Transfer Balance Cap impacts on SMSF death benefits

The practical complexities of the $1.6 million transfer balance cap for SMSFs could be more far-reaching than additional reporting requirements, writes Fabian Bussoletti.

While much of the recent focus surrounding the introduction of the $1.6 million transfer balance cap (TBC) has been on the additional reporting requirements to be faced by self-managed superannuation funds (SMSFs), the practical complexities of the TBC could be far more wide-reaching. The impact on an SMSF trustee’s ability to retain certain assets within the fund following the death of a member will now need to be considered for many clients.

This article provides an overview of some additional practical considerations and complexities faced by SMSF trustees following the death of a fund member due to the introduction of the TBC. 

Overview 

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Following the death of a fund member, an SMSF trustee(s) is required to pay a death benefit as soon as practicable. While the term as soon as practicable is not defined, it is generally acknowledged that a period of around six months is acceptable – of course, where extenuating circumstances exist, this period could be extended.

In terms of meeting this obligation, a fund trustee can pay a death benefit in the form of a lump sum, a pension, or a combination of both. However, the ability to pay a death benefit in the form of a pension is most commonly limited to pensions paid to a surviving spouse, although it is possible to pay a pension (at least temporarily) to certain children – typically with a commutation requirement at age 25.

While in some cases, the payment of a lump sum death benefit may be suitable, and in other cases it may be the only option, in many scenarios, previously established estate planning strategies would have involved paying a death benefit pension to a surviving spouse.

In such scenarios, the introduction of the $1.6 million TBC may have significant implications for these existing strategies.

Note: This article will focus on death benefit pensions paid to a surviving spouse. The TBC rules relating to child account-based pensions (ABPs) are complex and beyond the scope of this article. 

Death benefit pensions and the TBC

While it is beyond the scope of this article to provide a detailed explanation of the operation of the TBC, there are a few key points worth reflecting on.

It is now well established that upon the commencement of a retirement phase pension, a credit (increase) is applied to the pension recipient’s TBC account.

On the flip-side, a lump sum commutation from a pension (including a rollover back to accumulation phase) will result in a debit (decrease) to a pension recipient’s TBC account.

What is perhaps not as obvious, is the way that death benefit pensions are assessed for TBC purposes.

To keep things simple, where a death benefit pension is paid to a deceased member’s beneficiary, a credit will arise in the recipient beneficiary’s TBC account – albeit with some nuances depending on whether the death benefit pension is provided under an automatic reversionary, or otherwise.

So, if a death benefit is paid in the form of a lump sum, then from a TBC perspective there is no additional complexity – as there is no impact on the beneficiary’s TBC.

However, where a death benefit is paid in the form of a pension, closer scrutiny to the TBC position of the intended beneficiary is required. 

So what about SMSFs? 

The complexity alluded to above is not unique to SMSF members.

However, what is unique to SMSF members are the potential practical impacts that complying with the TBC in these scenarios may have on the composition of the fund’s assets – potentially resulting in the need to liquidate or otherwise physically transfer assets from the fund.

Perhaps the best way to highlight some of these issues is through some case studies.

Case study 1: Bob and Mary are the members of the B & M SMSF – and directors of the corporate trustee.

The fund has the following assets:

• Cash and term deposits: $500,000;
• Share portfolio: $600,000 (no net capital gain);
• Property: $1,000,000 (unrealised gain of $600,000); and
• $2,100,000

Both Bob and Mary are receiving account-based pensions with the following balances (at 1 July 2017):

• Bob: $1,200,000; and
• Mary: $900,000

Their current estate planning, as it relates to their SMSF interests, is that on the death of either member, the surviving spouse will receive a death benefit pension via a binding death benefit nomination (BDBN).

Initial observations:

Based on their 1 July 2017 balances, neither Bob nor Mary have excess TBC issues. 

Similarly, as the fund assets are entirely being used to support pensions, the fund assets are treated as segregated pension assets (for tax purposes). As such, all the fund’s income (including any realised capital gains) are currently exempt from tax.

Prior to the introduction of the TBC, when Bob and Mary’s plans were first implemented, the outcome following the death of either member was relatively straight-forward. That is, the deceased member’s remaining pension balance would have been paid to the surviving spouse as a death benefit pension.

As a result, all fund assets would have remained in the pension phase, and all fund income (including any realised capital gain) would have continued to enjoy a full exemption from tax – without the need to obtain an actuarial certificate.

Let’s assume that Bob passes away unexpectedly. Based on their current arrangements, if Mary were to simply commence a death benefit pension with Bob’s $1.2 million, she would exceed her $1.6 million TBC and be subject to penalties associated with such a breach.

This is because, once the death benefit pension is commenced, the value of the death benefit pension (at the time it is commenced) is credited to Mary’s TBC account – in addition to the existing $900,000 credit – clearly leading to a breach of her $1.6 million TBC.

So, is there a solution?

While it is no longer possible for any part of Bob’s death benefit to be rolled back to the accumulation phase, a relatively simple solution for Mary might be to commute part (or all) of her existing ABP, transferring the commuted amount back to the accumulation phase. She will then have TBC space available, which she can use to commence the death benefit pension.

