By Mark Ellem
The income an SMSF earns from its assets to pay pensions is exempt from income tax. This is called exempt current pension income (ECPI).
There are two methods used to claim ECPI. First, the unsegregated or proportionate method, which uses an actuary to determine the percentage of the fund’s eligible income that will be exempt from income tax. The actuary must provide a certificate to support the claim for ECPI.
Second is the segregated method, whereby assets are set aside to pay pensions, that is, assets of the fund are identified as specifically belonging to member pension accounts. Income from these assets are tracked and claimed as exempt from tax. Similarly, income generated by the remaining assets, that effectively belongs to the member accumulation accounts, is tracked to ensure that it is included as assessable income of the fund.
For an SMSF that has both accumulation and pension accounts simultaneously throughout the financial year, the unsegregated method is most commonly used as it’s administratively easier than the segregated method. The unsegregated method treats all the fund assets as one pool and there is no requirement to track income between pension and accumulation accounts.
An SMSF that only has account-based pension is referred to as a ‘100% pension fund’, that is, there are no member accumulation accounts. The ATO treats this type of fund as a fully segregated fund, that is, the fund has set aside all of its assets to pay pension benefits to members. The fund will claim ECPI under the ‘segregated method’ and is not required to obtain an actuarial certificate.
It is common ‘industry practice’ to simply apply the unsegregated method for the entire financial year. However, the correct approach is to apply both methods to the relevant portion of the financial year. Let’s look at an example:
Bill and Joan are members of their SMSF. At the start of the financial year, Joan, who’s retired, has an account-based pension and no accumulation account. Bill is not retired and has an accumulation account. Their respective member balances are split roughly 50/50.
Bill retires from work at the end of December, there’s a party, gold watch, the works. Bill commences an account-based pension on all of his accumulation account on 1 January.
This means that from 1 January, the SMSF is a 100% pension fund, that is, from 1 January the SMSF has a segregated pension account and the income from those assets can be claimed as exempt from fund 15% income tax without the requirement to obtain a certificate from an actuary.
As the fund did not set aside specific assets to fund Joan’s account-based pension, the fund would need to claim ECPI under the unsegregated method and obtain a certificate from an actuary to apply to all of the fund’s eligible income derived during the first half of the financial year.
As previously mentioned, it has been ‘industry practice’ to claim ECPI for Bill and Joan’s fund for the entire financial year using the unsegregated method. That is, an actuary-issued percentage that will apply to all the fund’s income for the entire financial year. Given that for six months of the financial year, 50% of the fund was in pension accounts and for the other six months, 100% was in pension accounts, you would expect an actuarial certificate with an ECPI percentage of around 75%. Therefore, 75% of all the fund’s income for the entire income year would be exempt from fund 15% income tax.
Firstly, it’s an incorrect application of the law, according to the ATO, and I for one support this view. Section 295-390 ITAA 1997 is the relevant provision for claiming ECPI under the unsegregated method. As outlined above, it says that you cannot claim as exempt, under this provision, income from:
For a fund that is 100% pension, the income derived is income from segregated pension assets and would be claimed as exempt under section 295-385 and consequently you cannot apply the ECPI percentage to that income.
Secondly, it could result in the fund paying more tax. Let’s say Bill and Joan’s SMSF derived $100,000 of assessable income in the year. If it was derived uniformly throughout the year, the claim for ECPI under each method would be as follows:
Method 1
Apply unsegregated for the entire year (industry standard)
Method 2
Claim first half using unsegregated method and second half under segregated method
So, it’s the same under both. What’s all the hoo-ha about?
What if included in the $100,000 was a net assessable capital gain of $40,000 from the sale of an asset in the second half of the financial year and the remaining $60,000 was derived uniformly over the financial year? Let’s recalculate now:
Method 1
Apply unsegregated for the entire year (industry standard)
Method 2
Claim first half using unsegregated method and second half under segregated method
That’s an extra $10,000 claim for ECPI, which is a reduction to the fund’s tax bill of $1,500. Bill and Joan would be happy if their SMSF accountant correctly applied both the segregated and unsegregated methods to the relevant period in the financial year, rather than using ‘industry practice’. This comes about as any CGT event in relation to a segregated pension asset is disregarded, however, if the unsegregated method is used for the entire financial year, effectively you are making a 100% exempt capital gain, partially assessable.
Whilst the ‘industry practice’ may be perceived as an easy method to adopt for a fund that is 100% pension for only part of a financial year, it may not result in the best tax outcome for an SMSF. The timing of income received, particularly capital gains on the disposal of a fund asset, if skewed to the period of the financial year the fund was 100% pension, would warrant the application of both the unsegregated and segregated method to get the best tax outcome for the SMSF, which is the correct application of the law.
Of course, from 1 July 2017, an SMSF or Small APRA Fund (SAF) is not able to use the segregated method to claim ECPI where at least one member has a retirement phase interest in the fund; the member has total superannuation exceeding $1.6m at 30 June prior; that same member was receiving a retirement phase pension just before the start of the year; and that same member had a super interest in the fund, at any time during the income year. For these SMSFs and SAFs, they will have to use the unsegregated method to claim ECPI for the entire income year. However, the issue of which method to use to claim ECPI for unaffected SMSFs and SAFs, will continue.
