SMSF pensions: Watch out for a shock (ing) tax bill on fund assets

This article has been updated due to the July 2011 release of Draft Taxation Ruling TR 2011/D3 ‘Income tax: when a superannuation income stream commences and ceases’. The ruling is not yet legally binding but a final tax ruling will be issued after taking into comments received from the super industry and interested citizens.

During 2010, SuperGuide published a response to a question from a reader. The reader asked: what was the tax status of a pension account (not the benefits paid out, but the actual account) after a self-managed super fund member died?

I provided a lengthy response but my short answer was: When a pension member dies and he or she has not arranged for a reversionary beneficiary, there is a strange quirk in the system that means the pension account reverts to accumulation phase. What does this mean for the family of the deceased? Well, it means that when the fund assets are sold, any capital gains are subject to tax before the proceeds can be paid out as death benefits to beneficiaries. I based my response on an ATO interpretative decision published in 2004, and pointed out that the ATO decision was not binding and the facts behind the 2004 decision left it open for someone to challenge the decision.

Unfortunately, in July 2011, the ATO released a draft tax ruling (TR 2011/D3) confirming the tax treatment outlined above, as well as providing further clarity on when a pension account remains active upon a person’s death.

Some members of the super industry, especially within the SMSF sector, have expressed surprise at this latest ruling as if the ATO’s view is a new development. I’m surprised that industry professionals are surprised. The view relating to the cessation of a pension account has been kicking around for awhile, and even if super experts were not previously aware of this hardline view from the ATO, it’s now time to get some clarity on the issue.

Trish Power’s view: I personally think the current view taken by the ATO is ridiculous, and inconsistent with the principles behind offering superannuation pensions. Death benefits are by definition within the sole purpose test, and form an integral component of the superannuation system. I strongly disagree that ‘when a member dies they no longer have an entitlement to receive superannuation income stream benefits’. Payments to superannuation dependants (including non-dependants for tax purposes) are simply an extension of the pension benefit. Hopefully, some legal eagle within the super industry will successfully argue that the pension account continues (and accordingly the tax-exempt status of the pension account) until a death benefit is paid from the account.

If the ATO’s current view prevails, that is a pension account reverts to accumulation phase before death benefits are paid as a lump sum, such an approach will require some dynamic tax management strategies in retirement. The most obvious strategy is to regularly sell assets during retirement, to reduce the potential capital gains. What makes this draft ruling even more draconian is that the ATO wants to make it retrospective to 1 July 2007. Can you imagine the trauma for those Australians who have lost loved ones in the past 4 years, and now have to revisit financial affairs that have been finalised and potentially pay a massive tax bill to the ATO.

The rest of this article is a composite of my original August 2010 article and extracts from the latest ATO ruling. The reader’s full question from the August 2010 article is set out below.

Q: My question is about taxation within super when a member dies. We are two members in the one SMSF, both drawing pensions. We have nominated each other as reversionary beneficiaries and benefits are to be paid to our legal estate in case the nominated reversionary beneficiary dies before the pension member. In which circumstances does a member pension account (tax-free) revert to income 15% and CGT 10% tax regime? Is this when the first member dies or the second? Does reversionary death nomination have any effect on the tax liability on earnings for the pension fund accounts at death, or when winding up the fund? Please suggest any source material if possible.

Your question contains several questions, so I will provide some background on the issues you mention for the benefit of other readers, and then answer each question in turn. Note that my responses should be treated as general information, and you need to get specific advice on your personal circumstances.

How the tax system affects super

When a super account enters pension phase, the earnings on assets financing the pension are free of tax. What this means is that capital gains, dividend income, interest income and any other type of income that the pension account receives is exempt from the tax system.

Note: If you choose to continue an accumulation account while also taking a pension from a pension account, then tax is still payable on fund earnings in the accumulation account. For example, fund earnings are subject to 15% earnings tax, although capital gains on assets that have been held for more than 12 months receive a 33.3% discount, which translates into a tax rate of 10% on those capital gains. You can also continue making contributions to the accumulation account, subject to meeting a work test if aged 65 or over.

