Is super segregation still possible for SMSFs?

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When the Government’s recent changes to superannuation laws were under discussion, the prevailing ‘logic’ in the financial advice industry was that a $1.6 million pension cap required segregation of assets in a SMSF between accumulation and pension. However, this logic was overturned in the final legislation.

It initially seemed likely that trustees would need to choose, based on their personal risk and return requirements, what assets to leave in the $1.6 million maximum ‘transfer benefit cap’ pension and what assets would be transferred back to accumulation.

However, the legislation that was eventually passed outlawed segregation for tax purposes inside a super fund.

The Government does not want you to be able to use segregation to manage your tax in your pension fund. It is banning segregation for tax purposes.

Instead, a proportionate method will be used for tax purposes. Simply, all the assets of the fund will be taxed based on the proportion that is in pension and the proportion that is in accumulation (which will be worked out by an actuary). If you have $2 million in super, with $1.6 million in pension and $400,000 in accumulation, then 20% of gains will be taxed at accumulation rates and 80% will be taxed at pension rates.

Segregation historically

Segregation has always been available to SMSFs from a tax perspective, but has not been widely used, mainly because pension funds were allowed to contain an unlimited amount. Most people would generally have their entire super balance in pension, making segregation somewhat irrelevant.

Or they would use the proportionate method anyway, as it is administratively easier (and generally preferred by accountants).

But segregation certainly had its uses and potential benefits. For example, in two-member funds, where only one person was in pension, it might have made sense to have purposefully chosen assets backing the pension for tax reasons, and other assets backing the other member’s accumulation account.

(Note: you will still be able to segregate assets for investment strategies for individual members, but not for the tax paid on earnings by the fund in super/pension.)

Banning segregation from a tax perspective will take away a lot of guesswork, or a lot of crystal ball gazing, from what was likely to be the lot of SMSF trustees post 1 July 2017.

But using segregation did pose opportunities. And, despite what the Government appears intent on trying to achieve, segregation is unlikely to be dead. It might have to take a different form.

Beating the segregation ban

One possible approach is to have two SMSFs.

Under the current legislation, the Government/ATO is aiming to stop SMSF trustees from using segregation within a fund to avoid paying taxes.

But it is difficult to see how the ATO could stop segregation being used effectively across multiple funds under current reporting requirements.

Aaron Dunn of the SMSF Academy took me through the following example.

Let’s take a member with $2.6 million currently in pension in SMSF1, which includes a property worth $1 million. In time for 1 July 2017, the trustee takes the $1 million property and transfers it to a second SMSF (SMSF2).

There has been a CGT event, as it would be considered a disposal by SMSF1, but the transfer occurs while SMSF1 is in pension phase, so there would be no tax to pay.

SMSF1 now has $1.6 million in pension. It then rolls back $1 million from pension to accumulation. The member then has only used $600,000 in pension of the $1.6 million cap.

It then turns on a pension for the $1 million property in SMSF2. This property is now the only asset in the SMSF and is, therefore, effectively segregated. If this is likely to be a high income, or high growth asset, and you’ve chosen it for that reason, then the segregation – according to what the experts currently believe – would have been achieved.

This would appear to be allowable under the new rules, but it’s early days and something that will require extra consideration by the experts.

There will be some extra costs in setting up and running the second SMSF, but if the trustees believe that it will deliver dividends in excess of those costs, then it could be worth it.

Dunn said that it is too early to tell how this will work in regards to reporting (to the ATO) the movements in and out of pension phase for SMSF1 and SMSF2.

So the strategy comes with a ‘kids, don’t try this at home’ warning. At least not yet. There’s no great rush to, as the new rules don’t hit for five months. But, the best brains in the business are still trying to work their ways through the new laws.

What are the potential downsides?

If the asset being transferred is property, then a potential downside is stamp duty in some states. This is something to check, state by state (potentially with your SMSF accountant). Dunn said that some states will not charge stamp duty when the beneficiaries remain the same, but other states will charge it.

