In the following webinar recording, Aaron Dunn, CEO and Co-founder Smarter SMSF and Rebecca Oakes, Technical Manager at Act2 Solutions discuss important insight into the most common issues and strategy considerations around ECPI within SMSF.
Aaron: Welcome everyone to today's webinar on the practical insights on ECPI. So I am joined today by Rebecca Oakes, so welcome back and thank you for being a part of today's session. Rebecca: Hi Aaron thanks for having me. Aaron: No worries. So what we're going to go through today of course everyone is the fact that we are going through the practical insights on ECPI. So what we're trying to do in the way in which we constructed today's session was to try and help you through the many questions that in particular Act2 get around certain ways in which ECPI exempt current pension income is calculated, but also then give you some further insights around ideas that you can be considering throughout that decision-making process so let's just go through and have a look at what we're going to be covering today.
So of course, whenever we run these training sessions, we have to put up our disclaimer that incorporates the fact that we have prepared this content as it stands under the laws today so please obviously take that into account. So, as I said before I'd like to welcome Bec. Bec is the technical manager at Act2 Solutions and she has been working within the actuarial technical support for about seven years now so she is an SMSF specialist at the SMSF association and of course has a Bachelor of economics from UTAS and an Advanced Diploma of Financial Planning. She is a very good golfer as well so I had the misfortune, or fortune, I don't know what we’d call it Bec, of playing golf together at the national conference in February earlier this year. We went off and played up at Top Golf, which was a hell of a lot of fun playing golf and actually having a few drinks at the same time and I think we may have finished one-all. I think that's probably the best way to think about it. Bec: I’m pretty sure you went last out of the group.
Aaron: So, what we want to cover in today's session is first we're going to spend some time looking at many of the common misunderstandings when it comes to the claiming of exempt current pension income. In particular, we're going to focus on the eligibility requirements around dealing with the segregated method and there's some different ways in which we need to look at this both in the context of disregarded small fund assets, but then also in the context of deemed segregated periods. So Bec will break down this information and we will also apply some polls throughout today as I touched on earlier to help ensure that you have an embedded understanding of the way in which the certificates need to be prepared, because if they are not prepared correctly, you can see some very distinct and different outcomes. So we're going to be showing you as well within the webinar what information you may need to also be incorporating inside your SMSF software to ensure that you actually get those right outcomes as well.
The other area we'll talk to is the calculation of exempt current pension income where we have periods of both accumulation phase and retirement phase, and this is something in particular as you start to talk to the advice elements of your clients again some misconceptions around the level of tax exemption that may or may not apply in that scenario when you're selling in the retirement phase, but you may have had periods of full non-retirement phase throughout that financial year, and how you can then overcome those things. We'll talk through some Covid considerations that have of course impacted pensions and more specifically, some ECPI considerations and strategy ideas around that and then finally we'll wrap up with some proposed measures from the first of July 2020 as well. Which we may see we may not see we just need to obviously keep track of what's happening within the federal landscape.
So let's start kick things off, Bec over to you in terms of what are some of the common misconceptions that you see here when we look at the requirements on eligibility to use the segregated method and they’re kind of remote to you.
Bec: right so the biggest misconception that we're seeing at the moment is understanding eligibility to use the segregated method. So, for the 2017/18 financial year and onwards actual certificate providers now need to ask whether the fund is eligible to use the segregated method for the given financial year. Now a common misunderstanding that we're seeing back from clients is they answer that question with ‘well, no, the fund doesn't have any assets set aside to be segregated so the fund must not be eligible to use the segregated method’. Now that's not how you go about answering the question. Essentially what the question is asking is, if the fund wanted to use the segregated method could it? Would it be allowed? To answer that question we need to refer to section 295-387 of the income tax assessment act. Now that act is called disregarded small fund assets
Aaron: Before we jump there Bec, can I just ask a question because the concept here when someone says ‘yeah but we haven't actually segregated any fund assets inside the fund’ segregation, when we look at it from an ECPI point of view, can be looked at in very different ways can’t it? So, we can specifically set aside assets and therefore that would be deemed segregated, but what other ways exist that would create a fund that would have segregated fund assets for the purposes of ECPI. Bec: Yes sure, so everyone is familiar with what you've just said about how you at the start of a financial year set aside an asset to be segregated, but from 1 July 2017 a different type of segregation has been implemented and essentially what it is where a fund is eligible to use a segregated unsegregated method and there are periods during the financial year with a fund solely supporting retirement phase those periods are deemed segregated and the fund has to use the segregated method for that period of time. Aaron: So that that concept has been you know somewhat legislated or interpreted now by the ATO that way. But ordinarily you know, if you if you had a mum and dad fund and mum and dad were a hundred percent pension phase for the entire year that is a quasi-form of segregation. Whilst they have ordinarily pulled all of the fund investments and proportionately allocated the benefits to them, they haven't needed to get an actuarial certificate in those circumstances, putting aside the disregarded small fund asset concept. But they haven't needed to because by default they're deemed to be I think that the legislation talks about where it's solely set aside to discharge the funds pension obligations or pension liabilities, so therefore by default it's deemed to be a segregated asset. So you do have these very different extremes, I guess, of what segregation means in the context of claiming ECPI . Bec: Yeah correct. So I guess everyone prior to 1 July 2017 were familiar with the concept if there was an entire year with the funds supporting the retirement phase then it would be segregated. But from 1 July 2017, a new concept has been implemented where the period can be much shorter than that it could be one or two days that a fund could be segregated.
