Application of the proportioning rule after ceasing a pension
Issue raised
Is the trustee of an SMSF required to completely recalculate the tax-free and taxable portions of a member's superannuation interest where the pension member has 'rolled back' their pension into accumulation phase (for a short period of time) and then subsequently decided to recommence a pension using the same superannuation entitlements?
Background information
It has become increasingly common for members of SMSFs to reconsider the benefits of receiving a pension from their superannuation fund in light of falling investment returns and a volatile share market.
In many cases, members who were in pension phase have decided to undertake an 'internal rollover' whereby they convert their superannuation pension back into accumulation phase. This decision is being made so that the members can avoid 'drawing down' any more of the superannuation entitlements and allow the fund to avoid realising any large losses. Naturally, this decision means that the superannuation fund loses the pension asset exemption on those assets which were originally being used to support the payment of the pension to the member of the fund.
Invariably, members who have confronted the above situation have then decided to recommence receiving a new pension from their fund given the recent recovery of equity and property markets.
In most cases, members who then commence a new pension (that is, second pension) have not made additional contributions into the superannuation fund whilst the fund reverted, albeit temporarily, back into accumulation phase. Despite this, there may be some income and other accretions that may have been received by the fund during the period the member's entitlements were in accumulation phase.
In these circumstances, the biggest compliance challenge facing trustees is then calculating the tax-free and taxable components of the member's superannuation interest when they commence the second pension (often referred to as the new pension) from the same original superannuation interest. In other words, the biggest question being asked is how do the trustees of the fund calculate the tax-free and taxable components of the second pension?
In practical terms, do the trustees of the fund calculate the tax-free and taxable components of the pension without regard to the original proportions calculated with the original pension or do the trustees need to include these proportions when applying the proportioning rule for the second (that is, new) pension?
Industry view / suggested treatment
Unfortunately, there are two views on the application of the proportioning rule in the above circumstances.
On a more literal interpretation, the trustees of the fund are required to completely recalculate the tax-free and taxable proportions at the start of the second (new) pension without regard to the tax-free and taxable proportions that were applied to the original (that is, first) pension. Such an outcome arises on the basis that paragraph 307-195(3)(a) requires the taxpayer to calculate the tax-free and taxable proportions of a superannuation interest 'at the commencement' of the pension. It is contended that the fact the taxpayer may have previously commenced a pension with the same (or similar) superannuation entitlements does not disrupt the application of this provision.
Another interpretation applies a more liberal reading to the application of paragraph 307-125(3)(c) in these circumstances. Under this interpretation, it could be argued that the taxpayer must go back to the original tax-free and taxable components that were calculated at the commencement of the first (that is, original) pension and these proportions need to be taken into account when determining the proportioning rule on the new (that is, second) pension.
Technical reference
Section 307-125
Impact on clients
Unknown at this stage
Priority of issue where ATO view is required
High - It is understood that the above situation has become almost common place and advisers are still unsure about how to apply the proportioning rule. It is therefore contended that this issue is addressed as soon as is possible.
ATO initial response
Yes. Where a member of a SMSF commutes their pension in full and 'rolls back' the remaining balance of their pension account to the accumulation phase within the fund, the trustee must recalculate, in accordance with section 307-125 of the Income Tax Assessment Act 1997 (ITAA 1997), the tax free component and the taxable component of any new benefit subsequently paid from the fund.
This requirement arises because the full commutation of the pension changes the member's superannuation interest in the fund from one that was supporting a superannuation income stream to a new accumulation interest.
The following provides a simple example of how the components of any new benefit paid in the circumstances contemplated in the query are to be recalculated.
Bob, a member of an SMSF, commenced an account based pension on 1July 2008 with the full amount of his accumulated superannuation savings.
The opening pension account balance was $100,000.
The tax free component (TFC) percentage of Bob's pension interest is 50% and the taxable component (TC) percentage of the pension interest is 50%.
Bob decides to commute his pension in full on 30June 2009 and rollover his remaining pension account balance back to the accumulation phase within the fund.
His remaining account balance is $60,000, reflecting a payment to Bob of $20,000 and negative investment returns of $20,000 during the 2008-09 year.
As per paragraph 307-125(3)(c) of the ITAA 1997, the TFC of Bob's commutation lump sum is $30,000 and the taxable component is $30,000.
Bob decides to commence a new account based pension on 1July 2010 with the full amount of his new accumulation interest.
As at the time just before the new pension is commenced, the balance of Bob's new accumulation interest was $80,000 comprising the $60,000 lump sum resulting from the full commutation of his original pension and $20,000 positive investment returns.
It is assumed for simplicity that Bob made no contributions to or withdrawals from his new accumulation interest prior to commencing his new account based pension.
As at the time just before the new pension is commenced, the TFC percentage of Bob's new accumulation interest is 37.5% ($30,000 / $80,000) and the TC percentage of the interest is 62.5% (100% - 37.5%).
Hence the TFC percentage of Bob's new account based pension is 37.5% and the TC component is 62.5%.
Meeting discussion
The chair talked the members through the question and the ATO's initial response and invited the member who submitted the question to comment.
Members agreed with the response provided.