Death & Super Case Study

Transcription

1 Andrew Andreyev, Principal Andreyev Doman Lawyers June 2012

2 1 The background facts A. Fred (60) and Jane (51) are in a de facto relationship. B. Jane is married to George, but they have been separated for 10 years. They have not divorced or entered into a formal property settlement. C. Jane has two children with George, Judy (27) and Elroy (23). D. Judy is married to Henry, and they have a young child, Astro (2). E. Elroy still lives at home and is studying full time. F. Fred also has two children from a previous marriage - Dino (30) and BamBam (26). BamBam has a mental disability and lives with Fred and Jane. Married (separated) De facto relationship George Jane (51) Fred (60) Wilma Deceased Lives at home and studies full-time Henry Judy (27) Elroy (23) BamBam (26) Dino (30) Married to Henry with one young child Mentally disabled and lives with Jane and Fred Lives out of home and in estranged from Fred Astro (2) G. Up until recently Jane owned and ran a successful company, Sprocket Industries Pty Ltd, which manufactures cogs. Jane acquired the shares in Sprocket Industries in This year she sold the shares in Sprocket Industries Pty Ltd for $3 million, and intends on accessing the small business CGT concessions to minimise her tax. H. Jane and Fred have a self-managed super fund - 'the Galaxy Fund'. This fund has been around since Jane was married to George. I. Member benefits within the Galaxy Fund are: o Jane: $1 million; o Fred: $600,000; and o Elroy: $10,000. J. The Galaxy Fund has individual trustees, Jane, Fred and Elroy.

3 2 K. The Galaxy Fund has three main assets: o A residential investment property in Queensland ($550,000); o The retail premises formerly used by Sprocket Industries ($800,000); and o Listed shares (the balance). L. Jane has as small life insurance policy in the Galaxy Fund with a payout value of $500,000. M. Fred owns his own home, where he, Jane, Judy and BamBam live. N. Fred has retired. Jane has been meeting the bulk of the family's day to day living costs. O. Fred has given his son Dino his Enduring Power of Attorney. P. Jane has not updated her Will since separating from George 10 years ago. Her Will appoints George as Executor and leaves all of her Estate to George, and then to her 'Children'. 'Children' was defined to be children of her marriage with George, i.e. Judy and Elroy. Q. Jane has an old binding nomination in place for the Galaxy Fund for all her super to be paid to her Estate (made in 2000). R. Fred does not have any nomination in place. S. The Super Deed for the Galaxy Fund has not been updated since 2001.

4 3 George No EPOA No EPOG No Will No Nominations No EPOG Jane s Will (20+ years) Jane (51) Fred (60) Dino George Binding Death Benefit Nomination (2000) Super Fund Deed (2001) Enduring Power of Attorney Jane and Fred s Objectives Jane wants to provide for Fred during his lifetime, but then wants her Estate to pass: o Half to her children, Judy and Elroy; o One quarter to support BamBam (but not Dino); and o One quarter to be put into an Education Trust for her grandchildren. Jane wants to protect the entitlement of her children from third party claims. (1) Income stream for life Jane (51) DECEASED (2) Residual capital Fred (60) 25% 25% 25% Henry Judy (27) Elroy (23) Grandchildren BamBam (26) Education trust Following BamBam s death Nominated Charity

5 4 Fred believes that Jane can look after herself. Fred has been estranged from Dino for about 10 years, and only wishes to leave him a small nominal amount of $50,000. Fred wants all of his wealth to be left to support BamBam. On BamBam's death he would like any remaining capital to go to a charity that provides residential care for children with mental disabilities. $50K Jane (51) Fred (60) Balance of Estate BamBam (26) Following BamBam s death Dino (30) Nominated Charity What are the issues? How should Jane deal with the proceeds from selling Sprocket Industries? What would happen if no further planning was implemented by Jane or Fred? What can be done by Jane and Fred to ensure that their objectives are met? Sale of Sprocket Industries Small business CGT retirement exemption We assume that Jane passes the threshold tests for accessing the CGT small business concessions. Given she has owned the shares in Sprocket Industries since 1995 she may qualify for the small business CGT '15 year retirement exemption'. A number of further tests must be satisfied, including the shares qualifying as an 'active asset' for half the ownership period, and Jane must 'retire' as a consequence of the sale. Alternatively she may seek to apply some of the other exemptions, such as the general 50% CGT discount, the 50% active asset exemption, and the $500,000 retirement exemption.