Disregarded Small Fund Assets
Okay so back to disregarded small fund assets. So essentially this piece of legislation it's just a list of three requirements and if a fund satisfies all three requirements, then the fund will not be eligible to use the segregated method for the given financial year. And the technical terminology you would use is that the fund has disregarded small fund assets. So if you were to say there's no disregarded small fund assets, essentially you're saying the fund is eligible to use the segregated method. So let's just run through what those three requirements are.
So the first one is that at any time during the given financial year there is at least one superannuation interest supporting retirement phase within the SMSF.
The second requirement is just prior to the start of the financial year so 30 June a member within the SMSF has a total super balance that exceeds 1.6 million and they're also a recipient of a retirement phase income stream. Now that retirement phase income stream can be inside the SMSF or outside the SMSF. Aaron: So unlike, there will be scenarios where they might be running you know multiple pensions and and this covers of course that it may be a pension that actually sits outside of this message there may be retail fund or an industry fund or something, but we do need to bring all this back for the purposes of the calculation of TSP. And I think again that can be a common trap when working out whether this does or doesn't apply. Bec: Yes, correct, you need to be aware of the money that’s in Super that’s outside the SMSF.
And then the last third requirement is whoever satisfies requirement 2, that same member holds a superannuation interest within the SMSF. Whether that's in retirement phase or non-retirement phase.
So just to recap, if you satisfy all three of those requirements then the fund is not eligible to use the segregated method. So I guess having a look at those three requirements if you had a fund where you know all the members in the SMSF have a total super balance of less than 1.6 million you can know straight away that the funds eligible to use the segregated method as you know that they're not going to satisfy requirement 2.
Aaron: So this this for everyone's benefit you may recall you may not, but this was a this was a very deliberate policy setting by the federal government when they introduced the general transfer balance cap back on the 1st of July 2017 because what they didn't want funds to be able to do was to specifically set aside different assets within the fund and then move those assets in between segregated strategies to effectively eliminate tax as was ordinarily the case before 1 July 2017. So you didn't want to have a member that may have had four million dollars in Superannuation rolled back 2.4 and have 1.6 in retirement phase but then decide to move assets between the accumulation and pension phases to try and avoid the tax that would have ordinarily applied within the fund. So, on that basis, most of those clients are not eligible to apply the segregated method and therefore they would need to obtain the certificate which would work out that proportionate calculation of assets inside the fund. This is where we started to see clients looking at trying to run multi fund strategies, and again the ATO looking at part three requirements about those types of measures as well.
But just to finish off I guess on a superannuation context here is whilst there is an ability to or there's no ability to apply a segregated approach to the level of tax that would apply in those circumstances, there is an ability to set aside specific assets within multiple interests inside of members account so within an SMSF across pensions or accumulation account because you can from a sis perspective set aside and run member directed investment strategies. It does become very tricky complex around how you need to distinguish between accounting allocation and tax allocation, but technically that could actually occur.
But what we're really focusing on here is ultimately the fact that there would be no ability in this instance to be able to try and work the system because the certificate is going to have to be required and this and the actuarial certificate he's going to need to consider what has happened throughout that entire financial year in determining the calculation of ECPI.
Where is this Question Asked?
Alright Bec so here then I guess where is this question asked? Bec: yes okay so when you're applying for an actuarial certificate, if you're filling out the Excel form without two solutions it's a new section that we've added at the end of the form. So if you answer the question ‘yes the fund is eligible’. the forms actually smart enough to pick up on if there's any deemed segregated periods and then it will let you know in the table below. So in this example you can see the forms picked up from 1 July to the 30th of September it's deemed segregated. Now if you're completing the actuarial certificate process through BGL 360 it will actually ask you the question just prior to getting redirected to the actuary’s website. And a great thing that BGL do is they actually state what the total super balances are so you can double check them before you answer the question. Now if you're completing the application process through class or super made, class and super made they actually work out the answer for you and those in the back end they actually send us the answer. So unfortunately when you're applying for an actuarial certificate you don't actually get to see what answer has been sent to us, however when you get the actuarial certificate, we will state on the certificate what the answer was. I will go through that shortly how you can find that on the actuarial certificate.
