Episode 26 – CGT relief: segregated method and adopting the proportionate approach

In this week’s podcast (episode 26), Aaron discusses some of the challenges confronting practitioners in applying CGT relief using the segregated method, in particular around the decisions of adopting the proportionate method for income tax purposes.

Aaron highlights within this podcast the confusion in the fund’s actuarial requirements upon switching to the proportionate method for income tax purposes, dependent upon whether the change of method has occurred inadvertently during the pre-commencement period, or deliberately on 30 June 2017 to allow for one or more members to comply with the introduction of the transfer balance cap.

Find out more about the CGT relief documents by registering for the upcoming webinar, 5 key documents to help you comply with the super reforms.
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Read the transcript

Aaron Dunn:

You’re listening to the SMSF Academy Podcast, and this is Episode 26.

Speaker 2:

Welcome to the SMSF Academy Podcast, the show designed to help professionals stay ahead of the curve. Now, here’s your host, the man that’s in the know and shows you how SMSF is done right, Aaron Dunn.

Aaron Dunn:

Hi, there. Aaron Dunn here, and welcome to the SMSF Academy Podcast for this week. Today, we’re going to be looking at the topic of CGT relief. Now, it’s a session that we could be talking for hours and hours on end, but what I specifically want to be looking at today are some of the common questions that I’m getting asked around the segregated method, and in many respects, some of the bits and pieces of information that we’re really only seeing in the commentary around the topic of CGT relief.

I talk specifically here around some of the requirements and messaging that we see in the marketplace around the need to get an actuary certificate or don’t we need to get an actuary certificate, and trying to help you understand and navigate your way through decisions where, in particular, a fund may be moving or switching to the proportionate method. Today, we’re going to go through some of those key decisions that you need to put in place, subject to the way, ultimately, that you document the decisions that actually happen around the application of the CGT relief.

One of the most important things when we think about the segregated method is we have two approaches in how we are dealing with segregation inside an SMSF. Now, we may have set aside specific assets within the fund, so we had segregated current pension assets versus segregated non-current pension assets. But we also have this notion of segregation by default where, in essence, a fund is 100% in pension phase, and that is, arguably, the more common approach that we see.

In particular, as we get to the 30th of June, we may have seen that position either change by a conscious decision to, say, comply with the transfer balance cap, or it may have happened inadvertently by some other way, shape or form, such as when a contribution may have come into the fund. Most importantly, what we need to ensure, though, is that the application for CGT relief is consistent with the object of these new measures.

In essence, what we’re saying here is where the trustee fails to comply to commute that income stream before the 1st of July 2017, so say we’re doing that switching or adopting the proportionate method, then, in that instance, we’re actually going to have the fund being ineligible to apply CGT relief in the first place. We’ve, of course, got our previous guidance within the Practical Compliance Guidance, PCG 2017/5. Like I said, a fund may cease to be segregated, and that may have arisen because of that partial or full commutation back to the accumulation phase. It could have been made by some form of transfer in or contribution where the fund was, by default, a segregated fund.

We know around the CGT relief provisions within the income tax (transitional provision) measures that for a segregated method to apply to the cost-base reset, we needed to have had those CGT assets as segregated current pension assets at the start of the pre-commencement period. That is critically important as a process because the pension doesn’t need to be in existence if we were looking to apply the proportionate method for CGT relief.

We did see the government extend that pre-commencement period to also include the 1st of July for transition to retirement income streams that were ultimately going to continue, insofar that they were no longer going to be deemed to be segregated current pension assets, primarily because they are not in the retirement phase, and they get no tax exemption in respect to those amounts.

The other conditions under the segregated method was that we need to ensure that the fund held the asset throughout that pre-commencement period, obviously, disregarding the deemed sale and repurchase because the relief applied. We need to ensure that the fund is a complying fund at the start of that pre-commencement period to the time that the asset stopped being a segregated current pension asset. Finally, we needed to ensure that there was a choice for that CGT relief to apply to that particular asset.

We spoke also earlier about the fact that we have, when we segregate, to either reallocate particular assets from the pension phase to the accumulation phase, where we want segregation to continue. In many instances, that may only likely occur for segregation purposes until the 30th of June 2017 because post-1 July 2017, we may see many funds that would be prohibited from applying segregation under the Section 295-385 (ITAA 1997) because we have pension members that have a Total Superannuation Balance in excess of the general transfer balance cap.

The more common approach that we’re seeing right across the industry is where there’s been this conscious decision to adopt the proportionate method. Here, the benefit of this adopting the proportionate method ensures that the CGT relief here can apply to all assets that have ceased to be segregated current pension assets. This is where we’ve got some differences in the approach that is happening thereafter because of the fact that there’s a proportionate approach, which ordinarily requires an actuarial tax certificate to be required to determine a fund’s tax exemption for that particular point in time.

We also note that the ATO recently has provided some updated guidance around the way in which they see in a particular year, a fund has maybe switched from segregated to the proportionate method by virtue of a contribution and so forth. Rather than this whole-of-year approach that the industry has looked at in determining a funds tax exemption, we are needing to segment and deal with the different accounting periods and apply tax exemption in those respective periods, one under the segregated approach, and then, say, if a contribution came in, we’ll then need to obtain an actuarial tax certificate for that period of time where we had accumulation and pension members.

But, importantly, that decision as to whether we need a certificate or not, is going to be a function of a cost/benefit in doing so because, of course, there is no formal requirement here to obtain a certificate. We do need to work out whether we actually believe there is a benefit in doing so.

