive any death benefit by using a binding nomination directed to Bill s wife as a tax free benefit. Restructures Bill s TPD cover for the same cost Bill has both $1,000,000 inside super as any occupation and $1,000,000 outside of super under an own occupation definition. The fund gets 100% deductibility for the any occupation premium, and more importantly for Bill he now has own occupation cover Restructures Bill s income protection cover to provide: comprehensive short term (2 year) cover outside of super a period which will cover most claims occur, and long term cover within super to provide cover for periods longer than 2 years. This solution costs an extra $80 a year ($1.50 per week), but he retains 100 per cent deductibility. Appropriate ownership is strategically ensured to maximise the probability of Centrelink concessions in the event of permanent or temporary incapacity. Summary Enshrining adviser best interest duties into legislation may at first glance appear to have added a level of complexity. However, what this really does is to codify what has already been embraced in day to day best practice principles across the advice industry. With a positive mindset change creates opportunities. Although placing life cover into super has many obvious advantages, we need to think beyond only a funding efficiency consideration to deliver the best outcome for the client and to genuinely answer that ultimate question Is this in the best interest of my client? 5

6 Insurance as part of a self-managed superannuation fund s investment strategy By Julie Steed, Technical Services Manager There are a number of changes to superannuation rules that place additional requirements on SMSF trustees. These include requirements to: consider insurance as part of a self-managed superannuation fund s (SMSF s) investment strategy regularly review the fund s investment strategies ensure that asset ownership details are correctly recorded and that market values are used. SMSF trustees need to ensure that a review of their SMSF investment strategy is undertaken by 1 July These legislative changes provide advisers with opportunities to provide advice to SMSF trustees to ensure they meet their obligations as trustees. The changes have been made to operating standards under the SIS regulations 1, which means that they must be complied with at all times. A breach of this kind of operating standard may result in trustee disqualification, civil penalties and loss of the fund s compliance status. Penalties of up to 100 penalty units (up to $17,000) can apply where the contravention is intentional or reckless. The regulations have been in effective since 7 August Insurance is now required to be considered as part of a fund s investment strategy When formulating the fund s investment strategy SMSF trustees are now required to consider whether they should hold insurance policies for the members. While there is no requirement that the fund obtains insurance cover, the need (or otherwise) must be actively considered. As at 30 June 2011, the ATO estimates 2 that SMSF assets were valued at $423.2 billion while the value of insurance policies held in SMSFs was $169 million - less than 0.05 per cent of fund assets. The problem of underinsurance in Australia is widely understood and accepted, and while there may be many good reasons why clients may not hold their insurance within super, the Government is keen to ensure that proper consideration is given to the need for insurance in super. Insurance can include life, total and permanent disablement (TPD), income protection and trauma insurance. In conducting the review, it is worth remembering that the Government has previously announced its intention to ban superannuation funds from holding insurance policies that do not meet a superannuation condition of release. A key consequence is that this is likely to limit the ability to hold own occupation TPD policies and trauma policies within super in the future. Trustees need to be aware of their obligations and are likely to require assistance from financial advisers to assess their insurance needs. This can include assessing the benefits of holding various types of insurance within the SMSF versus outside of super. Documentation is the key to compliance for these changes Trustees need to consider the insurance needs of the members and then determine whether insurance is required, and if so, then whether it should be held within the SMSF. The decisions need to be documented to form part of the fund s investment strategy. This may be achieved via a separate minute of the trustee. Also, as part of the regular review of investment strategy, trustees will need to document the review of insurances as part of that strategy. The notation could be as simple as: The trustees have considered the insurance needs of members of the fund. They have determined that the insurances held by the members within the fund remain appropriate. Alternatively it could be: The trustees have considered the insurance needs of members of the fund. They have determined that it remains appropriate for the fund not to hold insurance policies for the members. However, if trustee s documentation of the assessment of insurance needs is too brief, they risk the potential for future claims to be made against them by disgruntled next of kin. Trustees may therefore wish to undertake and hold a more detailed analysis of their insurance needs in a separate document (which could be a statement of advice provided by a financial planner) We expect that advisers would use similar terminology when providing a statement of advice to an SMSF trustee with regard to insurance needs as they would when providing a standard statement of advice to individual members. 1 Superannuation Industry (Supervision) Regulation ATO publication SMSFs a statistical overview

