ATO ID 2012/32 and legislation in relation to reserves

ATO ID 2012/32 and legislation in relation to reserves Australian Taxation Office Treasury Submission by the Superannuation Committee of the Legal Practice Section of the Law Council of Australia 25 June 2012 GPO Box 1989, Canberra ACT 2601, DX 5719 Canberra 19 Torrens St Braddon ACT 2612 Telephone +61 2 6246 3788 Facsimile +61 2 6248 0639 Law Council of Australia Limited ABN 85 005 260 622 www.lawcouncil.asn.au

The Superannuation Committee is a committee of the Legal Practice Section of the Law Council of Australia. Its objectives include ensuring that the law relating to superannuation is sound, equitable and demonstrably clear. It fulfils this objective in part by making submissions and providing comments on the legal aspects of proposed legislation, circulars, policy papers and other regulatory instruments. Set out below are the Committee's comments in relation to ATO Interpretative Decision 2012/32 released on 4 May 2012 and comments generally on the legislation governing the operation of reserves in superannuation funds. In the Committee's view, the matters raised in the ATO ID have broader implications that are very significant, and demonstrate that this aspect of the legislation requires amendment. The Committee suggests action which it believes the ATO should take pending such amendment, and highlights the areas where amendments are required. 1. ATO ID 2012/32 Excess Contributions Tax: concessional contributions reserves 1.1 Under this ATO ID the issue was whether when determining the amount of a person's concessional contributions under subsection 292-25(3) of the Income Tax Assessment Act 1997 (ITAA 97) a self-insurance reserve is a "reserve" for the purpose of sub-regulation 292-25.01(4) of the Income Tax Assessment Regulations 1997 (ITAR). 1.2 In making its decision the ATO confirmed that a self-insurance reserve is a "reserve" for the purpose of sub-regulation 292-25.01(4) of the ITAR. 1.3 This decision is of particular importance to trustees of superannuation funds and their members because the classification of a self-insurance reserve as a reserve for the purpose of sub-regulation 292-25.01(4) means that the payment of insurance benefits from these reserves to members will be counted as concessional contributions of the relevant member where: the amount distributed has not been allocated in a fair and reasonable manner to an account for every member of the fund (or an account of every member of a class of members of the fund); or the benefit paid (together with any other distributions from that reserve for the financial year) is 5% or more of the member s account balance or interest at the time the amount is allocated. 1 1.4 When an insurance benefit is paid from a self-insurance reserve maintained in a fund to a particular member of the fund such benefit has not been distributed to every member of the class of members who are covered by self-insured benefits offered by the fund. On that basis to the extent that payments of insurance benefits to members are funded from such reserves those payments will always be counted as concessional contributions. This would be the case unless it could be successfully argued that each individual member who is covered by self-insurance is a separate "class" of member for the purpose of the regulations. 1.5 However, even if it could be argued successfully that each member is a separate class, in many instances the insurance benefits paid from a self-insurance reserve will be 5% or more of the member's account and therefore the payment would be deemed to be a concessional contribution in any event. 1.6 The result of this could be catastrophic from a member's perspective as it means that the insurance benefits they are entitled to in a time of need could be subject to excess 1 Section 292-25(3) of ITAA 97 and sub-regulation 292-25.01(4) of ITAR ATO ID 2012-32 and legislation in relation to reserved Page 2