When a pension account member dies

When a pension member dies and he or she has not arranged for a reversionary beneficiary, there is a strange quirk in the system that means the pension account reverts to accumulation phase. What does this mean for the family of the deceased? Well, it means that when the fund assets are sold, any capital gains are subject to tax before the proceeds can be paid out as death benefits to beneficiaries. If the beneficiaries are non-dependants (such as adult children), then you can expect two tax hits:

• Earnings tax on the sale of fund assets (assuming capital gains)
• Death benefits tax on payment of benefits to non-dependants

Even when the benefits are paid to dependants (and then tax-free), any tax on capital gains from the sale of fund assets is still payable in the circumstances outlined above.

Source: The source of this tax approach to fund earnings when a pension member dies, is an ATO interpretative decision from 2004, ATO ID 2004/688: Superannuation Exempt income – segregated current pension assets. Quoting from the ATO decision:

Where a fund ceases to have a current pension liability due to the death of a sole member with no contingent pension payable, the assets cease to be ‘current pension assets’ and the income is no longer exempt pension income. As a result the exemption provided for by section 282B of the ITAA 1936 ceases to apply.

In July 2011, the ATO released further information on this issue, confirming the 2004 position, in the draft tax ruling TR 2011/D3 ‘Income tax: when a superannuation income stream commences and ceases’.

Paragraph 24 of TR 2011/D3 states the following:

A superannuation income stream ceases as soon as the member in receipt of the superannuation income stream dies, unless a dependant beneficiary of the deceased is automatically entitled under the superannuation fund’s deed, or the rules of the superannuation income stream, to receive an income stream on the death of the member.

For example, a married or de facto couple, are members of a SMSF and the trust deed provides that is a member is in receipt of a superannuation income stream when the member dies the income stream will continue to be paid to their spouse. In this situation, the pension would continue including the tax-exempt status of the pension account.

A pension will also be considered to have transferred on the member’s death if a valid binding death benefit nomination is in place at the time of the member’s death, and the nomination entitles the beneficiary (a dependant) to a reversionary pension.

Note: For such a pension entitlement to continue the draft tax ruling (paragraph 114) states that the rules of the income stream must specify that the pension will be automatically transferred to the beneficiary (a dependant). The rules must also specify both the person to whom the benefit will become payable and that it will be paid in the form of a pension. If the trustee has the discretion to pay either a lump sum or pension to a dependent beneficiary, the pension ceases on the member’s death (paragraph 116), and the account loses its tax-exempt status.

What if there are two members?

The 2004 ATO decision didn’t specifically with this situation but by systematically going through the super rules it was possible to find an answer to this question. Based on the 2004 ATO decision, I assumed that a pension account would lose its tax-exempt status on the death of the member, unless a reversionary beneficiary was in place.

Where a two-member fund is running two pensions, and each pension member is the reversionary beneficiary of the other, then the loss of the tax-exempt status would only become a problem when the last member dies.

If a SMSF pension member has nominated a reversionary beneficiary (must be a death benefit dependant – such as spouse, dependent child under age 18), then on his or her death, the pension continues to be paid to his spouse or other nominated beneficiary. In these circumstances the tax-exempt status of pension income continues because the pension has never ceased.

The 2011 draft tax ruling stated this same position with similar but more official wording (refer to paragraph 24 earlier in the article).

The reader asked what happens if the nominated beneficiary dies before the primary pension account holder. Again, in the situation where two pension fund members are the nominated beneficiary of each other, then the nominated beneficiary of one pension, is the primary pension account holder of the other. Accordingly, the pension of the deceased member continues to be paid to the reversionary pensioner and the tax-exempt status is retained.

What about on winding up?

If the surviving SMSF member of a couple eventually dies, and a reversionary pension is no longer in place because the reversionary pensioner passed away at an earlier date, then the pension assets for the last member revert to accumulation phase, based on the draft tax ruling. Any capital gains arising from the sale of assets will be subject to earnings tax, albeit a 33.3 discount if held for longer than 12 months.

Note: The discussion above relates to pension assets, rather than the payment of death benefits. Death benefits remain tax-free when paid to dependants under the tax laws (spouse, children under 18, financial dependants and those who had an interdependent relationship with the deceased). The taxable component of a death benefit is subject to tax when paid to non-dependants under the tax laws – this includes independent adult children.

On the treatment of death benefits, you may find the SuperGuide following articles useful:

• How can a SMSF live forever?
• Estate planning: Beware the dastardly death tax
• Estate planning: Dear Dad, Tax for everything

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