Just before we go to that I just want to clarify how critical it is that within class and super made that you have the correct total Super balance recorded in there so if you have an SMSF where there's a member in SMSF that has money in super but outside the SMSF, you need to make sure that that information is recorded within the software so that class and super made are going off the correct total super balance and therefore setting us the correct answer. Aaron: So Beck so BGL so in simple fund 360 just looking at that sort of analysis that you've said there yeah even though simple fund 360 says you know the total super balance here for John and Mary Jones is is those figures, if you know they are different because they had external monies yeah you can still override by the buttons there whereas you can't do that inside class and super mate. Yes. So it is absolutely reliant upon the preparer to ensure that that TSP information is accurate in the software so that it can do those calculations.So then where is this obviously shown on the certificate?
Bec: okay sure so if you have a fund that’s eligible to use the segregated method then on the last page of the Act2 actuarial certificate, under instructions and notes, we will say that the fund there were no disregarded small fund assets. Which means the fund is eligible to use the segregated method. Then on the second page of the actuarial certificate that's where we state what the actuary's percentage. is and just below that we will highlight if there's any deemed segregated periods that we've picked up on. and so you can see in this example we've picked up on a deemed segregated period and then we're saying from the fourth of April until 30 June that is when the actuary’s percentage applies to ast that's when it's unsegregated. Now on the flip side if you've got a fund that's not eligible to use the segregated method, then under our assumption and note section it will say that there are disregarded small fund assets and that the funds not eligible to use the segregated method. Now where you have a fund in that's not eligible to use the segregated method then you can always expect to see that we will say that from the first of 1st of July to the 30th of June the at-risk percentage applies to as it is unsegregated. Aaron: so it's pretty much the old way of which we always knew how to do things.
Bec: Okay so what we're gonna do now is we're just gonna run through an example of how you go about answering the question on eligibility to use the segregated method, but then I want to go into highlighting what the ECPI implications are when you get the answer wrong, and how material that can be towards claiming exempt current pension income. So okay consider the wild and free Superfund and we've got two members: William and Sophie. So William holds an account-based pension valued at 800,000 and and he continues to receive this account based mention into the 2020 financial year now William he also holds an accumulation interest valued at $600,000 on 30 June 2019. And on the 1st of February 2020 William commences an account based pension with his entire accumulation balance. Now Sophie on the other hand, she has an account based pension valued at 1.1 million at 30 June 2019 and she continues to receive this account based pension into the 2020 financial year. Now the fund has chosen not to elect to segregate any of their assets and they intend on being unsegregated for the 2020 financial year.
Is the SMSF eligible to use the segregated method for the 2020 financial year?
So given this information it's the SMSF eligible to use the segregated method for the 2020 financial year? So we've just turned on the poll here and you've got some choices so we're looking here to see whether the fund or not can or can't use the segregated method. So your choices are ‘no as they've not elected to segregate any assets specifically of the fund’ or ‘no as they don't meet all three of the requirements that Bex spoke about before under Section 295 Freddie’ or ‘yes as they don't meet all of those three requirements, again that we spoke about before, or ‘I'm not sure’ and we've got that in there which is more than fine and this is very much the reason why we've done this session today, because it is all about helping you to break down how you need to go about determining whether the fund is eligible or not to use the segregated method in different in these different circumstances. So we'll give this another 10 or 15 seconds and then I'll turn the pole off, share that with everyone and then we will go through the answers with you and really the reasons why the answers are what they are and why they aren't some of the choices that may have been made as well. So I'll turn the poll off there so give you a three to one and that's it and then what I will quickly do is share the results with everyone so you can see there. Hopefully Bec you can see that information as well and let's now go into the response okay okay over to you Bec.
Bec: We’re just going to run through how you would have gone about answering this question. So on the left hand side of this table I've got those three requirements again that are under Section 295-387 so let's run through them and see if they satisfy all three of those requirements or not.
So the first one as you recall was: ‘at any time during the given financial year there is at least one superannuation interest supporting retirement phase within the SMSF’. Well yes William and Sophie both have a superannuation interest that's in retirement face for the 2020 financial year. So that's the first requirements been met.