contributions tax (ECT) of up to 78%. 2 This is particularly likely to be the case where members are in receipt of a self-insured total and permanent disablement (TPD) benefit which are usually large lump sum payments, but could equally apply for self-insured death or temporary disability/income protection benefits. 1.7 As most death and TPD insurance benefits in superannuation are large lump sums it is highly likely that they will be both: 5% or more of a member's account; and more than $25,000, and therefore in excess of the concessional contributions cap applicable to members of all ages from 1 July 2012. 1.8 The Committee is of the view that it could not have been the intention of the Government to impose additional taxes on recipients of insurance benefits merely because their benefits are paid from a self-insurance reserve within a superannuation fund rather than from the proceeds of an external insurance policy. 1.9 It should be noted that the treatment of self-insured benefits in this way puts members of superannuation funds which maintain self-insurance reserves at a distinct disadvantage vis-à-vis members of superannuation funds which provide insurance through an external insurer. The Committee is not aware of any Government policy that would support this differing treatment, which seems inequitable and unjust. Further, it may not be a matter which a member is able to influence or control. The Committee believes that this is an unintended consequence of the legislation relating to reserves which should be urgently reformed. 1.10 Recommendations: The legislation should be amended to make clear that an amount paid by way of a benefit to or in respect of a member, where that amount is sourced from a self insurance reserve, is not taken to be a concessional contribution. Pending amendment of the legislation, the Committee recommends that the ATO should confirm that it will not seek to raise ECT assessments by reason only that insurance benefits have been paid to members from a selfinsurance reserve. The ATO should also confirm that it does not expect that funds which make such payments report amounts sourced from a self insurance reserve as contributions. 1.11 With respect to ATO ID 2012/32, it was concluded by the ATO that the payments from the self-insurance reserve "to a member's account" were payments from a "reserve" for the purpose of sub-regulation 292-25.01(4) of the ITAR. 1.12 However, under the facts of this ATO ID the only payments made to a member's account were substituted employer and member contributions paid by the trustee during a member's disability to reflect the continuation of contributions that the member and employer were required to pay immediately before the member's disability. 1.13 The remainder of the insured benefits were paid directly to the member from the selfinsurance reserve in accordance with the fund's trust deed. It is stated in the ATO ID that these payments have no effect on the member's account. 1.14 Recommendation: The ATO ID does not appear to address specifically whether payments from the self-insurance reserve directly to members are payments from a reserve for the purpose of sub-regulation 292-25.01(4). The Committee recommends that the ATO review the ATO ID to clarify this specific issue. 2 Section 292-20(1) and 292-85(1) of ITAA 97 and section 5 of each of Superannuation (Excess Concessional Contributions Tax) Act 2007 and Superannuation (Excess Non-Concessional Contributions Tax) Act 2007. ATO ID 2012-32 and legislation in relation to reserved Page 3

2. Problems associated with the use of other reserves under the existing legislation 2.1 Presently under the existing legislation, subject to limited exceptions, all amounts distributed from reserves are concessional contributions unless the amount: is allocated in a fair and reasonable manner to the account of every member of the fund (or the account of every member of a class of members of a fund); and together with other distributions from that reserve for the financial year (if any), is less than 5% of the member s account balance or interest at the time the amount is allocated (the General Rule). 3 2.2 The General Rule above does not apply in relation to distributions from two reserves being: a contributions reserve; or a pension reserve. 2.3 It is appropriate that both these reserves are exempted from the General Rule as: contributions reserves are essentially suspense accounts which hold contributions pending their allocation to members accounts and therefore distributions from them need to retain the character of the contributions as they were initially made to the fund (i.e. as either concessional or non-concessional contributions); and pension reserves need to be exempted to allow pension payments, commutations and death benefits to be paid without them being characterised as concessional contributions because they are 5% or more of a member's account. 2.4 However there are other types of reserves that in the Committee's view should be exempted from the General Rule, which are as follows: Anti-detriment reserves (i) (ii) (iii) (iv) (v) These are used by many funds to pay out anti-detriment benefits to the eligible dependants of deceased members or their estate. An anti-detriment benefit is an additional payment made by superannuation funds on top of a regular death benefit designed to compensate the recipient for the contributions tax paid by the deceased member during their lifetime. The benefit payable is a lump sum that reflects the extra amount the deceased member would have in his/her account had no contributions tax been paid. To compensate the fund for paying this amount, section 295-485 of the ITAA 97 allows the trustee a deduction which effectively results in the antidetriment benefit paid being refunded to the fund because of the tax saving. However, the trustee must first make the payment before it can receive the tax deduction. Accordingly for many superannuation funds and particularly SMSFs, where possible, a reserve is used to retain enough monies to fund the payment of the anti-detriment amount until the benefit of the tax deduction can be recovered. In the June 2009 NTLG Superannuation Technical Sub-group Meeting the ATO confirmed that an anti-detriment payment will be regarded as a concessional contribution if the payment is funded from a reserve and is 3 Section 292-25(3) of ITAA 97 and sub-regulation 292-25.01(4) of ITAR ATO ID 2012-32 and legislation in relation to reserved Page 4