The question, that we ask, and we did recently in our CGT relief webinar, was does the fund you need to obtain an actuarial certificate when the fund used the segregated method on the 9th of November (2016), which was the start of that pre-commencement period, and switched to the proportionate method on the 30th of June (2017)? We are satisfied that it held the asset throughout that pre-commencement period, and it had a member that was having to comply with, in essence, the object of the CGT relief, which was to comply with the transfer balance transfer cap or as a result of the TRIS reforms.

The ATO have made quite clear for some time that in those type of circumstances, as the fund will start to have assets that support both the accumulation and retirement phase interests, you will need to obtain an actuary certificate to support the use of the proportionate method.

That’s certainly going to be the case where we have the situation whereby the contribution may have come in on the 15th of June and we have a range of income that is being generated through to the 30th of June. Where it’s a little bit different is if we made that conscious decision to switch on the 30th of June and we’re going to then have to look at, well, what income was derived on that particular date? In what sequence did we put in place the relevant process or documents to ensure that the fund is maybe having to account for that income, or whether the decision to actually commute was the last event of the day?

When we look at the requirements for an actuary certificate, it is, of course, not a compulsory requirement to obtain to determine the fund’s tax exemption. The only legislative requirement here is, is if we want to claim tax exemption, we then need to get that certificate for the actuary to determine what that percentage is.

Other than that, the only mandatory requirement for a certificate sits within defined benefit pensions where we’re looking at it on a solvency basis. So there is a real need here to look at the cost-benefit analysis based upon the income that was earned in that period and the ATO have stated this previously that you can make that decision. So if the income here is very little, it is reasonable here for the trustee to not claim any tax exemption in respect to that period in question.

What we have posed to our members and the way in which the documentation should be drafted here is what if the decision to switch to the proportionate method was done on the end of the day following the allocation of the income that was ultimately received and accrued? We used the word “receive” and “accrued” in here because, of course, we will have distributions from unit trust funds, managers and so forth that we won’t have accounted for. Therefore, it may come into question when the receipt of that income was ultimately received initially, so cash, reinvested, and then, distributions that will have accrued.

So where we then have a fund that is entirely in pension phase up until the commutation to roll back to accumulation on the 30th of June, which we note that time we are creating an accumulation interest, so the member would have a retirement phase interest equal to the $1.6 million, we would simply say that all income is exempt up until that point in time, which would include all gains and losses. Which, therefore, when we look at it on a segregated basis, we are applying the segregated method for CGT as well under Section 118-320 (ITAA 1997), so we disregard all gains and losses. Now, on that basis, we don’t have any certificate required for any of the above income, gains or losses, because of the fact that we have treated all of the income received on the 30th of June based upon the segregated method.

However, our last decision for the day is where we are now switching to the proportionate method. Whilst the ATO have said and we’ve seen this throughout the media, there is a need to obtain a certificate, what we are choosing to do is to not obtain a certificate because we have no further income earned in the 2017 financial year after we have rolled that back to accumulation phase. What we have done is in our SMSF documents that we have available within our campus platform, our silver and gold members can access these as part of our membership, whether you are a free member or wish to buy these on a pay-as-you-go basis, you can access these documents yourself and see really the inclusion of the information.

I think this makes it very clear as to whether you need a certificate or not. Because not only are we putting in place a minute that talks about the adoption of the proportionate method and lining this up, really, with a decision that has occurred on the 30th of June, we had not only talked about a consistency with the object of the relief, we’ve talked about the method for determining the CGT relief, and then, the fact that we have made this decision at the end of the day, having accounted for all the income.

So then, what we do is put in the appropriate resolutions in obtaining market valuations, etc, etc. Then, as part of the fund’s tax return, we then put in place the second trustee meeting that looks at the qualifying provisions, the fact that we’ve done it in the approved form, the fact that the choice that is being made is irrevocable and therefore, the assets that have been processed within your SMSF software will show it having that reset date and you have accounted for through the appropriate record-keeping requirements in Section 121-20 of the Income Tax Assessment Act (1997) to make sure that you’ve got the appropriate documentation and, therefore, in those resolutions ensure that those appropriate steps have been taken as well.

This is where the putting in place the right building blocks here will become critically important. When I look at some of the documents that I’ve seen, some are too general, I guess, to be able to achieve the outcomes that you’re wanting to do, and as I’ve demonstrated in today’s session.

So just be aware of what is out there. It’s one of the things that I consistently see that there is a mixed level of communication, the way in which you can interpret how these rules work, making sure you understand the nuances around the decision to switch, how that switching may have occurred, but most importantly, how you put in place the appropriate documents to ensure that your client(s) gets the right outcome as well.

That’s really all I wanted to touch on today. In particular here with the segregated method, we will run a separate podcast here around the proportionate method to really drill down some of the key decisions that need to be made in there.

But when we look at this segregated method, I see that switching to the proportionate method as the critical decision. Not only does it open up the opportunity for you to apply the CGT reset to more than the specific assets that need to comply because they’re no longer segregated current pension assets, but, of course, it ensures that you put in place the right steps, without necessarily having to rely on an actuarial certificate to give you the tax exemption for that particular year as well. So documentation, documentation is king.

If you do have any other questions, you can feel free to reach out to me at info@thesmsfacademy.com.au.Otherwise, feel free to reach out via social media channels. Thank you for joining me today for the SMSF Academy Podcast and I’ll look forward to you joining me for next week’s session. Take care and bye for now.

Speaker 2:

Thanks for listening to the SMSF Academy Podcast. Please note that the podcast provides general advice only, and is based upon our understanding of the law at the time of the recording. If you have any comments or questions from this podcast, or wish to subscribe to the series, you can find us at thesmsfacademy.com.au. Tweet us at the SMSF Academy, like us