7 Trustees of SMSFs also need to be mindful that they are unlikely to be licenced to give personal advice to other members of the fund. This means that trustees will need to balance the superannuation law requirement that the fund s investment strategy considers insurance for members with their ability to provide members with advice in this area. Transferring member owned insurance policies into the fund If the review of your client's insurance needs determines that it is more appropriate for existing insurances, currently held outside of super, to be held within superannuation, it is important to remember that if your client has an insurance policy in their own name, it cannot be transferred into the name of the SMSF. This would be a breach of the related party acquisition rules. A solution may be to approach the insurer to see if they will cancel the existing personal policy and reissue it in the name of the SMSF trustee, without full underwriting. If this happens, it is important to consider whether the terms and conditions of the policies are the same. If the existing personal policy has been held for many years, there may be benefit features of value to the client, which are no longer available. Don t ignore other insurances A review of fund s investment strategy to consider your client's personal insurances may provide a timely prompt to ensure that other insurances are in order. If funds have property (such as an investment property), they should ensure that the property is adequately insured. This includes the need to hold public liability insurance for the property to ensure that the trustees are covered for any injuries that may occur to visitors to the premises. If the SMSF has purchased a collectable since 1 July 2011, the collectable is required to be insured in the name of the trustee. If clients already held collectables in the fund as at 30 June 2011, insurance will be required from 1 July Regular review of investment strategies Superannuation fund trustees are now required to regularly review the fund s investment strategy. SIS regulations have always required trustees to formulate and give effect to an investment strategy but they must now formally review their strategy on a regular basis. This is generally every twelve months or when a life event (for example, marriage or birth of a child) occurs. The change is designed to ensure that trustees do not simply set and forget their investment goals. They need to be reviewed regularly to ensure that they remain relevant and appropriate as circumstances change. Events that should prompt SMSF trustees to consider an additional review of their investment strategy may include the admittance of a new member, changes in a member s personal circumstance (marriage, children), commencing a pension or significant changes in market conditions. The regulations require that the investment strategy considers: risk and return diversification liquidity ability to meet liabilities insurance for members (new for SMSFs only) Trustees will need to ensure that the SMSF s investment strategy review is documented and will be built into a regular investment review cycle. It is also important to ensure that the investment strategy is appropriate for all members of the fund. For example, if two SMSF members have significantly different risk profiles, it would be necessary to ensure that this is reflected in the fund s investment strategy. This may involve establishing and maintaining different investment strategies for each member. Trustees will need to ensure that a review of their SMSF investment strategy occurs by 1 July Trustees must also ensure that actual investments are monitored against investment strategy. Trustees who allow investments outside of strategy or trust deed rules may be subject to penalties. Separation of assets is now vitally important The requirement to review investment strategy also provides an opportunity to ensure that the ownership of fund assets is correctly documented. We now have an operating standard which requires the trustee of a SMSF to keep the assets of the fund separate from any other assets that are held by trustees or standard employer sponsors and their associates. The requirement to separate assets has always been (and continues to be) a covenant in the SIS Act. The covenant is taken to be incorporated in the trust deed of a fund. However, breaches of the covenant only result in penalties if the SMSF members take action against the trustees for breach of trust. Given the mutuality between the SMSF members and the trustees, this is unlikely. Despite the current and longstanding requirement to keep assets separate, breaches consistently represent over 25 per cent of the value of all SMSF audit contravention reports 3. The introduction of the requirement as an operating standard in the SIS regulations means that it is now much easier for the ATO to apply penalties for intentional or reckless contraventions of this breach, so this has now become a much more significant risk of penalties for SMSFs. Breaches of this regulatory requirement carry penalties of up to 100 penalty units ($17,000). 3 ATO publication SMSFs a statistical overview