5% or more of the deceased member s account because there is no applicable exception to the General Rule above. (vi) Despite industry lobbying, the ATO confirmed this view again in the March 2010 NTLG Superannuation Technical Sub-group Meeting citing that it was bound to follow the legislation. (vii) As an anti-detriment payment would now usually represent more than 5% of a deceased member s benefit, if the anti-detriment component of the benefit paid is greater than $25,000 (i.e. the concessional contribution cap in all cases from 1 July 2012) ECT of up to 78% would be payable on that component of the benefit. Whilst the anti-detriment reserve issue is more transparent for SMSFs, it is likely that large funds would, due to the inherent timing issues, also be making anti-detriment payments from operational risk or other reserves which should technically be reported as concessional contributions by those funds. (viii) (ix) (x) It is also unclear under the legislation whether an anti-detriment payment from an anti-detriment reserve could ever satisfy the other requirement to avoid it being deemed a concessional contribution i.e. that it be allocated in a fair and reasonable manner to every member of a class of members of the fund. Again it would have to be successfully argued that each individual member who receives an anti-detriment payment from a reserve is a separate "class" of member for the purpose of the regulations, in order to avoid the amount being deemed as a concessional contribution. The Committee does not believe that it is the Government's policy intention that anti-detriment payments should be subject to additional taxes in the form of ECT. Such an imposition would seem to defeat the purpose of allowing for anti-detriment payments. Expense reserves (i) (ii) (iii) (iv) These are reserves used by a large number of industry superannuation funds which hold amounts set aside to pay for the administration of the fund, including accounting and legal fees, investment management fees, insurance and other expenses. (See the Committee s comments in section 4 below as to whether these are in fact "reserves" for superannuation law and/or tax purposes.) Often these reserves are comprised of amounts that have been charged as administration fees to members' accounts. At various times it may be decided to return excess amounts from these reserves to members. In fact, APRA and ASIC state that any excess over an appropriate amount acquired for the purpose of a reserve should be allocated back to members. 4 It would seem unjust that the return of excess amounts from these reserves would be counted as concessional contributions because they were 5% or more of a member's account. It should be noted that under the existing legislation the return of any excess amounts would be more likely to cause an adverse tax impact on members with small balances than large balances as the amounts returned to a member with a small account balance will more easily constitute 5% or more of their account. This in 4 APRA and ASIC, Unit Pricing Guide to Good Practice, November 2005, page 74; APRA Draft Prudential Practice Guide SPG 235: Use of Reserves in Superannuation Funds, paragraph 12 ATO ID 2012-32 and legislation in relation to reserved Page 5

turn could lead to an ECT assessment. Such a result appears harsh and unintended. (v) (vi) There is also the requirement that an allocation from an expense reserve be made in a "fair and reasonable manner" to avoid it being deemed as a concessional contribution. The Explanatory Statement (ES) to the Income Tax Assessment Regulations 2007 (No. 3) which introduced the regulation states: In determining what is fair and reasonable it is necessary to have regard to members proportionate interests in the superannuation plan. It would ordinarily be expected that the allocation would be in proportion to the existing interests of the members so that particular members are not favoured over others. (vii) The ATO considered this excerpt from the ES in the NTLG Superannuation Technical Sub-Group Meeting of 8 September 2009 when considering reserves and concluded that: To be fair and reasonable the Tax Office considers that the allocation of an amount from a reserve should be allocated to each member s interest in proportion to that interest in the superannuation fund. 5 The ATO further stated that APRA agreed with this view on the matter. (viii) (ix) (x) However, in the case of allocations from an expense reserve, if a trustee allocates amounts in proportion to a member s interest, as apparently required by the ATO (and APRA), this would lead to an unfair result where members are in many cases charged a flat dollar administration fee. For example, consider a circumstance in which one member has a $1 million account and another member has a $100,000 account, but the trustee has charged $1000 to each of them over 10 years in administration fees in order to administer the fund. In fairness, they should both receive the same amount distributed from any surplus from the expense reserve (where this comprises amounts derived from administration fees) and not receive a distribution based on the size of their respective accounts. The requirement to distribute from an expense reserve in proportion to a member's account to avoid a concessional contribution being deemed is clearly not satisfactory in this situation. (c) Operational risk reserves (i) (ii) (iii) An operational risk reserve is often maintained by industry superannuation funds to meet the costs of any operational errors that are not otherwise recoverable from third parties or under insurance coverage. Under the new Draft Prudential Standard SPS 114 Operational Risk Financial Requirement, utilising an operational risk reserve is required by APRA as one of the means by which funds can meet the proposed Operational Risk Financial Requirement being introduced under the Stronger Super reforms. However, under the existing legislation, any distribution from this reserve to a member s account to compensate them for any operational errors will be 5 Minutes of NTLG Superannuation Technical Sub-Group Meeting, 8 September 2009 ATO ID 2012-32 and legislation in relation to reserved Page 6

