The Transfer Balance Cap and Capped Defined Benefit Income Streams

In this article, we revisit one of the most significant measures of the recent superannuation changes – the transfer balance cap. In particular, we consider the special rules that apply to certain capped defined benefit income streams.

What is a Capped Defined Benefit Income Stream?

Special income tax and transfer balance cap rules apply where a person commences, or was already receiving (as at 30 June 2017), certain income streams. The relevant legislation refers to these income streams as Capped Defined Benefit Income Streams (CDBIS). In addition to any other income stream types that may be prescribed by regulations, table one outlines the types of pensions and annuities considered to be a CDBIS.

A typical CDBIS defined benefit lifetime pension promises a defined series of payments for life. Typical recipients may include former government employees and defence force personnel, although some publicly listed companies may also offer this type of superannuation benefit to their employees.

Table 1: Capped defined benefit income streams

Pension type	Will be a CDBIS if commenced…
Certain lifetime non-commutable pensions or annuities	At any time
Lifetime annuities	Before 1 July 2017
Life expectancy pensions and annuities	Before 1 July 2017
Market linked income streams	Before 1 July 2017

Source: AMP

How is a CDBIS taxed?

From 1 July 2017, the tax concessions available to income payments from a CDBIS are limited to the total income payments for the financial year which are less than the defined benefit income cap.

The defined benefit cap is calculated as the general transfer balance cap for the financial year divided by 16. So, for the 2018-19 financial year, the defined benefit income cap is $100,000 (i.e. $1.6 million divided by 16). 

Typically, CDBIS income payments are broadly subject to the tax rates shown in table 2 below.

Table 2: Taxation of income payments from CDBIS

Age at time of receiving income payment	Tax-free component	Taxable (taxed) component	Taxable (untaxed) component
Under preservation age	Nil	Marginal tax rates**	Marginal tax rates*
Preservation age to 59		Marginal tax rate less 15% tax offset*	Marginal tax rates*
60 or over		Tax-free	Marginal tax rate less 10% tax offset*

* Add Medicare levy.

** Income streams payable resulting from permanent incapacity or death receive a 15% tax offset.

Source: AMP

However, where total annual income payments from CDBIS’ exceed $100,000 (i.e. the defined benefit income cap), additional tax is payable.

In these situations, where the CDBIS is payable entirely from a taxed source, 50 per cent of the excess income above the defined benefit cap (i.e. 50 per cent of the income above $100,000) will be included in the member’s assessable income and taxed at their marginal tax rate.

As outlined in table two, superannuation income stream benefits payable from an untaxed source are generally added to an individual’s assessable income, with the benefit of a 10 per cent offset (after age 60).

However, excess defined benefit income (i.e. above the $100,000 defined benefit income cap) from an untaxed source, will not be entitled to the 10 per cent tax offset. (i.e. the 10 per cent tax offset is capped at $100,000).

The level of excess defined benefit income, where the income stream benefit is payable from an untaxed source, is worked out by applying the person’s untaxed defined benefit income stream payments to any amount remaining of their defined benefit income cap after having first applied the tax-free and taxed source defined benefit income.

Valuing a CDBIS for Transfer Balance Cap (TBC) purposes

While in some circumstances there may be a need to refer to regulations to work out the appropriate TBC value of a CDBIS, where the CDBIS is a lifetime income stream, its TBC value will typically be based on its annual income entitlement multiplied by a factor of 16.

The annual income entitlement is worked out by annualising the first income stream benefit payment amount from the income stream over an income year.

For the other types of CDBIS referred to earlier, their value for TBC purposes is likewise based on the annual income entitlement. However, this annual entitlement will instead be multiplied by the remaining term for the income stream (i.e. the number of years (rounded up) remaining on the term product).

Example 1: Valuation of lifetime CDBIS

On 20 September 2018, Sarah (aged 60) commences a lifetime defined benefit pension from a taxed superannuation fund source. Under the terms of the pension, Sarah is entitled to receive $2,000 every fortnight. Sarah’s first payment in 2018-19 is $2,000 and is referrable to a 14-day period.

Her annual entitlement is accordingly worked out as follows:

$2,000 / 14 × 365 = $52,142.86

Applying the multiplication factor of 16, Sarah’s pension has a value of $834,285.71.

A credit of this amount arises in Sarah’s transfer balance account, and in this example is clearly within her personal transfer balance cap of $1.6 million.

As explained later, this valuation won’t have any practical relevance unless Sarah is also receiving or commences to receive a non-CDBIS retirement phase income stream (e.g. an account-based pension (ABP) in retirement phase).

Further, as the annual income from this (her only CDBIS) is less than $100,000 p.a., the yearly $100,000 defined benefit income cap will have no impact.

As she has already attained age 60, all the income from her lifetime pension will accordingly remain tax-free.

In simplified situations where a person in the retirement phase will only ever receive superannuation retirement income from CDBIS sources, the transfer balance cap, with all of its credits/debits and procedures, can be regarded as being somewhat theoretical.