8 Asset valuations A recent legislative change now requires all assets to be valued at market value for the 2012/13 year of income, and for all subsequent years. Market value must be used when preparing the fund s accounts and member statements. Market value is defined in the SIS Act 4 as the amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller under the following assumptions: the buyer and the seller dealt with each other at arm s length in relation to the sale the sale occurred after proper marketing of the asset the buyer and the seller acted knowledgeably and prudentially in relation to the sale Previously, assets were only required to be valued at market value if the fund had in-house assets and when a pension was commenced. If clients have assets that require valuations, they should prepare for this in plenty of time to complete 2012/13 year end work. Breaches of this regulatory requirement carry penalties of up to 100 penalty units ($17,000). However, this is also a strict liability offence and penalties of up to 50 penalty units ($8,500) can be applied simply because the breach has occurred. This means that there is no requirement for the breach to have been intentional or reckless. Trustees should review their portfolios and ensure that they are prepared for all assets to be valued at market value. Conclusion These changes place greater onus on SMSF trustees to ensure investment strategies and the insurance cover provided by the fund meets the needs of members. They provide opportunities for you to work with your clients to regularly review the fund s investment strategy, to properly consider the insurance needs of your clients and to document their reviews. You can also assist clients to ensure that the assets of the fund are held separately from the assets of any other parties and, if this is not already in place, that arrangements are made to move to market valuation of assets. 4 Superannuation Industry (Supervision) Act 1993 Q&A: Salary sacrificing leave entitlements into super is this a real opportunity? By Damian Hearn, National Manager Technical Services Salary sacrificing leave entitlements into superannuation upon termination can deliver significant taxation benefits to higher income earners, but this can be a complicated area of advice. In many cases the strategy will not be available because an appropriate salary sacrifice arrangement (SSA) was not created before leave entitlements were accrued. This question and answer outlines the advantages of the strategy, and the issues and complexity involved. It is, however, worth noting that current superannuation rules make this an area of limited application and opportunity. Can leave entitlements be salary sacrificed into super upon termination? Answer: Yes. However, an effective SSA must be in place. This means that the SSA must have been set up relating to the employee s future earnings, and have been in place during the period the leave entitlements were accrued. An effective SSA cannot be set up retrospectively. What are the planning obstacles of the strategy? Answer: The potential for this strategy has been reduced by the lower concessional contribution cap of $25,000 applying from 1 July Assuming many higher income earning clients may already be maximising their concessional contributions via normal SSAs applying to wages and salary, this may leave limited opportunity to salary sacrifice leave entitlements upon termination of employment. Furthermore, employers in some sectors may not be able to allow employees to enter into these arrangements due to Australian employment law and relevant state based legislation stipulating minimum leave provisions. 8

9 What are the benefits of taking leave as a lump sum upon termination? Answer: Although accrued annual and long service leave are not eligible for the generous tax treatment of an employment termination payment, in some situations there can be a tax advantage in receiving these benefits as a lump sum upon termination, as opposed to taking actual paid leave where this income is taxed at the client s marginal rate of tax. However, for clients who have an effective SSA in place, and who have room within their concessional contribution cap, there is an opportunity to salary sacrifice accrued annual and long service leave into superannuation, which will effectively cap the amount of tax at 15 per cent (within contribution cap limits). For comparison, the following table shows the tax treatment for these benefits taken as a lump sum. Accrued long service leave Up to 15/08/ /08/1978 to 17/08/1993 On or after 18/08/1993 Assessable amount Maximum tax rate for resignation / retirement 5% Marginal rates Tax rate for redundancy Marginal rates 100% 30%* 30%* 100% Marginal rates 30%* What impact does the concessional contribution cap have? Answer: It is important to consider the amount of concessional contributions the client has already made, and is expected to make, in that financial year. The reduced concessional contribution cap now applying has reduced the scope to apply this strategy. Maximising the opportunity to salary sacrifice leave entitlements into superannuation will depend upon the timing of the termination of employment. Terminating employment in the last few months of the financial year may leave little or no unused concessional contribution cap. A solution may be to defer the termination to a new financial year, although this is usually out of the client s control. What happens to your client s personal income tax return? Answer: Entitlements provided under an effective SSA are not assessable income for your clients 1 as they are considered exempt income 2. Benefits paid under an ineffective SSA are considered payments of salary or wages, and form part of the employee s assessable income (if contributed to superannuation, they will be considered as a personal after tax contribution). An effective SSA must be in place before the accrual of leave entitlements. Helping your clients avoid setting up an ineffective agreement can save them a significant tax bill. Accrued annual leave Up to 17/08/1993 From 18/08/1993 *Plus Medicare levy Assessable amount Maximum tax rate for resignation / retirement 100% 30%* 30%* 100% Marginal rates Tax rate for redundancy 30%* Why can it be so complicated? Answer: Salary sacrificing of annual leave and long service leave benefits is more complicated than normal SSAs applying to wages and salary. This is because a SSA must be in place before any entitlement to leave accrues. It is also important to understand that there is a distinct difference in the treatment of annual leave and long service leave with respect to when the leave is deemed to have been accrued. This difference is dictated by the Australian Tax Office (ATO) in Taxation Ruling 2001/10. 1 As per section 6.5 or section 6.10 of the Income Tax Assessment Act As per section 23L of the Income Tax Assessment Act 1936 The complexity of the strategy may also be compounded by the provisions of Australian federal employment law (Fair Work Act 2009) and relevant state based legislation. Both may stipulate different and contrary views to what is permitted under tax law. They may expect employees to take or accumulate a minimum amount of leave that may be cashed out on termination of employment. For example, long service leave forms part of the National Employment Standards that apply to all employees covered by the national workplace relations system. 9

10 What is the Australian Tax Office (ATO) view? Answer: It is important to understand when the accrual of leave begins in different circumstances. The interpretation consistent with the ATO view in Taxation Ruling 2001/10 states that the accrual of leave entitlement begins when an employee becomes entitled to be paid'. For long service leave, there is generally a qualifying period before any entitlement to leave accrues. This means that entitlements have not been earned until the qualifying period has been completed. As a result, where termination occurs before this, the employee has no enforceable right to receive the payment. The following example illustrates this point: Example Joshua Joshua is entitled to long service leave after 10 years of service. If he leaves employment before this, he is not eligible to receive a pro rata payment. If Joshua enters into an effective SSA in his ninth year of employment, which included both wages and leave entitlements, and then resigns after the tenth year, he would be eligible to salary sacrifice his long service leave entitlements to superannuation, as the agreement was in place before his entitlements were accrued. However, irrespective of his individual employment contract, if the relevant federal or state based legislation states that on termination of his employment after completing his seventh year of employment, Joshua on termination is entitled to a pro-rated payment of long service leave, then eligibility is said to occur at completion of year seven. This means that a valid SSA needs to be in place before the end of the seventh year. If an individual or an employer contravenes a provision of the National Employment Standards, penalties up to $10,200 per individual or $51,200 for a corporation may occur. Why is it more complicated for annual leave? Answer: Other leave entitlements, including annual leave, generally don t have a minimum qualifying period, and where the amount is guaranteed upon termination, can be more complicated. The ATO considers annual leave to have accrued from the commencement of employment, even where the employee may not be eligible to take that leave until a later date. This is illustrated by the following example showing an ineffective SSA due to the timing of when the SSA was entered