6 5 As she is under 55 she would need to contribute the relevant amount to a complying super fund to qualify for the $500,000 retirement exemption. This contribution would not be subject to contributions tax in the super fund, and would form part of the 'taxfree component' of Jane's super interest. CGT cap amount If Jane is willing to retire, and thereby access the 15 year exemption, she could then make further super contribution from the proceeds of the disposal of the shares in Sprocket Industries - up to her lifetime 'CGT cap amount'. These additional contributions are excluded from her non-concessional contributions cap. The amounts that count towards the CGT cap amount (and which are excluded from the non-concessional contributions cap) are: Up to the $500,000 disregarded under the small business retirement exemption; The capital proceeds from the disposal of assets that qualify for the small business 15-year exemption; and The capital proceeds from the disposal of assets that would qualify for the small business 15-year exemption, but do not because: o the asset was a pre-cgt asset o there was no capital gain, or o the 15-year holding period was not met because of the permanent incapacity of the person (or a controlling individual of a company or trust). Jane could therefore make total contributions of the tax-free proceeds from the disposal of Sprocket Industries, up to her 'CGT cap amount'. In the income year the CGT cap amount is $1,255,000. Total amount contributed to super So in summary, Jane could contribute: $500,000 under the CGT retirement exemption; A further $755,000 of sale proceeds, to take Jane up to the CGT cap amount; $450,000 in non-concessional contributions (assuming no past bring-forward); and $50,000 in concessional contributions (prior to June 2012, otherwise only $25,000). This would make a total of $1,755,000 in super contributions. Contribution of these proceeds from the disposal of Sprocket Industries will increase Jane's 'superannuation interest' in the relevant fund. For present purposes we will assume that Jane simply contributes these proceeds to the Galaxy Fund. However, as noted later, there may be a real benefit in Jane establishing a new super fund to receive these proceeds - so that they are held in a separate 'superannuation interest'.

7 6 Summary of outcomes Jane will avoid/reduce the CGT on the disposal of her interest in Sprocket Industries. She will maximise the extent of assets in her super fund, which can provide a taxfree income in her old age. The character of Jane's superannuation interests In order to understand the consequences of a benefit paid from Jane's super fund on her death, it is necessary to understand the components of her super interest. Jane's super will be made up of both her pre-existing member account balance (pre Sprocket Industries), and the additional contributions made as a result of disposing of Sprocket Industries. Undeducted contributions CGT exempt amounts Pre-83 contributions Post-6/94 invalidity Crystalised segment (pre-2008) Insurance Policy Crystalised in 2008 Income Year Taxed element Untaxed element Contributions segment Non-concessional contributions CGT cap amount Concessional Contributions Life insurance proceeds Government schemes Sprocket Industries (proceeds) Tax-free component Taxable component taxed element Taxable component untaxed element $3 million From a super and tax perspective, Jane's superannuation interest will comprise two main categories: A tax-free component; and A taxable component. The taxable component can include an element: o taxed in the fund; and/or o untaxed in the fund. The tax-free component The tax-free component of Jane's super interest is the total value of the following segments: The 'contributions segment'; and The 'crystallised segment'.

8 7 The contributions segment includes all contributions made from 1 July 2007 that have not been included in the assessable income of the fund. The $500,000 small business CGT retirement exemption amount, the additional $755,000 CGT cap amount, and the non-concessional contribution amount, will all be included in the contributions segment of the tax-free component of Jane's superannuation interest. The crystallised segment includes the components of Jane's interest that would have been consolidated into the tax-free component in the 2008 income year, namely: The concessional component The post-june 1994 invalidity component; Un-deducted contributions; The capital gains tax (CGT) exempt component; and The pre-july 83 component. The crystallised segment is calculated by assuming that an eligible termination payment (ETP) representing the value of the superannuation interest (less any untaxed part of the interest, if any) is made in respect of the member just before 1 July The taxable component The taxable component of Jane's super interest is calculated by subtracting her tax-free component from the total value of her superannuation interest. The taxable component of a super interest may consist of an element 'taxed in the fund' and an element 'untaxed in the fund', depending on whether the benefit is paid from a taxed or untaxed source. If the Galaxy Fund has claimed (or intends to claim) tax deductions on premiums paid for Jane's insurance policy, the taxed and untaxed elements of the taxable component of a lump sum death benefit may be increased by a proportion of her super benefit as follows: Taxed element = taxable component x service period / (service period + time to retirement) Taxed element = $500,000 x 15 / ( ) Taxed element = $258,620 Untaxed element = taxable component taxed element Untaxed element = $500,000 - $258,620 Untaxed element = $241,380 The tax status of Jane and Fred s super and other family assets is summarised below:

