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A recent ruling from the Commissioner has highlighted the importance of administering a pension correctly, with severe tax consequences for those that fail to comply.
The Commissioner has revealed that failing to make the required pension payments could jeopardise the tax-free status of a self-managed superannuation fund (“SMSF”) not just from the date of shortfall but for the whole financial year.
Commencement and cessation of a pension
With over 500,000 SMSFs in Australia and more than 58%1 of the SMSF member population over the age of 55, administering a pension (formally known as a ‘superannuation income stream’) is becoming increasingly common.
The date on which a pension commences or ceases is crucial to the tax outcomes within the SMSF:
- When a pension has commenced, it enters ‘pension phase’ and can access the current pension income exemption – resulting in a tax rate of zero on any earnings.
- Prior to commencement or following cessation, a superannuation fund is in ‘accumulation phase’ and subject to 15% tax on earnings and concessional contributions.
Confusion often arises as to when a pension technically commences or ceases, particularly if an unusual event has happened during the year, such as a shortfall in pension payments.
In order to provide more guidance relating to the commencement and cessation of a pension, the Commissioner has released taxation ruling TR 2013/5: Income Tax: when a superannuation income stream commences and ceases. The Ruling applies retrospectively from 1 July 2007.
When does a pension commence?
In the ruling, the Commissioner explains that a pension exists only where the SMSF trustee has a liability to pay the member a series of ‘periodic payments’ (that relate to each other) over an identifiable period of time.
The Commissioner clarifies that ‘periodic payments’:
- Do not need to be paid at set intervals (e.g. the 1st of every month);
- Can vary in amount; and
- Could include a single payment for a year, provided that this pattern is recurring over a number of years.
It is not uncommon for an SMSF pension member to draw down one annual payment. However, SMSF trustees should take care in this regard; the Commissioner has implied that such payments will not be treated as an ‘income stream’ if a pension commences and then ceases after one year.
When does a pension cease?
Generally, a pension will cease when there is no longer a member (or beneficiary of that member) who is entitled to the superannuation income stream. The following is a list of some common circumstances where a pension ceases:
- Failure to comply with the pension rules;
- Payment standards of the superannuation law;
- Exhaustion of capital;
- Where a member fully commutes their pension; or
- On death of the member (bearing in mind that there is an extension of the exempt current pension tax exemption immediately following the death of a member).
One common example where a pension could inadvertently cease under the above circumstances is where an SMSF Trustee fails to pay the minimum pension for an income year.
What happens if the minimum drawdown isn’t made?
An SMSF in pension phase is required to draw down a minimum annual pension as set out in the superannuation regulations.
The Commissioner has finally confirmed in his ruling that, in his view, failure to meet the minimum pension drawdown for a given financial year will result in the cessation of the pension at the beginning of the financial year.
In this situation, any amounts withdrawn during the year are, in the Commissioner’s opinion, superannuation lump sums. More importantly, the ‘pension’ portion of the SMSF will lose its tax-free status for that financial year.
Unfortunately, the ruling fails to address circumstances where the minimum drawdown is not met for a non-commutable pension (such as a transition to retirement income stream). Since lump sums cannot be paid from a non-commutable pension, it is uncertain as to how these amounts should be accounted for.
The Commissioner’s view also infers that simply accruing any pension shortfall at year-end may not be enough to ensure that the SMSF is entitled to its full exempt current pension income tax exemption.
Commissioner’s right to exercise administrative powers
In spite of the recent ruling, the Commissioner released a fact sheet in January 2013, which indicates that in cases where minimum draw-downs are not met, he may choose to exercise his powers of general administration, allowing the SMSF to continue to claim the current pension income tax exemption.
In order for the Commissioner to exercise his discretion, a number of specific conditions would need to be satisfied. One of these conditions requires that the SMSF Trustee (unless a result of matters outside the Trustee’s control) only made a small underpayment of not more than one-twelfth of the minimum pension payment required for that income year.
The Commissioner’s right to exercise powers of general administration should not be relied on as a tax planning mechanism, but rather a last resort if an inadvertent error has occurred.
Given the Commissioner’s approach to the treatment of pensions, it is crucial to ensure that clients are made aware of their minimum pension drawdown requirements each year. A reminder call to your client in the lead up to year end may be the best way to minimise the likelihood of them failing to draw down their minimum pension.
Should you require any further information regarding superannuation matters, please contact your local William Buck advisor.
1Based on June 2013 SMSF statistics released by the ATO on 20 September 2013