Now the second requirement was ‘just prior to the start of the given financial year a member within the SMSF has a total super balance of more than 1.6 million and they are also a recipient of a retirement phase income stream’. So in this case no neither William or Sophie had a total super balance of more than 1.6 million. So because all three requirements have not been satisfied the fund is eligible to use the segregated method.
So the answer was answer three, so what's really important to understand here is that William and Sophie haven't elected to segregate any assets, they intended of being unsegregated but they because they didn't meet all three of those requirements the fund is eligible to use the segregated methods. So you would still say yes. And another as I talked about before another quick way to answer that question once you get confident with it is just a check William and Sophie's total super balances first and be like yep neither of them have more than 1.6 million ok straight away I know that the answer is yes they are eligible. Aaron: So that third step really only applies where it's kind of like a 2a isn't it. It's not one two and three it's one two and 2a. Because once 2a has failed three is irrelevant. Bec: yes correct.
Okay so why does it matter if you answer this question incorrectly? So I'm going to show you what it looks like from an actuary point of view when we received the correct answer compared to what it looks like when we receive the incorrect answer. So when we receive that ‘yes the fund is eligible to use the segregated method’, then we look for any periods during the financial year with the fund solely supporting retirement phase and put them as deemed segregated. So we know from the first of February to 30 June that this fund will be deemed segregated. And the earnings received during that period are a hundred percent tax exempt. So when we do our calculations we're only looking at the period one July and to the 31st January and in this scenario we've calculated as seventy six percent of tax exempt.
Now let's have a look at it if we receive the incorrect answer. Well if we received ‘no funds not eligible to use the segregated method’, then we would have to treat the fund as being unsegregated for the entire financial year and we would come back with a percentage of 85 percent tax exempt. Aaron: You've used a weighted calculation and haven't you right throughout the year. Bec: Yes. So even though the actuary percentage is higher when we in this example when we received the incorrect answer, what is really important to highlight is if, for example, this fund received a large trust distribution or capital gain somewhere between the first of February and 30 June, if we received the correct answer it would have been entirely tax-exempt under the segregated method. But if we receive the incorrect answer then only 85 percent of it would have been tax-exempt. So that's how it can be really material towards how much exempt current pension can be claimed.
Periods of Full Non-retirement Phase
Alright next topic. Okay periods of non-full retirement phase. So a common misunderstanding that we're seeing among clients is that some clients think periods solely supporting non-retirement phase are 100% taxable and the actuary percentage only applies to periods where there's a mixture of retirement and non-retirement phase. Aaron: so non-retirement of course being accumulation. Bec: Yeah, so that understanding is not correct. So, periods that are solely supporting non-retirement phase they're not being segregated in other words they're not deemed a hundred percent taxable a period that solely supports non-retirement phase is still an unsegregated period, and when we do our calculations we need to include all the unsegregated assets in our calculations including the periods that are solely supporting non-retirement phase. And then when the actuaries percentage is calculated it applies to all the periods that are unsegregated including periods that are a hundred percent not retirement phase.
So what I want to do now is I want to run through an example of how that works but I also want to go into a strategy that we've been seen among clients that they’re trying to implement and due to their misunderstanding of how non-retirement phase periods are treated this strategy is unfortunately backfiring on them quite a bit. So I'm going to show that in this example. So consider the End of the Rainbow Super Fund and we have one member Georgina so at 1 july 2019 Georgina is entirely in accumulation phase, and her accumulation interest is supporting an investment property valued at 500,000 and shares valued at 300,000. So Georgina commenced an account based pension with her entire balance when she turns 65 on the 1st of December and she also receives a low-income contribution and a co contribution totalling $1,000 on the 1st of March. Now let's just say for this example that the fund is eligible to use the segregated method for the 2020 financial year. Aaron: so there's no other assets outside of this that would push her above the 1.6.
Bec: correct yes so this is what it looks like for the End of the Rainbow Super Fund for the 2020 financial year. so as you can see Georgina is fully in non-retirement phase and then on the 1st of December she moves to full retirement phase and then on the 1st of March she moves back to a mixture of retirement and non-retirement phase.
Poll: How many periods are there for the purposes of calculating ECPI?
So we're going to do a poll now looking at that graph how many periods of it for calculating exact current pension income so is there one two three, or, ‘I'm not sure’. Aaron: So how do we need to actually break this this financial year out in determining tax exemption for the period here. So again, it's just for you to choose are we dealing with one period only so do we have a certificate that applies for all of the year do we have two periods here or do we have three periods again looking at the diagram that Bec went through or of course I'm not sure is always the great default option that you can go to as well. So quite an interesting one here Bec, so we'll give it another 15 seconds or so, so again how many periods do we have if you think back to that diagram to ensure that how we need to look at the calculation of ECPI. So what I'll do is shut that down now so I'll turn that off and we'll share the results. So we sort of had about half two periods a third three periods so thank you. So Bec let's move back to understanding this a little bit further, over to you again.