9 8 Summary of superannuation interests Jane Fred Tax-free component $1,705,000 - Taxable component - taxed $1,308,620 $600,000 in the fund Taxable component - $241,380 - untaxed in the fund Total super interest $3,255,000 $600,000 Summary of total 'family' assets Jane Fred Super interests $3,255,000 $600,000 House - $750,000 Cash at bank $1,245,000 - Total assets $4,500,000 $1,350,000 The consequence of these components and elements is discussed further below. What would happen if Jane takes no action before she dies? Jane's Existing Will If Jane has only informally separated from George Jane's informal separation from George will not have revoked Jane's Will. Accordingly, George is still entitled to receive all of Jane's Estate under her existing Will. 100% Grandchildren Judy (27) Jane (51) DECEASED George BamBam (26) Elroy (23)

10 9 If Jane formalises her divorce with George Jane's divorce from George will not revoke her Will completely. However, it will revoke any benefit to George (as a former spouse). Accordingly, George will not be entitled to any benefit, but Jane's Estate will then default to Jane's two children, Judy and Elroy. This would not include BamBam. Jane's divorce will also revoke George's appointment as Jane's Executor. If there is no named 'replacement Executor', someone will then need to apply for 'letters of administration' to administer Jane's Estate, or the Public Trustee will take on this role. However, Jane's divorce will not revoke George's appointment under her Will to act as the 'trustee' for the bequests left to Judy and Elroy (because they are George's children). This would be relevant if Jane's Will established longer term testamentary trusts, or if Jane and George's children were under 18 (which is not the case here). 50% Judy (27) Grandchildren Jane (51) DECEASED 50% Elroy (23) BamBam (26) Summary None of Jane's objectives would currently be met. If this outcome arose, then a number of parties may have a claim under the family provision inheritance legislation, most notably, Fred as a de facto spouse, and possibly Elroy as a dependent step child. Effect of Jane's existing Binding Nomination The effect of Jane's existing binding nomination to the Galaxy Fund will depend on whether her Nomination is valid and still binding. If the nomination is valid and still binding Whether the nomination is valid will depend on whether it has been made in accordance with the provisions of the deed regulating the Galaxy Fund (the 'Super Deed'), as well as any SIS Act requirements. This may require certain formalities to have been satisfied, such as signing in front of witnesses, and acceptance by the trustees of the Galaxy Fund. This should not be assumed either way. It is possible to both not properly formalise an intended binding nomination, and to informally make an unintended binding nomination. A valid and binding nomination is usually evidenced by:

11 10 The signed Nomination; and Minutes of the trustees of the super fund confirming acceptance. Given the age of the Nomination (12+ years) it would ordinarily be invalid if given to a public-offer fund - as they need to be updated every 3 years. However, this limitation does not necessarily apply to a self-managed super fund. That said, the Super Deed must make provision for non-lapsing binding nominations. Many old super deeds incorporate the 3 year requirement under the SIS Act. If this is the case, then the Nomination would no longer be binding. 1 It may be necessary for Jane and Fred to update the Super Deed for the Galaxy Fund. Jane's separation or divorce from George will not of itself revoke her Binding Nomination with the Galaxy Fund. However, it is possible for the Super Deed to provide that permanent separation or divorce does invalidate a binding nomination. This is an issue that should be addressed in the Super Deed update. If the nomination is valid and binding, then all of Jane's super from the Galaxy Fund will be paid to her Estate (in accordance with the existing Binding Nomination), and then on to George (as per her existing Will). 100% Jane (51) DECEASED George If Jane and George get divorced, then the super benefit would then flow to Jane's children, Judy and Elroy. BamBam and the grandchildren would still not benefit. 50% Judy (27) Grandchildren Jane (51) DECEASED 50% Elroy (23) BamBam (26) 1 Whilst all other superannuation funds must comply with the requirements of SIS Reg 6.17A of the SIS Regulations and section 59(1A) of the SIS Act, the Commissioner has confirmed in SMSF determination, SMSFD 2008/3 that SMSFs are not bound by the three year review and renew process.

12 11 If the nomination is not valid or not binding If Jane's Binding Nomination was either not validly made in accordance with the Super Deed, or is no longer binding on the trustee, then where Jane's super goes will be left up to the discretion of the trustees of the Galaxy Fund - in this case, Fred and Elroy. Elroy has always been jealous of Judy's academic and financial success, and therefore may not wish to make any distribution to her. Elroy could 'do a deal' with Fred to split the super between Fred and Elroy, and exclude Judy. This is what effectively occurred in the Katz v Grossman Case. Galaxy Fund Grandchildren Judy Elroy Fred BamBam Can the payment of Jane's super interest be challenged? If things were left as they were, and Fred and Elroy decided to split Jane's super between themselves, Judy and/or BamBam may wish to challenge their actions. Challenging trustees with regard to how they pay super benefits raises a host of complex issues. The following only touches on the key issues. Superannuation Complaints Tribunal Because the Galaxy Fund is a self-managed super fund Judy and BamBam would not be able to apply to the Superannuation Complaints Tribunal ('SCT') to have the decision reviewed. The SCT simply does not have jurisdiction. If the fund was a 'public offer' APRA fund then an application to the SCT would be possible. It is worth noting that the SCT does not review decisions of trustees on their merits. The SCT is required to determine whether the decision was 'fair and reasonable' in its operation in relation to the complainant in the circumstances. (See the fair and reasonable test in section 37(6) of the Superannuation (Resolution of Complaints) Act). Bring an action in the Supreme Court The Galaxy Fund is a 'trust', and is therefore subject to the equitable jurisdiction of the Supreme Court of NSW (and the other states), as well as the provisions of the Trustee Act. A person with 'standing' can bring an action to the Court seeking a number of things, including:

