Peter Hogan explains some of the issues and obstacles that may be faced when attempting to create reserves in an accumulation-style SMSF.
The use of reserves by superannuation funds has changed over the years as funds have evolved. They are still extensively used by trustees of defined benefit funds to manage member benefit entitlements, forfeited benefits, self-insurance liabilities and investment fluctuations.
However, reserves only have limited applications in most accumulation style funds, including self-managed super funds (SMSFs) that are not run as defined benefit funds.
This is because the members' entitlements are typically limited to amounts credited to their accounts, which can include contributions made or received, along with income and growth from the underlying investments.
Also, where reserves are used in an SMSF, the allocations will be counted towards the members' concessional contribution cap, unless certain exclusions apply. This imposes a significant restriction on the size of the reserves that can be created and subsequently used.
What types of reserves can be used?
The main types of reserves created by SMSF trustees are contribution reserves and investment fluctuation reserves.
Some funds create insurance reserves, however, there are some compliance risks associated with these and adverse tax outcomes can arise.
Changes to the types of benefits that can be provided has meant most of the other types of reserves are no longer available to accumulation-style SMSFs.
Monies held in a contribution reserve must be allocated to a member's account within 28 days after the month of receipt of the contribution.
This gives trustees some scope to manage contributions allocated to members' accounts at year end. This was acknowledged by the ATO in the NTLG Superannuation Committee meeting in June 2012.
Where contributions are made in the month ending on 30 June and allocated to a member's account within 28 days after the month that contribution was made, the contribution for contribution cap purposes is allocated to the next financial year.
The contribution remains deductible in the year of contribution, provided certain other conditions are met, and is potentially subject to tax as a taxable contribution in the year of receipt.
Investment fluctuation reserves
Investment fluctuation reserves are established by allocating income from the fund's investments to a reserve rather than a member's account.
These types of reserves double up as contingency or operational risk reserves for SMSFs to fund future liabilities, such as general insurance premiums or anti-detriment payments.
The opportunity to create investment fluctuation reserves arises because the allocation of income and capital growth (as well as the proceeds from an insurance policy) does not formally occur until accounts for the fund are finalised after year end.
This provides trustees with some flexibility to decide how much of the return from investments is to be allocated to members and how much is allocated to a reserve if desired.
Prior to being formally allocated, the money can be used to meet fund liabilities as they fall due without being treated as an allocation from a reserve.
Complications can, however, arise when allocating amounts to an investment fluctuation reserve where there is member direction as to investments and there are multiple investment strategies being implemented by trustees (and hence different earning rates for each member's account).
Allocating reserves to members
Regulations restrict the allocation of monies from reserves by trustees by penalising allocations that exceed certain limits. The relevant rules can be found in Regulation 292-25.01 ITAR 97.
Sub-section 292-25(3) ITAA 97 provides that amounts allocated from reserves as set out in the Regulations are to be treated as concessional contributions for the purposes of the contribution cap rules.
Regulation 292-25.01 ITAR 97 states that allocations from reserves are to be treated as concessional contributions unless certain exemptions are met.
Should the actual concessional contributions made together with allocations from reserves exceed the concessional contribution cap, then excess contributions tax is payable on the excess.
In this way, it is expected that trustees will avoid the application of the excess contributions tax and so limit allocations from reserves to amounts that will not cause a breach of that cap.
Reserve allocations which don't count towards the CC cap
Exclusions to allocations from reserves being treated as concessional contributions can be found in Sub-regulation 292-25.01(4) ITAR 97. This sub-regulation is split into two sets of rules in paragraph (a) and (b).
Paragraph (a) requires that amounts are allocated in a "fair and reasonable manner", and that the amount so allocated for the financial year is less than 5 per cent of the value of the member's interest in the SMSF at the time of allocation.
Should this limit be exceeded, the whole of the contribution would be treated as a concessional contribution, not just the excess.
It is quite clear that these rules in Paragraph (a) around allocation from reserves apply to members of SMSFs.
Paragraph (b) deals with reserves used solely for the purpose of enabling the fund to discharge all or part of its pension liabilities as they fall due.
The intention of the rules here, as evidenced by the Explanatory Memorandum accompanying the introduction of these Regulations, is to deal with allocations from solvency reserves supporting complying pension liabilities of a particular fund.
As SMSFs have not been able to commence complying pensions since 1 January, 2005, there is little scope for these rules to apply to SMSFs.
The strong indication is that it would not be appropriate to use amounts allocated from such a reserve to commence or add to an account based pension, for example. This was discussed in detail in ATO ID 2012/84.
A reserve set up in an SMSF where there are no complying pension liabilities cannot access the exemption in Paragraph (b) when amounts are allocated either to members' accumulation or account based pension accounts.
The use of reserves in an SMSF can provide flexibility for trustees by enabling them to plan and provide for future fund liabilities.
However, the consequences of over allocating amounts will result in the payment of excess contributions tax on the whole amount allocated from the reserve.
It is this penalty which is in place to discourage trustees from exceeding the limits and so controls the level of use of reserves and maintains the integrity of the contribution cap rules.
Peter Hogan is manager of SMSF Advice with NAB Wealth and MLC Advice Solutions.
Originally published by SMSF Essentials.