deemed to be a concessional contribution if it is 5% or more of the relevant member's account balance. This may result in the relevant member being subject to ECT of up to 78%. (iv) (v) Again, the Committee points out that this is more likely to affect members with small account balances than large account balances. Additionally, similar to the position above with respect to expense reserves, the ATO's view as to what would be a fair and reasonable distribution from such a reserve needs to take account of the fact that compensation in respect of errors may require payment of a flat dollar amount to each member (or payment determined in some way other than in proportion to members' interests). In such circumstances it would be unfair to deem these distributions as concessional contributions simply because they are not in proportion to a member's account. 2.5 Recommendation: On the basis of the above, the Committee recommends that the ATO should confirm: (d) (e) that a fair and reasonable allocation from a reserve need not be one paid in proportion to a member's account balance; and that an allocation from an anti-detriment reserve will not be taken to be a concessional contribution. If necessary, the legislation should be amended to achieve this result. 3. Issues with the legislation governing contributions reserves 3.1 Whilst contributions reserves are not subject to the problems mentioned above, the Committee notes that despite the ATO s position the current legislation with respect to contributions reserves is anomalous. 3.2 The interaction between the ITAA 97 and the ITAR operates such that a contribution paid into a contributions reserve and then allocated to a member's account is counted as a concessional contribution twice: firstly, when the contribution is received by the superannuation fund in respect to the member (section 292-25(2) of ITAA 97); and secondly, when the amount is allocated from the contributions reserve to the member's account (section 292-25(3) of ITAA 97 and regulation 292-25.01(2) of the ITAR). 3.3 To deal with this issue, the ATO has released ATO ID 2012/16 to confirm that, despite the legislation, contributions which pass through a contributions reserve will be counted as a concessional contribution only once being at the time of the allocation from the reserve to the member s account subject to the allocation being made within the time limit stipulated in Division 7.2 of the Superannuation Industry (Supervision) Regulations 1994 (SISR). 3.4 This decision was stated to be based on case law which indicates that unless there is a clear intention to tax an amount twice, an interpretation should be adopted which avoids double taxing. 6 (In this regard the Committee notes that for allocations from the expense reserve and operational risk reserve there is also a double taxing effect, given that amounts used to build those reserves will have already been subject to 15% income tax on assessable contributions and earnings.) 6 Dixon J in Executor Trustee and Agency Company of South Australia Ltd v Federal Commissioner of Taxation (1932) 48 CLR 26 ATO ID 2012-32 and legislation in relation to reserved Page 7

