A key superannuation reform affecting transition-to-retirement (TTR) income streams is the loss of the earnings tax exemption from July 1, 2017. As TTR income streams where the member has not met a full condition of release will not be in the “retirement phase”, earnings on assets supporting these streams will be subject to 15 per cent tax.
As a result of these changes, unrealised capital gains accrued prior to July 1, 2017, on assets supporting a TTR income stream may become taxable when the assets are eventually sold.
To preserve the tax exemption that applies to assets supporting TTR income streams up to June 30, 2017, transitional Capital Gains Tax (CGT) relief is available. Transitional CGT allows a complying superannuation fund to reset the cost base of an asset to its current market value without being required to sell and reacquire the asset.
However, the decision on whether to apply CGT relief is complex. In some cases, applying CGT relief may actually increase the amount of capital gains tax payable.
Which funds can apply the relief?
While transitional CGT relief is available to all superannuation funds, advisers will generally only be required to assist clients with SMSFs and Superannuation Wraps. Where a client is a member of a large superannuation fund that operates pooled investment structures, the trustee will be responsible for applying CGT relief.
Segregated or unsegregated
Different CGT relief eligibility requirements apply depending on whether the superannuation fund uses the segregated or unsegregated method to calculate its exempt income. For the purposes of this article, we will examine the eligibility of funds that were using the unsegregated method at November 9, 2016.
Due to the administrative simplicity of the unsegregated method, most SMSFs that have both pension and accumulation assets generally use the unsegregated method. Conversely, where an SMSF only has members in pension phase, the fund must use the segregated assets method. Superannuation Wrap accounts also generally use the segregated method.
Given that different eligibility requirements apply depending on which segregation method a fund uses, it is critical that an adviser confirms which segregation method the fund used on 9 November 2016.
Eligibility criteria
Where a fund uses the unsegregated method to calculate exempt income, it will be eligible to apply the transitional CGT relief to an asset where:
- The fund was paying a TTR income stream to a member of the fund
- The asset was not a segregated current pension asset (a pension asset) or a segregated non-current asset (an accumulation asset) at any time between 9 November 2016 and 30 June 2017
- The fund had a tax-exempt proportion for the 2016-17 year (as specified in an actuarial certificate) greater than nil
- The fund held the asset throughout the period from the start of 9 November 2016 until the end of 30 June 2017
- The fund was a complying superannuation fund at all times between 9 November 2016 and 30 June 2017
- The trustee made an irrevocable choice to apply the relief on or before the day the fund’s income tax return for 2016-17 is due to be lodged
It is important to note that members of SMSFs using the unsegregated method are not required to commute their TTR income stream prior to 30 June 2017 to qualify for CGT relief.
Eligibility trap
Funds using the unsegregated method on 9 November 2016 need to take care not to convert to being fully in the pension phase or fully in accumulation phase at any time between 9 November 2016 and 30 June 2017, as it could result in the fund failing the eligibility criteria to apply the transitional CGT relief.
For example, where a fund using the unsegregated method:
- withdrew and paid out all its accumulation benefits as lump sums;
- withdrew and transferred all its accumulation benefits to another fund via a rollover; or
- used all its accumulation benefits to commence pensions;
and this occurred between 9 November 2016 and 30 June 2017, the fund would be ineligible to apply the transitional CGT relief rules.
To avoid this situation, trustees using the unsegregated method should ensure they retain at least a small accumulation account in the fund at all times between 9 November 2016 and 30 June 2017.
Effect of applying the relief
Where the fund makes the choice to apply CGT relief to an asset, it will be deemed to have sold and repurchased that asset for its current market value on 30 June 2017. The deemed sale and repurchase of the asset:
- resets the asset’s cost base to its current market value as at 30 June 2017, and
- resets the acquisition date of each asset for the 12-month eligibility period for the CGT discount to 30 June 2017.
Resetting an asset’s cost base therefore preserves the tax exemption that applied to any accrued but unrealised capital gains on assets supporting pensions that would otherwise become taxable from 1 July 2017 due to the TTR income stream tax changes.
Assessable capital gains
It is important to note that where a fund uses the unsegregated method, part of each asset held by the fund is used to support both pension and accumulation liabilities. Therefore, the deemed sale and repurchase would trigger an assessable capital gain or loss.
Where the deemed disposal results in a fund realising capital gains, a fund can choose to either:
- Bring the capital gain to account in the 2016-17 tax return and pay any CGT liability as if the fund had actually sold the asset; or
- Elect to defer the capital gain and carry it forward until the year the asset is sold.
When calculating the amount of assessable gain on each asset, the trustee will need to ignore any capital losses, then apply the 1/3rd CGT discount (assuming the asset has been held for 12 months or more) and then apply the fund’s exempt proportion for the 2016-17 financial year.
When is applying CGT relief worthwhile?
Applying CGT relief effectively locks in the tax exempt proportion that applies in 2016-17. The fund is then required to bring the capital gain to account in the 2016-17 tax return or calculate the deferred gain and carry it forward until the year of disposal and then pay the CGT liability at that time.
When deciding whether to apply CGT relief, it is important to compare the fund’s tax exempt proportion in 2016-17, to the tax exempt proportion that would apply when the assets are eventually sold.
Where the fund’s tax exempt proportion is likely to reduce in the future, applying the relief may reduce a fund’s future assessable gain on the sale of an asset. This could occur where a client meets a condition of release in the future and their TTR income stream becomes a retirement phase income stream that exceeds their transfer balance cap. In this case, funds may be rolled back to accumulation phase and the resulting tax exempt proportion could be lower than in 2016-17.
Conversely, where a fund’s tax exempt proportion is likely to increase in the future, electing to apply the relief could actually increase a fund’s future assessable gains on the sale of an asset. This could occur when a client commences additional retirement phase income streams upon meeting a condition of release. Therefore, trustees of SMSFs using the unsegregated method paying TTR income streams should consider whether they wish to apply the relief, as it could result in the fund being required to pay a CGT liability on a capital gain that may otherwise have been exempt.
Craig Day is executive manager of Colonial First State’s FirstTech team.
