One measure contained within the 2016 federal budget is a proposal to repeal what is colloquially known as the “10 per cent test”. If implemented, this change will remove a key impediment currently faced by certain individuals that want to make personal tax effective contributions to superannuation, including those on income protection claims.
Recap: what IS the ‘10 per cent test’?
Also known as the “less than 10 per cent rule,” the 10 per cent test allows certain individuals to make personal tax deductible contributions to super, where they would otherwise not qualify due to earning employment income during the year.
In broad terms, the rule allows an individual to claim a tax deduction for personal contributions made to super, so long as less than 10 per cent of their total assessable income for the income year (including salary sacrificed super contributions and reportable fringe benefits) is attributable to superannuation guarantee (SG) qualifying employment activities.
Practically, this means that individuals operating purely as either a sole trader or as a partner in a partnership need not consider the 10 per cent test when planning to make deductible contributions to super. Also, those who are unemployed, independently wealthy, or even retired for the full year, but who can still contribute to super, may also qualify to claim a personal tax deduction for these contributions (assuming they have assessable income to offset in the first place). If, on the other hand, an individual has engaged in some form of SG qualifying employment activity (including as a director of a private company), then the 10 per cent test may prohibit a personal tax deductible contribution from being made. If the 10 per cent test is not satisfied, generally the only remaining method of making pre-tax super contributions is via a salary sacrifice arrangement. However, not everyone has the luxury of entering into a salary sacrifice arrangement.
Who benefits?
If legislated, several categories of individuals will benefit, including (but not limited to):
- Individuals who undertake both self-employment and PAYG-employment during an income year (for example on a short-term contract/project)
- Employees that do not have the ability to enter into an effective salary sacrifice arrangement with their employer including those crystallising a capital gain or receiving an employment termination payment in the latter part of the income year, and
- Certain individuals who are receiving income protection benefits (see discussion below).
Even those taxpayers who may have an option to salary sacrifice may prefer to contribute and claim a personal tax deduction instead, under the proposed new rules. This will provide them with far greater flexibility and control over the amount and timing of the contributions, and negate the need for a prospective salary sacrifice agreement with their employer, which can come with some traps for the unwary.
For those with income protection benefits
Insured benefits received from an income protection policy form part of the individual’s assessable income, irrespective of whether the policy was owned inside or outside of the super environment. As a way of managing any resultant tax liability, an individual may consider making tax deductible contributions into a super fund. However, based on the current legislation, entitlement generally hinges on whether the individual meets the 10 per cent test. And, for some individuals, therein lies the problem.
In recent private binding rulings* the Commissioner of Taxation has characterised income protection benefits received by an individual as SG qualifying employment income. The practical implication is that the 10 per cent test would be impossible to satisfy in the absence of significant non-employment sources of income (i.e. investment income).
A common theme prevalent in these (negative) private rulings is that the individual remained “on the books” of the employer for all or part of the relevant income year. In other words, in these cases the Commissioner of Taxation is treating the income protection benefits as employment income – if in the relevant year the individual is still technically employed – notwithstanding the fact that an insurance company or super fund is paying the benefits in accordance with the terms of an income protection policy.
While private binding rulings are not to be relied upon, and the facts of each individual case differ, the removal of the 10 per cent test will prima facie enable those individuals that remain employed, whilst in receipt of income protection benefits, to make tax deductible contributions to super. Based on the current law such individuals would generally not qualify.
We note for completeness that salary sacrificing income protection benefits directly to super is unlikely to be an option for these taxpayers, given the inability to enter into an effective salary sacrifice agreement with a life insurance company.
Other factors to consider
As always, any decision to make contributions to super will nevertheless have to be weighed up against the usual considerations, such as:
- Does the cash flow/taxation position of the individual allow/warrant for such contributions in the first place?
- Is the individual prepared to forego the contributed funds until retirement due to the super law preservation rules?
- Is the individual willing and able to manage the timing and administrative requirements of the requisite Notice of intent to claim a deduction for personal super contributions form?
- Has the individual quantified the impact on contribution caps particularly if “top-up” superannuation contributions are being made by the life insurer, pursuant to the terms of the income protection policy?
Long overdue?
The 10 per cent test was originally introduced as an integrity measure to prevent abuse of the former age-based super contribution limits. However as many readers would appreciate, age-based limits were abolished from 1 July 2007 and replaced with annual superannuation contribution caps. The 10 per cent test is therefore not only outdated, but as alluded to above, it unintentionally prevents certain categories of individuals from making tax deductible super contributions. The proposed removal is a welcome one, which will not only level the playing field, but also eliminate unnecessary administrative burdens that are arguably preventing individuals, including some on income protection claim, from accumulating retirement savings in a tax effective manner.
*Refer to the following private rulings:
https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1012899119016.htm
https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1012824898171.htm
The headline was changed on 6/7/2016 to more accurately communicate the story.