So, even though there might not be any capital gains tax, having to pay up to around 5.5% in stamp duty, if applicable, could turn a good idea into a marginal one.

 

Bruce Brammall is Managing Director of Bruce Brammall Financial Pty Ltd and Bruce Brammall Lending Pty Ltd. The information contained in this article is general information and does not consider anyone’s specific circumstances. If you are considering a strategy such as mentioned here, consult your adviser.

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7 Responses to Is super segregation still possible for SMSFs?

  1. PM June 8, 2017 at 10:53 PM #

    I personally find the whole 4A stuff rather confusing. A few examples:

    1. I have two non-SMSF clients that are seeking advice around the $1.6m cap. Their industry funds are forcing them to roll money back to the accumulation phase and have the proceeds go into a separate super account. If I advise them to employ different investment strategies across the pension and accumulation phase, is that tax avoidance?
    2. Let’s just say these clients wanted to start a SMSF in the future. Can I set up two SMSFs? Or is it because a SMSF is involved that is tax avoidance? Do I need to consolidate into the one? Am I acting in the clients best interests by combining their accumulation and pension interests in the one fund?
    3. If a client rolls their SMSF accumulation interest to a non-SMSF, is that tax avoidance? If it isn’t, how long would the funds need to be in that non-SMSF for it not to be tax avoidance?

    I could go on.

    Anyway, just my two cents.

  2. David February 19, 2017 at 9:02 PM #

    From my reading the ATO guidance note on this is pretty clear. It looks at total superannuation balances across all funds to determine the taxable split between pension and accumulation, and calculates tax on that basis. All that having two SMSFs will do is increase admin costs and inefficiency in having two funds. While the ATO may struggle to deal with this complicated legislation on a practical basis, this won’t last forever.

  3. Jeff Humphreys February 17, 2017 at 10:02 AM #

    “Simply, all the assets of the fund will be taxed based on the proportion that is in pension and the proportion that is in accumulation (which will be worked out by an actuary)”

    The legislation removes the need for an actuary to do this work – another loophole? albeit with a ‘kids, don’t try this at home’ warning.

  4. Steve Martin February 16, 2017 at 12:17 PM #

    Great! Very helpful, thanks for this article! My gut feeling is that segregating by using separate funds may not be a great idea for most of us. Ideally, after 1 July, you would like to grow the tax free pension fund and reduce the taxable income and maximise the asset growth in the accumulation fund. The problem is that you still need to pay the minimum pension from the pension fund, so holding assets in high growth low income assets in the pension fund creates a liquidity problem. Holding the funds in the unsegregated single fund enables the fund to earn sufficient income to pay the minimum pension and the balance of assets in high growth low income assets lifts the value of the pension account as well as the accumulation account. As the legislation has passed, any action to attempt segregation by establishing a new fund to avoid tax has a pretty obvious problem: the possible trigger of the general anti avoidance rule.

  5. Chris Jankowski February 16, 2017 at 12:15 PM #

    If you had a $1 million property as the only asset of a superannuation fund in pension phase then it is unlikely that this fund would be able to pay the required minimum pension (typically 5% of assets value) out of the rental income after expenses.

    • SMSF Trustee February 16, 2017 at 3:58 PM #

      One of the many reasons why it should be forbidden for super funds to own more than about 20% of in any one individual fund or asset and no more than 20% in illiquid assets of any kind. All those debates about whether super funds should be able to borrow would be wiped out by such simple risk management rules being required as part of the investment strategy.

    • Alex May 10, 2017 at 4:03 PM #

      I am no expert and am just fiddling around. I did a rough calculation and think it is plausible. What happens if you have a rental yield of more than 5%? What I am trying to get at, is what if the rental yield is sufficient to pay the minimum pension payment? That would be ideal, isn’t it?1

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