This is due to the fact that the income stream is non-commutable, meaning it is not possible to apply the transfer balance cap concept whereby any excess above the $1.6 million would otherwise be required to be commuted and rolled back to accumulation or removed from superannuation altogether.

Instead, to provide a similar reduction in tax concessions, increased tax (as explained above) will potentially apply where a person’s yearly income stream payments from their CDBIS sources exceeds $100,000.

Income combination type situations

The added transfer balance cap complexity, including the need to value a CDBIS, comes into focus in situations where a person has (or commences) both a CDBIS and any type of commutable retirement phase income stream (e.g. an ABP).

In these income combination type situations, it will be necessary to apply a modified transfer balance cap calculation, requiring the value of each income stream, including the CDBIS, to be calculated and credited to the person’s transfer balance account.

Ordinarily where a person’s transfer balance account exceeds their transfer balance cap, they will have an excess transfer balance. However, where the person has a CDBIS, the value of their excess transfer balance is modified by a two-step calculation that works out the lesser of the following two amounts:

• Amount one: the person’s transfer balance account less their transfer balance cap
• Amount two: the person’s transfer balance account less the balance relating to their CDBIS.

What this effectively means is that a CDBIS cannot by itself result in an excess transfer balance. As such, any excess transfer balance will be limited to the transfer cap credit relating to the non-CDBIS (see example two below). 

Where the modified cap calculation is exceeded in these combination situations, some or all the commutable income stream(s) must be commuted and either rolled back to accumulation or removed from superannuation altogether.

The CDBIS will typically remain intact, but additional tax will also be potentially payable where the yearly income it generates is more than $100,000.

With an account based non-commutable CDBIS, although the account balance may exceed the person’s pension transfer balance cap, the tax exemption on the earnings of the assets backing the CDBIS remains in place.

Example 2: CDBIS and excess transfer balance

On 1 August 2018, Jane (age 61) starts to receive a lifetime defined benefit pension with a value of $3 million ($187,500 pa ($15,625 monthly) income times 16).

At this stage, this is her only income stream benefit and so the credit balance in her transfer balance account is $3 million made up entirely of the $3 million capped defined benefit balance.

Although Jane’s transfer balance account ($3 million) exceeds her $1.6 million transfer balance cap (‘amount one’ above), Jane does not have an excess transfer balance because the transfer balance excess is entirely attributable to her CDBIS (i.e. ‘amount two’ will apply and is equal to nil).

The result is that Jane is not required to reduce her non-commutable lifetime pension but will instead be subject to additional income tax in relation to her CDBIS defined benefit income amount that exceeds $100,000 pa.

Example 3: CDBIS and reduced excess transfer balance

Following on from Jane in example two above, let’s consider what would occur if on 1 January 2019 Jane also decides to purchase an ABP using $200,000 she had accumulated in another fund. This pension is not a CDBIS.

The $200,000 is also credited to Jane’s transfer balance account, which now increases to $3.2 million.

For the purposes of the above modified calculation, Jane now has an excess transfer balance of $200,000 (the lower excess amount applying the above two-step calculation) being the amount by which her transfer balance account ($3.2 million) exceeds her ($3 million) capped defined benefit balance amount.

Jane will accordingly be forced to commute the ABP stream and roll back to accumulation or remove the amount from superannuation altogether. She will also be subject to excess transfer balance tax.

A potential trap... When is a market linked income stream not a CDBIS?

A rather simple observation to be made from reading table one is that a market linked income stream (MLIS) which commenced on or after 1 July 2017 (e.g. a new MLIS funded from the commutation and rollover of a pre-1 July 2017 MLIS) is not a CDBIS. 

Theoretically, this means:

• Where a pre-1 July 2017 MLIS (i.e. a CDBIS) is commuted, a debit should be applied to the member’s transfer balance account;
• The purchase price of the new MLIS (i.e. not a CDBIS) will be applied as a credit towards the member’s transfer balance account; and
• The $100,000 pa defined benefit income cap will not apply to the new MLIS. That is, where paid from a taxed fund to a person age 60 or over, income payments will be tax-free.

However, according to the Australian Taxation Office’s (ATO’s) view:

• The commutation of a MLIS after 1 July 2017 produces a nil debit to the member’s transfer balance account; while
• Commencing a new MLIP will result in a credit to the member’s transfer balance account. 

Without the corresponding debit to reflect the value of the initial commutation, this means that some individuals may inadvertently find themselves in excess of their transfer balance cap as a result.

Notwithstanding the Commissioner’s view on this matter, the ATO believe this is an unintended consequence of the legislation and are working with Treasury to rectify this issue.

Given the uncertainty surrounding this area, we recommend that clients defer the commutation and rollover of a MLIS until legislation is implemented to rectify the issue.

Alena Miles is technical strategy manager at AMP.