The amendments to the Income Tax Assessment Regulations 1997 on 4 June 2013 have clarified issues surrounding the calculation of exempt current pension income and the calculation of the taxable and tax-free components of a death benefit arising from a non-reversionary pension. However, there are still some issues that need to be ironed out with the requirement to pay a minimum pension in the year of the pensioner’s death and subsequently.
What was the issue?
Investment earnings on assets in superannuation funds which support a pension are exempt from income tax. However, there has been a degree of uncertainty as to what happens with this exemption upon the death of the pensioner. The uncertainty increased following the issuing by the ATO in 2011 of Draft Ruling TR 2011/D3 which specified that a pension would cease at the member’s death, unless it was automatically reversionary. Where a pension was not reversionary, it would revert back to accumulation phase.
One possible consequence was capital gains on assets sold after death were subject to tax, and all capital gains may have become taxable, eroding the value of the death benefit available for beneficiaries. This was especially a concern when assets were sold in the financial year after death.
What is a reversionary pension?
A pension which has a reversion provides an automatic and immediately continuing right to future benefits to a beneficiary on the pensioner’s death, usually payable as a pension but may be payable as a lump sum or combination. In the case of a non-reversionary pension, the superannuation income stream is considered to cease on the death of the pensioner and beneficiaries may be provided with an option to draw the residual as a lump sum, newly created pension or a combination. Whether a reversionary pension is better than the other depends on the situation. For example, a reversionary pension may have Centrelink implications for income test purposes which do not arise with a non-reversionary pension.
Taxation Ruling TR 2013/5 which is the finalised ruling provides the Commissioner’s view on the commencement and cessation of account-based pensions, as well as other pensions. These permit the income on investments supporting a non-reversionary pension to continue to be treated as exempt current pension income after the death of the member and up until the time a death benefit lump sum has been paid and/or at the time a pension commences subsequent to the pensioner’s death. In addition, the amendments provide rules concerning the calculation of the tax free and taxable components of any benefit paid subsequent to the cessation of the account based pension. The law as it has operated for reversionary pensions is not affected by the amendments and the relevant rules for these pensions continue to operate without change.
Exempt current pension income
The Commissioner’s stance relating to non-reversionary pensions was published by the in ATOID 2004/688, confirmed in Taxation Ruling TR 2011/D3 and finalised in Taxation Ruling TR 2013/5. In cases where a pensioner had died the ruling indicates that any income and taxable capital gains earned on the assets which previously supported a superannuation income stream benefit became taxable on the death of the non-reversionary pension. This position remains until a subsequent death benefit income stream became payable. If a lump sum is paid from the cessation of the non-reversionary income stream any income and taxable capital gains were taxable in the fund at the rate of 15%. In the case of self managed funds in particular if there was a taxable capital gain arising from the sale of a fund asset the tax payable may be significant.
The rules now permit the income on assets which supported the income stream benefit at the time of death to continue to be treated as exempt current pension assets until any lump sum or subsequent death benefit pension commences. This allows the trustees of the fund to dispose of assets that supported that income stream until the ultimate payment is made from the fund.
While the income on assets supporting the superannuation income stream continue to remain exempt, amounts which relate to the proceeds of an insurance policy or from an anti-detriment payment will not form part of the exempt current pension income by definition. This can be illustrated in this short case study:
Andrew was in receipt of a non-reversionary superannuation income stream when he died on 1 April 2013. At the time of his death the balance in his income stream interest was $200,000. Subsequent to Andrew’s death the trustee of the fund added $15,000 as an anti-detriment payment plus earnings on the account balance of $10,000 when it was payable as a lump sum on 30 November 2013. The amount of $210,000 is taken as supporting the income stream benefit from Andrew’s death on 1 April 2013 until 30 November 2013.
Calculating the tax free and taxable components
Section 307-125 of the Income Tax Assessment Act 1997 provides the rule to calculate the taxable and tax free components of a superannuation benefit which is referred to as the proportioning rule. Subsection 307-125(3) indicates the time when these proportions are calculated. For example, in the case of a pension the tax free and taxable proportions are calculated immediately before the commencement of the pension on the taxable and tax free amounts in the member’s accumulation interest(s) in the fund. Para 307-125(3) provides that the regulations may provide an alternative method to calculate these proportions for certain superannuation benefits.
The new regulation 307-125.02 which applies from 1 July 2012 provides in the case of a non-reversionary superannuation income stream that was payable to a deceased member prior to their death that the tax free and taxable proportions will continue on the same basis as the original pension. However, anti-detriment payments or insurance related amounts are excluded from the calculation if they are added to the pension account balance after the pensioner’s death.
As an example, here’s how the new regulations work in relation to the tax free and taxable components of a non-reversionary superannuation income stream benefit:
George was receiving a superannuation income stream which was non-reversionary at the time of his death on 1 May 2013. The tax free portion of his superannuation income stream was 45% and the taxable proportion was 55%.
At the time of George’s death the balance of his non-reversionary income stream account was $500,000. In addition, an anti-detriment increase of $20,000 as well as the proceeds of an insurance policy of $400,000 was added to the account.
Under the rules of the fund George’s adult son, Harry, is entitled to a lump sum. The lump sum of $920,000 will consist of a tax free component of $225,000 (45% of $500,000), the taxable component of $275,000 and the anti-detriment increase as well as the insurance component which will have different tax free and taxable components.
An anti-detriment increase relates to an additional amount which is made under the fund rules to compensate for the tax paid on taxable contributions that form part of the death benefit lump sum. The superannuation fund is able to claim a tax deduction that relates to the anti-detriment increase, also referred to as the tax saving amount. Under the new legislation any anti-detriment increase which is added to a death benefit lump sum is treated as a taxable component and is not apportioned on the same basis as the taxable and tax free components of the original non-reversionary pension.
Proceeds of a life insurance policy
Where the proceeds of an insurance policy are added to the deceased member’s account, in the fund it will have a separate taxed and untaxed element. This will depend on whether a deduction has been claimed for premiums under section 295-465 or the future service liability under section 295-470 of the Income Tax Assessment Act 1997. Where no deduction has been claimed the proceeds of the insurance policy will be treated wholly as a taxed element. However, where the fund has claimed a deduction the proceeds will be apportioned under section 307-290 by the ‘service days’ divided by the total of the service days plus days to retirement. This will result in the amount having a taxed and untaxed element which results in tax of 15% and 30% respectively plus Medicare. In practice this treatment applies only to lump sums paid to people who are not a death benefits dependant in terms of section 302-195. As a general rule, that is, adult children of the member except for some limited exclusions.
In summary, the changes have clarified the continuation of the tax exemption and allow for the disposal of pension assets on a tax-free basis to the superannuation fund, increasing the value of the death benefit payments to the beneficiaries.
Next week, in Part 2 of this review of death benefit pensions, we look at which is best – a reversionary or non-reversionary superannuation income stream.
Graeme Colley is the Director Technical & Professional Standards at SPAA, the SMSF Professionals’ Association of Australia.