Death, taxes and superannuation pensions

The Australian Taxation Office has indicated the two certainties in life - death and taxes - will become closely intertwined when it comes to super pensions. David Shirlow addresses some of the technical issues which might arise.

They say there are two certainties in life: death and taxes. With the release of draft ruling 2011/D3, the Australian Taxation Office (ATO) is signalling that it has firmed its view that one certainty will trigger the other in relation to super pensions.

The draft ruling is part of the ATO’s process of formalising its views on when super income streams start and finish for tax purposes. It has given rise to some contentious technical issues, which seem inevitable given some underlying deficiencies in the 2007 superannuation tax reform legislation. While the ruling considers account-based pensions only, the principles discussed will typically apply to other pension types payable under the SIS Regulations.

The problem with death: broadly, the ruling indicates that, if a super pensioner dies and the pension does not revert automatically to the deceased's spouse or other dependant, then the pension ceases immediately upon death.

This means that, from the time of death, tax is payable on income derived in relation to assets supporting the deceased member’s account, including capital gains arising on sale of the assets in order to pay out a lump sum death benefit.

Thus the benefit is depleted not only by any benefits tax payable (and typically benefits tax will be payable where the benefit is paid to an adult child of the deceased), but also by the capital gain tax (CGT) and other tax liabilities. 

Some have suggested there is nothing new in this view, as it is in line with an interpretive decision the ATO had issued as early as 2004 (ID 2004/688).

However, that interpretive decision dealt with a specific set of circumstances and was based on the law prior to the 2007 reform amendments. The release of the ruling is a more comprehensive indication of the ATO’s approach to the current law. It opens the way to debate the validity of taxing pension accounts post-death not only on a technical basis, but also at the policy level.

The ATO and industry have been engaged in debate for an extended period of time via the National Tax Liaison Group Superannuation Technical Sub-group, and a number of industry and professional bodies are likely to challenge the ATO’s views on technical grounds.

There isn’t space in this article to outline the carefully considered arguments for and against the ATO’s position but, in any case, perhaps it’s time to focus not just on what the law does say, but on what it should say.

If it’s not saying what it ought to say then the solution is to have it amended. A number of submissions are also likely to be made to government advocating amendment of the law to remove uncertainty and ensure reasonable taxation outcomes.

Many would argue that, if the ATO’s view of the current law prevails, then the relevant tax provisions create two layers of tax and an unreasonable tax burden on affected death benefit recipients. This includes beneficiaries not only of self-managed super funds (SMSFs), but also many large funds.

Further, if the tax treatment of all relevant income stream accounts were to change immediately upon death, there would be administrative complications for many large funds. Typically, funds are notified of the death of a pensioner some days (or weeks, in some cases) after the date of death. Funds cannot retrospectively re-engineer the appropriate tax treatment of relevant accounts for the period from death until notification without extensive and expensive manual intervention.

From a planning perspective, if the ATO’s view prevails then advisers and their clients will need to continue to consider using reversionary pensions where possible and reconsider buy and hold investment strategies. For SMSFs, consideration also needs to be given to whether or not pension assets should be segregated and the role of anti-detriment benefit deductions in neutralising the impact of post-death fund tax.

Cessation of pensions in other circumstances: the ATO also considers that an income stream ceases in either of the following circumstances:

• Where there is a failure to comply with the pension rules and the payment standards in the SIS Regulations. For example, if the minimum annual pension payment requirement is not met in an income year, the income stream is considered to have ceased.
  Indeed, the trustee is taken not to have been paying a superannuation income stream at any time during the income year in which the relevant requirements are not met, which presumably means that the pension has ceased at the end of the previous income year (or was never an income stream, if the minimum payment requirement was not met in the first income year).
• Upon receipt of a valid request from the member to fully commute the income stream. One question is whether this view holds even if the request is expressed to be to commute the income stream at a future date.
  Another is whether the view holds even if there is still a final pension payment to be made. (Note that an income stream is not considered to have ceased upon receipt of a request to partially commute the income stream.)

As with death, one of the tax implications of cessation of income streams in these circumstances is that any subsequent income or capital gains realised in respect of the assets that were supporting the income stream will be subject to tax.

Lump sum benefits: further, if an income stream ceases in the circumstances described above then in effect the ATO also considers any subsequent payment from the relevant account is a superannuation lump sum.

The ATO also indicates that a payment made upon partial commutation from an interest (in practical terms, an account) that supports a super income stream is always a superannuation lump sum (never an income stream benefit). These views may have significant tax implications for clients under the age of 60, since the tax treatment of lump sum benefits differs from income stream benefits for them.

Thus the draft ruling reinforces the need not only to ensure pension payment standards are met annually, but also to plan carefully well before a direction is made to commute a pension.

David Shirlow is the executive director at Macquarie Adviser Services.