3.5 The same problem also exists for non-concessional contributions where the legislation also counts a non-concessional contribution that passes through a contributions reserve twice towards the non-concessional contributions cap. 7 3.6 Whilst the ES to the Income Tax Assessment Regulations 2007 (No. 3) which introduced the relevant regulations indicates an intention that contributions that pass through a contributions reserve only count towards the relevant contributions cap once, this is not apparent from the legislation itself. 3.7 The Committee also considers that the treatment of a contribution which passes through a contributions reserve as only counting towards a contributions cap at the time it is allocated to a member's account is consistent with section 1017E of the Corporations Act 2001 and regulation 7.9.08C of the Corporations Regulations 2001 which indicate that such amounts are held on a separate statutory trust until allocated to a member's account. 3.8 Recommendation: On the basis of the above, the Committee recommends that the legislation be amended to ensure that it indicates clearly and unequivocally that contributions which pass through a contributions reserve will only be counted towards a member's contribution cap once, provided the allocation from the reserve is made within the time limit stipulated in Division 7.2 of the SISR. The Committee queries whether this is simply a technical amendment that might be sought through TIES? 4. Problems caused by the absence of a definition of a "reserve" 4.1 Given the potential ECT problems associated with distributions from reserves it is very important that superannuation funds be able to identify and ascertain what accounts constitute a reserve. 4.2 However, there is no definition of the term reserve in any of the Superannuation Industry Supervision Act 1993 (SISA), the ITAA 97 or the ITAR, despite the term being used in both the superannuation and tax legislation. 4.3 The SIS Regulations do provide a definition of a reserve, but the definition is not of assistance because it simply refers back to reserves maintained under section 115 of the SISA and does not provide any guidance as to the characteristics of a reserve. 4.4 Compounding this issue is the fact that there is no clear and consistent guidance from the regulators as to the meaning of the term reserve. 4.5 APRA explicitly acknowledges that there is no definition of a reserve in Draft Prudential Practice Guide SPG 235 Use of Reserves in Superannuation Funds (draft SPG 235). It states that in the absence of a definition reserves in superannuation funds can be regarded as moneys which form part of the net assets of a fund and which have been set aside for a clearly stated purpose. 4.6 They add while reserves are moneys that have not been allocated to members not all unallocated moneys constitute reserves. According to APRA, accounting constructs such as suspense accounts used to record contributions and roll-overs pending their allocation to members are not reserves. 4.7 This directly contradicts the ATO's position under ATO ID 2012/32 that such accounts are reserves. 4.8 The Law Council notes that such accounts are as described as being reserves in the ES to the Income Tax Assessment Regulations 2007 (No. 3). 7 Refer to the interaction of section 292-90(4) of ITAA 97 with regulation 292.90.01(2) of the ITAR ATO ID 2012-32 and legislation in relation to reserved Page 8

4.9 APRA also states in draft SPG 235 that provisions for administration expenses, tax, management and service provider fees should not be regarded as constituting reserves, as such accrued costs and expenses are liabilities arising from past events. 4.10 APRA and ASIC in their paper Unit Pricing Guide to Good Practice further discuss the meaning of a reserve in which they state: " A reserve is an amount held separately to deal with various contingencies arising during the operation of the fund. A reserve is not the same as a provision which is an amount set aside to meet specific obligations of the fund such as provisions for fee and tax payments." 8 4.11 This distinction between a reserve and provision therefore remains nebulous and the ATO takes a much broader view of what constitutes a reserve. 4.12 In Superannuation Contributions Ruling SCR 1999/1 the Commissioner effectively deemed any unallocated amounts to be reserves and indicated that such amounts are the excess of the net market value of assets over the total of member s accounts at a particular date. 4.13 Further, in the recently released ATO ID 2012/32 it is stated that: "In the Commissioner's view 'reserve' as used in regulation 292-25.01 of the ITAR 1997 should be given a broad meaning to maintain the integrity of the contributions caps." However the ATO ID failed to indicate a precise scope for the meaning of the term "reserve" notwithstanding some references to relevant case law. 4.14 Recommendation: Due to the inconsistent approach between the regulators and general industry uncertainty over the issue, the Committee recommends that the legislation be amended to introduce a specific definition of "reserve" so that trustees and taxpayers have a clear understanding as to when allocations may be at risk of being deemed concessional contributions. The Superannuation Committee of the Law Council of Australia would welcome the opportunity to discuss any of the above issues further with either Treasury or the ATO. At first instance, please contact the Chair of the Superannuation Committee, Heather Gray, on (03) 9274 5321, heather.gray@dlapiper.com 8 APRA and ASIC, Unit Pricing Guide to Good Practice, November 2005, page 72 ATO ID 2012-32 and legislation in relation to reserved Page 9

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