Presentation at SPAA NC2011

1. Agenda Session format Consideration of a case study Tax, accounting, superannuation & financial planning aspects of paying income streams Decisions trustees need to make for their SMSF

2. Setting the Scene

3. Workshop Scenario Tony is 60 years of age & ready to retire & commence a market linked income stream Tony’s wife Tracey is 48 years of age & has no intention of retiring They are both members of their SMSF Tony’s account balance @ 30 June 2010 was $1.4M Tracey’s account balance @ 30 June 2010 was $630,000 SMSF investments are predominantly in direct Aussie shares, cash & international managed funds As trustees they have adopted a buy & hold strategy

4. Workshop Scenario Tony & Tracey have very different risk profiles but have a single investment strategy for the SMSF They considered having two different individual strategies but felt in the end it would be too complicated & expensive An annual investment return for the SMSF is calculated & allocated to member’s accounts on a proportionate basis Tony intends to commence his income stream @ 1 July 2011

5. Workshop Scenario Tony is aware there are tax benefits of starting an income stream He is aware that he will pay no personal tax on his income stream paid to him as he is 60 years of age However he has no real idea of the consequences for his SMSF & of any responsibilities he or Tracey may have as trustees He asks if there are any tax benefits for his SMSF? He also asks if he & Tracey can stay in the same fund now he is in pension phase So what are the issues here?

6. Tax features of commencing an income stream Transfer of member to pension phase: Not a taxable event Unrealised capital gains & losses reversed Tax effect accounting being used? No tax on income or capital gains on assets supporting the pension provided pension liability continues Possibly subject to exempt income calculation method if pensioners & non pensioners in same fund Reserves are generally taxable as do not form part of assets supporting pension Refund of unused franking credits

7. Workshop Scenario Tony has also asked if he & Tracey can remain in the same SMSF now he is intending to commence his income stream? The answer to this is that they can BUT what are the consequences for their SMSF?

8. Consequences of having both accumulators & pensioners in same SMSF Some part of income & realised capital gains taxable & some part exempt Segregated or non segregated method used to identify exempt income & realised capital gains SMSF treated as single tax entity CGT free movement of assets between pools Franking credits & other tax credits not apportioned & can be fully used to offset any tax liability of SMSF (including tax on contributions)

9. Tax issues around pension/accumulation mix Recognition of income & claiming of expenses Segregated & non segregated methods Calculation of capital gains Application of capital losses Appropriate valuation of assets

10. Recognition of income & claiming of expenses TR98/1 determination of income: receipts versus earnings Ruling applies to all taxpayers including SMSFs Recognises that receipts method is generally most appropriate for recognition of investment income Income such as dividends, interest, rent are recognised for tax purposes on a cash basis, when received

11. Recognition of income & claiming of expenses TR 93/17 – income tax deductions available to superannuation funds Incurred in gaining or producing assessable income, or Operating or working expense of the fund Not deductible if specifically incurred in gaining or producing exempt income General fund expenses apportioned if both exempt & assessable income

12. TR 93/17 – income tax deductions available to superannuation funds Assessable income can include contributions, net capital gains & tax credits Exempt income can include net capital gains & tax credits Benefit of tax credits to offset tax liability of fund not affected by apportionment of credits for calculation of assessable & exempt income Carry forward revenue losses applied against exempt income first Recognition of income & claiming of expenses

13. Segregated & non segregated methods Tax device to determine exempt pension income Interchangeable from year to year Does not require physical separation of pension assets from other assets Does not relate to separate account for different investment strategies being undertaken Is not a substitute for appropriate risk analysis & asset allocation

14. Segregated & non segregated methods S295-385 ITAA 97 exempt income from segregated current pension assets Assets invested or held in reserves at the time to enable fund to discharge all or part of its liabilities re super income stream benefits payable at the time Any excess difference between market value of identified assets & member’s account balance supporting benefit not treated as segregated current pension assets Applies to allocated pensions, market linked pensions or account based pensions

15. S295-390 ITAA 97 exempt proportion of income from current pension assets which are not segregated (either current or non current) Average value of current pension liabilities Average value of superannuation liabilities Value of particular liabilities signed off by actuary Based on fund’s assets, future contributions & expected earnings Certificate obtained before tax lodgement date Segregated & non segregated methods

16. S295-390 ITAA 97 exempt proportion of income from current pension assets which are not segregated (either current or non current) No current certificate No segregated current or non current assets Last value of superannuation lilabilities X Current value Last value of assets of assets Segregated & non segregated methods

17. Excluded from definition of ordinary & statutory income Assessable contributions -s295-385(2) ITAA 97 Non-arm’s length income -s295-390(2) ITAA 97 Segregated assets 100% of income & realised capital gains are exempt Non segregated assets Proportion percentage applied to assessable income & net realised capital gains Deductions applied only after this calculation Segregated & non segregated methods

18. Actuarial certificate must be obtained each year prior to lodgement of tax return – ss295-385(3)(b) & ss295-390(4) ITAA 97 IT2617 sets out guidelines for actuarial certificates Fund details & year of income Various values used & earning rate Statement that assets will discharge current pension liabilities as they fall due Actuary’s details Segregated & non segregated methods

19. No actuarial certificate is needed if: Segregated method is used Pension is one defined by Regulation – ss295-385(4) ITAA 97 Reg295-385.01 ITAR 97 defines these pensions to be: Allocated pensions Market linked pensions Account based pensions No equivalent regulation for s295-390(7) ITAA 97 Segregated & non segregated methods