Bec: Sure so the answer was two periods. Because the fund was eligible to use the segregated method and we have a period where it's solely supporting retirement phase from the first of December and to the 29th of February it would be deemed segregated. And then even though we have two unsegregated periods in this example there's only one actuarial percentage that will need to be calculated that will apply to both those unsegregated periods. So when you calculate exempt current pension income there's only two periods that you would have to calculate it for. Aaron: So that's a by-product of that contribution coming in is now really tied the March to June part of the year to the first five months of the year.
Alright cool so let's go through some of the common mistakes here then. Bec: Okay so what I was talking about before about a strategy that we're seeing that it's backfiring quite a bit because of their misunderstanding. So let's say that Georgina she tells herself she thinks okay first of July until the 30th of November I know I'm solely supporting accumulation, so I must be a hundred percent taxable for that period. And then Georgina thinks to herself okay from the 1st of December until the 29th of February I know my funds eligible to use the segregated method, so I must be deemed segregated for that period. then Georgina thinks to herself alright from the first of March until 30 June I know I'm in a mixture of retirement and non-retirement phase so I'm going to need an actuarial percentage for that period. But because most of my money is in retirement phase for that period I reckon I'm going to get an actuarial percentage of 99% tax exempt. Now Georgina she wants to sell a property during the year and she tells herself okay and it works best for me if I sell the property sometime between March and June but that's okay because most of the money is in a retirement phase and I'm going to get a really high percentage. So Georgina ends up selling the property on the 15th of April and then at the end of the financial year she applies for an actuarial certificate. And so we come back to Georgina and we say okay yes Georgina we agree with you there is a deemed segregated period from the 1st of December till the 29th March. However then we come back with a percentage of 44% tax excempt and Georgina is horrified and confused those economies Aaron: you get abused I'm sure. Bec: We explained to Georgina that when we do our calculations we include all the unsegregated assets in our calculations and a period that solely supports non-retirement phase is an unsegregated period so we had to include the 1st of July until the 30th November in our calculations and that's what's drastically brought down the tax-exempt percentage. Unfortunately we actually see that scenario quite a bit.
So let's do some strategy considerations that Georgina could have done to avoid this situation. So there it is with no strategy that we just went through. So a strategy that Georgina could have implemented is that she could have commenced a pension on the 1st of December with her entire accumulation balance less ten dollars. So if Georgina leaves ten dollars in accumulation phase what she's done is ensured that there's an accumulation account running for the entire financial year. When we do our calculations we look at and say the funds unsegregated for the entire financial year and we would have come back with a tax-exempt percentage the 58 percent rather than 44 percent because we would have included the period 1 December to the 29th of February in our calculations. Aaron: We're still we're still a fair way down from where she initially thought it was going to walk away with 99 percent wasn't she.
Bec: Yes so there is another strategy with Georgina could have done one better. What she could have done, she could have commenced a pension on the 1st of December with her entire accumulation balance, and then when she received the contribution on the 1st of March if Georgina knew that the sale of her property was coming up let's say she anticipated that it was going to be on the 15th of April she could have withdrawn her entire accumulation account just before the property was sold. So let's say the 1st of April, and what that would have done was it would have been assured that the property was sold during a deemed segregated period, meaning that the entire capital gain would have been tax exempt under the segregated method. Now the downside of that is that it would have drastically reduced the actuary’s percentage down to 16%. However, if Georgina knew that the majority of the income received for that financial year was going to be from the sale of that property then this strategy would have worked out really well for her because she would be getting an entirely tax exempt under the segregated method.
Aaron: So timing - it's the old saying- is that timing is everything now when it comes to this calculation so if we go back if we go back to the previous slide for a second you know this was all about if the old method didn't worry about the timing of income your calculation to get 58% was a basis of when income was earned in flows outflows and that sort of thing. However, strategically and we know this happens very regularly where people go yeah sure let's try and get this sale of the property in retirement phase tax-free, or as much as possible with tax-free, so we need to then very acutely consider the timing and what stage the, what phase I should say, the fund’s income streams are in or the members benefits are in because that is going to make a very big difference because if we get the timing of that wrong as you said we've now gone from 58% potentially down to 16.8 percent, versus if we get it done and we then get that sale contract date right being the 15th of April we've now got an eighty three and a bit percent benefit by actually you know nailing that strategy correctly with your SMSF clients.
