By Anthony Cullen
Senior SMSF Technical Specialist

If I were to ask the question as to what segregation means for an SMSF, I expect I would get common responses which include references to separating investments supporting pension and accumulation accounts, determining how a fund can claim Exempt Current Pension Income (ECPI) and the impacts of disregarded small fund assets.

The underlying theme here is tax implications for the fund, as outlined in the Income Tax Assessment Act 1997 and Regulations.

Whilst we certainly need to be aware of the tax implication, is that really all there is to consider when it comes to segregation?

With the introduction of 6 member funds we have seen an increase in queries relating to bringing children and/or their spouses into an existing fund and whether assets can be segregated to particular members.

The driving force behind this is asset or investment segregation more so than tax.  It is not uncommon for members at different stages of their lifecycle to have varying aversions to risk. For example, the children may be happy to consider cryptocurrencies while the parents are more comfortable with blue chip shares and some term deposits.

The Superannuation Industry (Supervision) Act 1993 (SIS) and Regulations are silent on the concept of asset segregation.  Having said that, SIS Regulation 5.03 does require trustees to allocate investment returns in a fair and reasonable manner, having regard to:

• All the members of the fund; and
• The various kinds of benefits of each member of the fund.

This could be interpreted as suggesting that different options are available, and it could be argued that allocating earnings based on certain assets being allocated to particular members, or to a particular member’s interests, would still be deemed fair and reasonable. 

Following on from this, whether a fund can segregate for investment purposes will be determined by the fund’s trust deed and the decisions of the trustees in accordance with said deed.

The ATO also acknowledge the concept of asset segregation on their website. On their page addressing the methods for calculating ECPI (QC21546) they have this to say in relation to the tax issues of using the proportionate method when the fund has disregarded small fund assets:

This change only limits an SMSF to using the proportionate method for the purposes of calculating ECPI. It doesn't limit a fund from segregating its assets to accommodate member investment choices, nor does it reduce the amount of ECPI a fund can claim. It just means the amount is calculated using the proportionate method. (Emphasis added).

As mentioned above, different stages of the lifecycle is a common driver for asset segregation between members. Other scenarios where differing investment choices may influence a trustee’s decision to look to segregate assets may include when business partners or siblings are in the same fund.  I’ve even seen separated couples stay in the fund together and look to separate their assets.

Example
Christian and Nathan are brothers and members of the Best on Ground Super Fund.  Christian commences a pension with $1.7m on 1 July 2021 and Nathan maintains an accumulation account of $425,000.  We’ll compare the difference between the fund remaining pooled and segregating for investment purposes (the fund would have been segregated for tax purposes if not for disregarded small fund assets).

Best on Ground Super Fund

Although rare, the above example could apply to single member funds as well i.e. assume that both interests belong to Christian.  The logic behind this is driven by the growth of one interest over another.

Tax

Regardless of whether you segregate for tax purposes or investment choice it is important to remember that an SMSF is taxed as a single entity. That is, the tax return is lodged based on the income derived from the fund as a whole and does not separately report details from various individual interests.

In the above example, due to disregarded small fund assets, the tax position of the fund is the same in both scenarios.  However, from an accounting point of view, in the segregated approach the franking credits are only applied to the pension account and alters the final allocation of the fund’s tax.

In relation to receiving the refund the trustees should ensure that it is either paid directly to the correct bank account or transferred to it within a short period of time. In addition to this, as the refund does not reflect what the pension interest is entitled to, any liability associated with the accumulation interest should also be transferred in order to make sure the transaction has been processed in accordance with the actual expectation.

As a side note, the same approach should also be considered when it comes to general expenses of the fund such as accounting/administration and audit fees.  Paying such expenses from one bank account will not necessarily cause the fund to not be segregated, but there is an expectation that adjustments are made to accommodate the allocation of the expenses.

In a similar way that SIS Regulation 5.03 requires investment returns to be allocated in a fair and reasonable manner, Regulation 5.02 requires costs to also be distributed in a fair and reasonable manner.

Most dedicated software programs will allocate general expenses on a proportional basis, even where they may only be paid from one back account. If not kept in check with transfers of assets (usually cash) between interests, a discrepancy between the interest and the value of the assets supporting that interest will grow over the years.   

Asset Holdings 

As with the taxing of the single entity, the ownership of any investments continue to lie with the trustees of the fund, regardless of any approach to segregation.

We often have conversations that include comments such as, “this asset belongs to member 1 or that asset belongs to member 2.” While I appreciate the sentiment and have probably been guilty of saying such things myself, it is not quite true. The assets belong to the fund and trustees make the decision whether an asset will be used to support a particular interest.

This is worth considering when it comes to the naming conventions of any asset holdings.  Segregated or not, assets should be held in the name of the trustees of the fund and, where possible, should also designate the SMSF as the beneficial owner.

To assist trustees in keeping track of asset allocations, an additional identifying designation may be used, where available.  Although not necessarily required, trustees often find running separate broker accounts, bank accounts etc administratively easier to manage separated assets.

The ATO confirm in TD 2014/7 that a fund can run a single bank account and remain segregated. However, it is expected that sub-accounts are maintained in order to clearly identify the segregated components.  

In the above example the Best on Ground S/F is receiving dividend income into the fund’s one and only bank account. The account started off being split 50/50 at the beginning of the year but will not be so come year end.  It will be up to the trustees to monitor all movements in the account to identify each member’s interest. From an administrative and practical point of view it may be less complicated to have separate accounts assigned to each member. 

A final thought

The major SMSF software systems all appear to have a slightly different approach to dealing with segregation. Can the software cater to your needs? What is the additional cost in both time and money to oversee and implement a segregated fund? Are separate funds a viable alternative option (can you get any more segregated)? 

Any decision to segregated should be considered on a prospective basis and should be well documented.  This includes consideration of the fund’s investment strategy and how risk/return, diversification. liquidity and ability to discharge liabilities is addressed for each distinct pool of assets. 

This article attempts to highlight that there is a difference between segregating for tax purposes and investment purposes.  Although asset segregation may be an option it does not mean it is the panacea to dealing with member choice.

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