If we assume that she commutes $500,000 from her existing ABP, and transfers this amount back into the accumulation phase of the fund, this will result in a $500,000 debit – thereby reducing her TBC account to $400,001. Subsequently, upon commencement of the death benefit pension, a $1.2 million credit will be credited to her TBC account. Mary’s TBC account will look something like this [refer to box]:

But, what are the SMSF impacts?

Once again, the solution discussed above for Mary is not unique to SMSF members. However, there are some SMSF relevant considerations worth highlighting.

Fund’s ongoing tax position

As some of the fund’s assets are now supporting an accumulation interest, a portion of the fund’s income (including any realised capital gains) will now be subject to tax at a maximum tax rate of 15 per cent.

Further, when determining the level of the fund’s exempt pension income (ECPI), since 1 July 2017, an SMSF is no longer able to use the segregated method to claim ECPI where:

1. There is one retirement phase interest in the fund; and
2. Just before the start of the year (i.e. 30 June of the previous financial year)

a. A person has a total super balance > $1.6 million
b. The person is a retirement phase recipient of a superannuation income stream (even if the pension is not paid from the SMSF)
c. That person has a superannuation interest in the fund (even if their interest in the SMSF is only an accumulation interest).

As a result, in Mary’s case, the B & M SMSF will not be able to segregate pension and accumulation assets for tax purposes in the future – removing, for example, any planning opportunity to hold (say) the cash and term deposits in the accumulation phase while holding the shares and property assets in pension phase.

In future, Mary must also ensure that she obtains an actuarial certificate for the fund each year (before lodging the fund’s annual return), in order to receive the pension earnings tax exemption.

This actuarial calculation will ultimately be used to determine the amount of tax payable by the fund. That is, for as long as the above criteria continues to be met, all future SMSF income (including realised capital gains), will be proportionately subject to tax at the maximum rate of 15 per cent.

This inability to, for example, segregate the fund’s property investment as a pension asset means that upon eventual disposal of the property, a proportion of the currently unrealised gain of around $600,000 will be assessable to the fund and subject to tax – a tax liability that would not have previously been factored into Bob and Mary’s planning.

Future estate planning considerations

Aside from the issues related to the ongoing structure, management and control of the B & M SMSF, future estate planning strategies must now also be considered for Mary.

For example, it is unlikely that a death benefit pension will be an option for Mary’s beneficiaries once she passes away – so a lump sum death benefit will need to be paid.

Following Mary’s death, to facilitate the payment of such a lump sum, the fund’s assets will need to be:

• Sold, with the fund using the resulting cash to make the lump sum payment(s); or
• Transferred directly to the relevant beneficiary(ies) as an in specie lump sum death benefit.

Under both these options, capital gains tax (CGT) is likely to be payable. However, even though Mary’s non-reversionary pensions technically cease upon her death, for tax purposes the proportionate pension tax exemption will continue until the point at which a lump sumdeath benefit is paid – ensuring any CGT payable by the fund is only applied to the proportion supporting any remaining accumulation interest (as determined actuarially). 

Case study 2: Now, consider Peter (age 50) and Gladys (age 48), both members of the Yummy Apples SMSF – and directors of the corporate trustee.

The fund has the following assets:

• Commercial property: $2,900,000
• Cash: $100,000
• $3,000,000

Peter and Gladys have the following account balances (currently in the accumulation phase) within the fund:

• Peter: $2,200,000
• Gladys: $800,000

Let’s now consider the complexity that arises if, say, Peter were to pass away.

Analysis:

Similar to Bob and Mary’s scenario discussed earlier, following Peter’s death, Gladys could choose to receive a death benefit pension.

However, based on the size of Peter’s account balance, the most Gladys could receive in the form of a death benefit pension is currently $1.6 million – meaning part of Peter’s superannuation interest (i.e. the remaining $600,000) will need to be paid from the fund as a lump sum.

Based on the composition of the fund’s assets, there is clearly a lack of sufficient liquid assets to make the lump sum payment. As such, this will require:

• Selling the property (in whole or in part); or
• Transferring part (or all) of the property out of the fund as an in specie lump sum death benefit. 

This will raise additional considerations for Gladys, including (but not limited to) Gladys’:

• Overall estate planning strategy (as assets paid out as a lump sum are likely to be estate assets);
• Income tax position (e.g. rental income will now be assessed at Gladys’ marginal tax rate);
• Level of asset protection; and
• Need to update the property title, and any existing lease arrangements, to reflect the change in ownership – as well as any associated transaction costs such as stamp duty.

Further, unlike Bob and Mary’s earlier scenario, the assets of the Yummy Apple SMSF are not supporting pensions. So, upon disposal of the property (either by way of sale or in specie transfer), CGT would be payable by the fund on the entire capital gain made on the property. 

Closing thoughts 

While the introduction of the $1.6 million TBC, and its interaction with the payment of death benefits, applies in the same way to members of both SMSFs and public offer superannuation funds, the practical implications can be far more wide-reaching for SMSF members.

The two cases highlight the ongoing use of SMSFs as an intergenerational wealth transfer vehicle is becoming increasingly limited.  

Fabian Bussoletti is technical strategy manager at AMP.