into. Example Beth Beth negotiates a SSA on 30 June 2013 in relation to her salary and leave entitlements. At the time she had had six weeks of accrued annual leave: four weeks relate to the period from 1 January 2012 to 31 December two weeks relate to the period from 1 January to 30 June however she is not eligible to take this leave until 1 January If she resigns before 1 January 2014, Beth will not be able to salary sacrifice her six weeks of accrued annual leave into superannuation. Beth s position is as follows: The four weeks relating to the period to 31 December 2012 is not covered by the SSA, as it was accrued before the SSA was in place. The two weeks relating to the period from 1 January 2013 to 30 June 2013 is similarly not covered by the SSA. Although she cannot take this leave until after 1 January 2014, it was accrued before the SSA was in place, irrespective of her entitlement to receive payment for this leave on resignation before 1 January She would however be able to salary sacrifice the amount of any annual leave accrued from 30 June 2013 to the date of her resignation. The following diagram illustrates these principles: Ineffective SSA as all 6 weeks have accrued Effective SSA for all future entitlements 30 June June June June 2014 Accumulated four weeks leave from 1 January to 31 December 2012 Accumulated two weeks leave from 1 January to 30 June 2013 has accrued, but restricted until 1 January

11 What else should you be aware of? Answer: Another common trap that can make a SSA ineffective is where the agreement is in place before the accrual of leave, but doesn t specifically include leave entitlements in the agreement. This is highlighted in Heinrich and Commissioner of Taxation [2011] AATA 16. In this case: The employee had accrued annual and long service leave entitlements during his years of service. Five years before termination the employee he entered into an agreement with his employer to forgo part of his salary in exchange for superannuation contributions. Importantly, the agreement included prospective salary and wages, but did not specifically include leave entitlements. The employee resigned and asked his employer to roll his leave entitlements into his superannuation as part of his SSA. He was told that this was not possible, and he then instructed his employer to pay his leave entitlement as a lump sum. The employee believed that he could have salary sacrificed a portion of his leave entitlement amount under his pre-existing SSA and sought a ruling from the ATO. The Commissioner, however, found that the leave entitlements had accrued outside of an effective SSA. Upon appeal, the Administrative Appeals Tribunal (AAT) confirmed the ATO decision, ruling that a SSA relating only to salary and wages was insufficient to include accrued leave entitlements, and that for leave entitlements to be included, this must be specified in the SSA. Another important point is to consider the benefits of being able to salary sacrifice leave entitlements against the client s age, and whether they would be happy to have it locked away in superannuation until they meet a condition of release. For more information on the IOOF TechConnect team or IOOF AdviserConnect services, please speak to your business development or relationship manager, go to or call adviser services: For IOOF Pursuit please call For Portfolio Administrator or AssetLink please call For Spectrum Super please call This document is for financial adviser use only it is not to be distributed to clients. Issued by IOOF Investment Management Limited (IIML) ABN AFSL as trustee of the IOOF Portfolio Service Superannuation Fund ABN and Service Operator of the Investor Directed Portfolio Services. IIML is a company within the IOOF group of companies consisting of IOOF Holdings Limited ABN and its related bodies corporate, and is not a registered Tax Agent. Examples contained in this communication are for illustrative purposes only and are based on the assumptions disclosed and the continuance of present laws and our interpretation of them. Whilst every effort has been made to ensure that this information is accurate, current and complete, neither IIML nor its related bodies corporate within the IOOF Group give any warranty of accuracy, reliability or completeness, nor accept any responsibility for any errors or omissions (including by reason of negligence) and shall not be liable for any loss or damage whether direct, indirect or consequential arising out of, or in connection with, any use of or reliance on, the information provided in this . The information in this and any attachments may contain confidential, privileged or copyright material belonging to us, related entities or third parties. If you are not the intended recipient you are prohibited from disclosing this information. If you have received this in error, please contact the sender immediately by return or phone and delete it. We apologise for any inconvenience caused. We use security software but dot not guarantee this is free from viruses. You assume responsibility for any consequences arising from the use of this . This may contain personal views of the sender not authorised by us. PLA