COVID-19 Pensions Considerations
Alright so let's now take a look at then this next area around some Covid considerations because we have seen the government announced as part of their economic response some changes to minimum pensions that were to be paid for this current year and then also for the next financial year.
Bec: Yeah so we just want to confirm that SMSFs will still be eligible to claim exempt current pension income in the 2020 and 2021 financial year if they only withdraw 50 percent of their account based pension minimum percentage factor. So for example let's say for the 2020 financial year you have a member that's required to withdraw four percent of their opening pension balance they can now only withdraw two percent and they'll still be entitled to get exact current pension income
Aaron: Yep and I would suggest that people have a look at a lot of the ATO FAQs around this particular area that they've got on their COVID-19 page, because not only does it talk about the fact that the minimum has been reduced and this really has just been inserted into the pre-existing schedule within the SIS regulations that was introduced back when the GFC occurred so that provides us with that 50 percent exemption. But it also deals with some considerations around whether if you've not taken more than the pension minimum amount reduced minimum out can you recontribute that amount, how you may whether you may want to deal with that benefit differently prior to when this legislation was introduced, whether you now also want to contemplate the format in how you may want to treat the benefit payments from the introduction of these measures. So if you've already met the minimum you may also want to be considering how to take any above minimum amounts in particular if they're from an accumulation account because you might want to be improving the tax exemption inside an SMSF, or whether you actually want to undertake a commutation as a bit of a transfer balance cap clawback strategy which is also quite common these days as well.
Bec: So if you have members that are paying market link, pension rather than the minimum payment factor being 90 percent of the calculated payment amount it's now dropped down to 45 percent for the 2019 and 2021 financial year. So due to the COVID-19 and the market conditions some SMSFs may want to consider implementing strategies to ensure that they can carry forward any anticipated capital losses that they expect to receive. For example they may need to sell an asset to be able to meet the minimum pension standards and know that they're gonna realize a capital loss. Aaron: So they might you know the Liquidity and the fund they might take the pension once a year and the reality is even if they might want to sell at this point in time, they may need to actually sell particular assets to be able to meet the pension obligations and that is important there's no concession here to meet the standard, you must meet the standard, the standards just been reduced in respect to the minimum amount that must be taken and I should just note on the market linked pension whilst that lower limit so what was the the ninety percent has been reduced to 45, that upper limit of one hundred and ten percent of the calculated amount based upon the pension valuation factor remains at a hundred and ten percent.
Carrying Forward Capital Losses
Bec: yeah alright so let's just go through carrying forward capital losses. So capital losses can be realised when a capital gain tax event occurs during an unsegregated period. And any net capital losses can be carried forward. However if a capital losses occurs during a segregated period, it must be disregarded and therefore the capital loss cannot be carried for it.Aaron: Yep so we've got very distinct tax legislation that deals with, in essence, the the different methodology here between the two. I think it's section 118320 that if you've got segregated assets you need to simply ignore and that's why inside the tax return you then have all these zero yet blank labels everywhere in the SMSF and your return, versus using the method statement when you work out the calculation for a net capital gain or loss, and therefore the ability to carry forward that capital loss.
Bec: Yeah so for SMSF that are anticipating that they're going to be realising a capital loss in the next coming months or so, there is a strategy that they can implement to ensure that they're able to carry forward that capital loss. Let's go through an example to show you what and what they can do.
Consider the Let The Good Times Roll Super Fund. We have two members, Karen and Dean. So at 1 July 2020 Karan has a balance of nine hundred and thirty thousand which is solely supporting accumulation phase. And Karen plans on retiring on the 1st of November 2020 and will commence a retirement phase income stream at that date. Now Dean on the other hand he's just receiving an account-based pension for the 2021 financial year. So there are no elected segregated assets in this fund, however, the SMSF is eligible to use the segregated method for the 2021 financial year. Now the fund holds an investment property which is valued at nine hundred thousand, and it's looking to sell this shortly after Karen moves into retirement to ensure that the fund has more liquidity to facilitate pension withdrawals. However due to unfavourable market conditions from COVID-19, they're expecting a capital loss from the sale of this investment property. So that's what it looks like for the 2021 financial year for this fund.
Poll: Can the Capital Loss Be Carried Forward?