20. Calculation of capital gains All SMSF assets subject to CGT whenever purchased Cost base is greater of the purchase price or 30 June 1988 market value (if held @ 30 June 1988) 2/3rds of net gain taxed @ 15% CGT is done as a separate calculation Capital losses applied against undiscounted gain first Net capital gain added to assessable income Net capital loss carried forward indefinitely until used to offset a capital gain

21. Application of CGT rules when determining exempt income Segregated method Capital gains & capital losses are ignored on assets in segregated pool only Capital losses are not “revived” to be carried forward if return to accumulation phase Non segregated method Net capital gain added to assessable income first, then exempt percentage applied to that assessable income Net capital losses carried forward in full until used

22. Segregated method advantages Can identify 100% of specific assets with large accumulated gains Can identify high income producing assets leaving growth type assets in accumulation phase Members can maintain sentimental attachment to specific assets Income accounted for separately & so easy to identify

23. Segregated method disadvantages Need to separately identify assets from accumulation assets Need separate bank accounts? Separate set of financial accounts must be maintained & audited All income kept separate & pension only paid out of this account Realised losses are ignored & cannot be carried forward

24. All expenses kept separate that relate specifically to pension assets Apportionment of general fund expenses only Difficult to segregate large lumpy assets? Segregated assets must be identified before commencement of pension & at beginning of each year Segregated method disadvantages

25. Non segregated method advantages All assets of fund can be kept together for accounting & administrative purposes Only one set of financial accounts must be maintained & audited Relatively simpler to administer Proportion of income tax free Proportion of all expenses deductible Can cater for large indivisible assets easily Net capital losses carried forward in full

26. Non segregated method disadvantages Proportion of income earned on assets assessable Proportion of net realised gains assessable Proportion of expenses non deductible Actuarial certificate required each year regardless of type of pension payable (subject to operation of s295-390)

27. Use of reserves Are unallocated amounts of money Do not belong to members of fund Do not form part of any retirement benefit or death benefit entitlement Are taxable even if fund is in pension phase Trust deed must not prohibit setting up and use of reserves S115 SISA allows reserves unless prohibited by governing rules

28. Reserves need an investment strategy Like having another accumulation account in SMSF S52(2)(g) SISA places obligations on trustees to manage reserves consistent with: SMSF investment strategy SMSFs capacity to discharge its liabilities as and when they fall due Use of reserves

29. Tony appreciates now that there are tax benefits for his SMSF in commencing an income stream However these all seem to be very technical issues to be addressed He asks if there is anything else he & Tracey can do as trustees to improve their overall after tax return? Workshop Scenario

30. Issues around investment of underlying assets Accumulation & pension pools of assets Which investments where? Tax consequences of decisions What are the members’ risk tolerances? Trustee responsibilities What are the investment objectives & strategy for the SMSF? Direction by members as to choice of investments

31. Investment of underlying assets Assuming a generic investment strategy for fund Assets which pay income with little capital growth Assets with strong capital growth & minimal income What allocation will minimise tax of fund as a whole? Timing of derivation of assessable income for tax Franking credits allocated across pools as SMSF is single taxpayer

32. Assuming a generic investment strategy for fund How relevant is the individual risk tolerance of the accumulator & pensioner? Tax benefit cannot be the dominant reason for allocation Tax benefit can be an incidental benefit Use the risk profile of member to support asset allocation decisions Investment of underlying assets

33. Trustee responsibilities & member direction APRA Circular No. II.D.1 Trustees have responsibility to: Formulate objectives & strategy Implement that strategy in choice of investments S52(2)(f) SISA & Reg4.09(2) SISR must be taken into account in the above process How does member direction fit in?

34. APRA Circular No. II.D.1 S58 SISA prohibits trustees from direction by others except SMSF trustees Members in SMSFs can direct how their super monies are to be invested Members will also have some control over the objectives & strategy of SMSF How does this affect trustee responsibility under s52(2)(f) & Reg4.09(2)? Trustee responsibilities & member direction

35. APRA Circular No. II.D.1 Trustees must still ensure investments are: Within the investment strategy of SMSF, and Still comply with the terms of s52(2)(f) & Reg4.09(2) Must also comply generally with SIS requirements In APRA’s view, trustees should reject directions to invest in assets which do not comply with the above points Potential loss of s55(5) SISA protection Trustee responsibilities & member direction

36. Tony & Tracey considered having separate investment strategies at one stage How would this fit into their asset allocation issues for tax purposes? Workshop Scenario

37. Issues around separate investment strategies More complex arrangements Greater monitoring of individual portfolios Less flexibility around which assets belong in which pool of assets as asset must fit specific investment strategy Greater justification for particular investment decision for reasons other than tax benefits

38. Separate allocation of income & capital gains Separate accounts to track the above Separate bank accounts to assist audit trail Free movement of assets between notional pools provided they are within the specific investment strategies Free movement without CGT consequences Issues around separate investment strategies

39. Strategies when starting a pension Investment strategy needs to be reviewed regularly Percentage ranges will change as pension minimums change and increase over time Investment timeframe may dramatically change due to health reasons May need to actively lock in gains to preserve capital which in turn may mean percentage ranges need adjusting Investment objectives set & need to be achieved

40. Last questions?