So having a look at that and let's say that the property is sold on the 1st of December, if you have a look at that graph: Can the capital loss be carried forward? Aaron: Let's turn the poll on here as well. So we want you to answer this whether as Bec said, ‘can this capital loss be carried forward?’ so first option is ‘yes the investment property is not an elected segregated asset’ so the net capital loss can be carried forward, or ‘no the investment property is not an elected segregated asset so therefore the net capital loss can be carried forward’, or ‘no the fund is eligible to use a segregated method for that financial year so all capital losses must be disregarded’ or ‘I'm not sure’, which once again is not a problem, you're here to learn .So we seem to have a very distinct answer here on this one Bec, so I will leave this on for another 10 or 15 seconds and we've got about half the audience that has voted so far. So again just trying to understand here how we would need to treat this, and what we're going to talk about in the answer is some of the considerations that you might want to contemplate based upon that scenario. So I will stop the poll there and share the result in a second. So we can see the results on the screen there and then I will stop that share back and we will carry on.
Bec: Okay, because the fund was eligible to use the segregated method it's going to be deemed segregated from the 1st of November to 30 June. So all the earnings received during oh sorry, and so any capital losses realized during that period are going to have to be disregarded. So because the property was sold on the 1st of December during the deemed segregated period, it must be disregarded and cannot be carried forward. Aaron: Yep so the answer there is ‘no’, so they got that one correct So it must be disregarded okay.
Bec: Let’s run through a strategy. So let's say that this time Karen she commences a pension on the 1st of November with her entire accumulation balance less $10. So by Karen leaving $10 in accumulation phase ensures that there's an accumulation account running for the entire financial year. Which means that the fund has to be unsegregated for the entire financial year. So it doesn't matter at what point the property's sold during the financial year, it's going to be sold during an unsegregated period, meaning that the capital loss can be realized and carried forth.
Why it may be important?
Aaron: I guess the interesting thing here Bec, people were probably saying ‘well does it actually really matter or not here why I might want to look at in the crystallization of this capital loss look to actually leave an amount in accumulation or create an environment that will allow me to carry forward’. I just raised a couple of things here as to why people may want to utilise that. Now an obvious one may be the fact that we may be looking to add members into the fund in the future, so it could be that you know on the basis that we may still see in the future the government has made that commitment earlier this year at the SMSF national conference, senator Jane Hume did indicate that the government was still committed to increasing the number of members in an SMSF to 6. So we may see more and more people looking to add children into the fund for example. So therefore you will have very distinct age groups within the fund and therefore there may be or there would of course be a future benefit of that of that capital loss being applied if you had younger members added into the fund.
I think the one that is more relevant however, is where in the future upon the death of one of the individuals inside this fund is that the survivor of those two is ultimately going to come up with an excess transfer balance account issue because we know if for exactly use a reversionary here as an example, and the trigger of that excess amount after twelve months from the date of death, the individual is going to have to make some decisions about whether they pull money out of superannuation or whether they roll money back to the accumulation phase. Then you're going to end up in this scenario of course where the fund is going to have to get a certificate that will apply a proportion of percentage to the retirement phase income streams and then apply a percentage to the accumulation account that now sits inside that fund. So in that instance, utilising or trying to retain that capital loss is going to be critically important, because it would enable them if they ended up selling assets in the future, and again that fund would have disregarded small fund assets at that future point in time so therefore we would be able to apply those capital losses proportionally against any capital gains that would occur in the future. That would be the one that I see as being critically important in this process. So thinking about these things as you're working through this right now, in my view make sure you're spending the time trying to understand and analyse what might be the right approach. Is there anything you want to add there Bec? Bec: No you’ve covered it all.
Proposed ECPI Changes
Aaron: Excellent. Alright so the other thing here just to finish off on is we are still awaiting further guidance from Treasury ultimately here in the first instance around some proposed changes that were announced in the federal budget last year. We do know that this year's federal budget has been postponed down to October, but one of the measures, or there were two lots of measures that were announced in that federal budget. One related to the extension of contributions post 65 so extending that out to age 67 and that that legislation was drafted by Treasury went through consultation and now sits as a bill inside Parliament and is likely that we might see that go through Parliament in the sitting days in the middle of June. However, simultaneously in that budget we did see a couple of announcements that were trying to fix red tape measures around the determination of ECPI. One of those is around a proposed choice model that would apply in determining ECPI. It's kind of a bit of a back to the future with Michael J Fox here, where in essence it's going to enable the fund to choose which method it would like to utilise in determining ECPI for the year.
So as Bec has talked through today, and you can see there in the in the green box, is we now have this concept of looking at different periods and the way in which income is received in those periods to determine whether we have to apply a deemed segregated approach or get a certificate or combination of bot. What this choice model is going to allow, if this is the way that obviously this all transpires, is that you will be able to determine or go back to the old set of laws if you believe that that would be a better tax outcome for the fund. So as I said this is a measure that was proposed to start first in July 2020. We haven't seen anything come from the government at this point in time or Treasury so we do need to wait I suspect therefore it's not as critical because if the measure start from first July 2020, it would relate to the 2021 return. But again we do need to find out and get further detail before we can obviously start to contemplate this further.
Now the budget papers quite interestingly spoke to the fact that they didn't see this as better, they thought it as revenue neutral to the budget. Now given that the amount of money that they're spending at the moment, even though they are 60 billion dollars back in favour, is that this is going to make a very important distinction and benefit based upon this choice. As Bec just went through in that capital loss scenario the way in which we are ultimately going to treat a disposal of that asset, that you can see on the point marked X, is going to come up with a very different tax outcome based upon the method. So again going back to the second examples that we spoke about, and the timing of how we dealt with the sale or disposal of that asset, meant that we were either potentially ignoring the gain in its entirety or we were paying potentially as low as 42 or even 16% if we got that calculation wrong.
So here, and again looking at our capital losses same scenario can apply, where this would allow us to either ignore the gain or potentially carry that game forward. So it is going to become critically important for us to understand how the tax differences may look to apply in the future, and if it does reference the fact that we are able to provide a choice, then I presume that we would see some form of election process to do so. And therefore, even though it is being driven by a tax benefit here, that fact that there would be choice provided into the legislation and we certainly wouldn't be able to see any sort of part for a measures apply in those circumstances.
Removing Certain Actuary Certificates
The other thing, and this was a bee in my bonnet since the legislation was introduced, and finally again once this obviously becomes law, is that where we have a fund that was at say 30th of June 2017 one had a TSP that member of 1.5 million dollars we didn't or we don't need to get an actuarial tax certificate, because the fund doesn't have disregarded small fund assets. However, through good performance, when we get to the 30th of June 2018 we now have a fund that has a members benefit and they have retirement faith benefits. And that TSB is over 1.6 million, so we're going back Bec to the calculations that we said right at the very beginning here, and that doesn't necessarily just need to be in this fund, it could be in multiple funds. But at that point you've now got to get an actuarial certificate for a hundred percent tax exemption. So it was an absolute nonsense outcome, and luckily it's only taken a couple of years, but luckily we are now trying to see a fix to this that will put an exception into the concept of disregarded small fund assets to allow for this to occur.
Bec we were having a conversation I think the other day about this as well, because this methodology here also impacts the capital loss scenario that we spoke about before. Because if the member is TSB at the 30th of June, previously was under 1.6 million dollars, then we are simply ignoring all of those capital losses. However, if the members benefit grows to above 1.6 at the immediate preceding financial year, we actually now have to get a certificate that determines 100% tax exemption. Which therefore would suggest that we would be able to carry forward that capital loss, because we're not looking at 295 385, we're looking at section 295 390 in determining that calculation.
Bec: Yeah exactly, they're being forced to use the unsegregated method. And as we talked about previously, when a capital loss is realised during an unsegregated period, it can be carried forward. Aaron: yeah absolutely. So at this stage as I said we don't have any draft legislation. I would presume that this would be going out for consultation as well so it would be nice to get some certainty around this sooner rather than later. But at this stage we are waiting to hear something further
So that pretty much wraps up. Bec, we do have some questions so I'll revert back to those shortly. But thank you to those of you that have joined us today. If you do have any specific questions that you'd like to ask from today's session, I encourage you to get in contact with you Bec. So what's the best way to get in contact with you?
Bec: If you call number (1800 230 737) normally I'm the first person to pick up. Send an email to firstname.lastname@example.org.
Aaron: Very good alright, well that is it's as I said we do have a few other questions there but I guess from my point of view thank you for being a part of today's session. I think it's a really good practical insight into the way in which individuals need to be regularly thinking about how ECPI applies, but also then laterally thinking about the strategies and stuff moving forward. Because you can't do stuff after the fact. So therefore you know you do need to be thinking about these things and encourage you know talking to you as well you know that's you're there as a technical support. So if people want to bounce ideas and stuff off I mean that's very much what you're there to do, to make sure that when the certificate gets applied for ,it actually matches what the intention was as part of the strategy.
Alright well I'm going to just stop the recording there but we do have a range a question so but so for those of you that do need to leave please feel free to do so, we will create a Q&A podcast with any other questions that are around as well and we'll get that shot out to you as well. But to Bec again thank you very much, it's been great and we hopefully will do another one later in the year or even maybe at our SMSF day, subject to whether we actually see some of that legislation as well.