13 12 To compel the trustee to properly perform their duties and powers under the trust. They may argue that the trustees have a conflict of interest, and that a distribution to the trustees represents a breach of trust and a breach of their fiduciary duty to act in the best interest of the beneficiaries. Of course, Fred could direct his share directly to BamBam (provided he qualified as a SIS dependant). They may argue that the trustees did not consider the interests of the full range of beneficiaries; To seek relief for any breach of trust by the trustee. For example, an accounting of the money distributed; and To petition the Court for the removal of the trustees. There are a number of hurdles to bringing a successful action in Court: Do they have standing to bring an action to compel proper action, and remove the trustee? Under Section 92 of the NSW Trustee Act, Judy and BamBam would need to establish that they are persons "interested in the property" of the fund. Are Judy and BamBam beneficiaries? Given that the super fund is essentially a discretionary trust with respect to Jane's beneficiaries, Judy and BamBam are only likely to have a 'mere expectancy' (in the absence of a binding nomination). Is there anything in the Super Deed that would give Judy and BamBam any particular entitlement? This needs to be looked at in each particular case. If Judy and/or BamBam do have standing, then the relief they may seek includes: Accessing information about the management of the super fund; Requiring the fund be properly administered in accordance with the Super Deed and principles of equity; Applying to the Court to challenge the improper exercises of the trustees discretion; and Applying to the Court to prevent any distribution being made to beneficiaries outside the class of beneficiaries specified in the Super Deed. Under the current law, even if the Court finds that the trustees have breached their duties, the Court cannot generally replace the erroneous decision. The Court is bound by trust law to remit the decision back to the trustees for their reconsideration (unless there are exceptional circumstances). This becomes a weapon that trustees use in litigation, i.e. even if you win, the matter will only be referred back to us. All that said, it is difficult to successfully challenge a trustee s decision in Court. However, this may be the only avenue available to Judy and BamBam - particularly if Jane's Estate is not based in NSW.

14 13 Inheritance family provision legislation If the super is paid to Jane's Estate, then the distribution of the super in accordance with Jane's old Will would clearly be subject to review under most State inheritance family provision legislation (see later below about how this would work). However, if the super interest is paid directly from the Galaxy Fund to one or more SIS dependants, review under the inheritance family provision legislation becomes more difficult. This is because the super never falls within Jane's 'personal Estate'. However, if the Estate is subject to NSW law, then the family provision sections of the NSW Succession Act 2006 provide a real avenue to attack a distribution from the Galaxy Fund directly to Fred and Elroy. Under the NSW Succession Act 2006, a Court, in considering the merits of a challenge, has regard not only to both the Jane's personally owned assets (and assets paid into her Estate in consequence of her death), but also to Jane's broader 'notional estate'. In NSW, Jane's 'notional estate' will include assets such as: The unallocated net assets of a 'family trust' (i.e. not including loans and unpaid allocations of trust income or capital); The balances of Jane's member accumulation accounts and account based pensions in her super funds; and Assets gifted by Jane within 3 years prior to her death. Reversionary pensions that could have been converted to a non-reversionary pension within 3 years prior to the initial pensioner s death and joint tenancies may also fall within the meaning of 'notional estate'. In NSW the family provision sections are very broad in their application. Jane's act (or omission) in making the original Binding Nomination, and in not updating the nomination, may be reviewable acts. The NSW Courts have applied the notional estate provisions in the Succession Act 2006 to superannuation, even though superannuation is generally subject to federal laws. People who may make an application include: A spouse, including a de facto spouse; A child; A grandchild; and A person wholly or partly dependent on and part of a household with the deceased. This is likely to include BamBam, given that he has lived with Jane and Fred. It is important to be aware of the time limitation for bringing an action. In NSW a person must bring an application for family provision orders within 12 months of the deceased s death. It is important to remember that the ability to challenge an estate works both ways - in that the potential of a challenge fetters a client's ability to decide who gets their assets after they have died.

15 14 Summary of outcomes George may end up with all of Jane s estate if they do not formalise their divorce. Judy and Elroy may end up with all of Jane s personal estate if a divorce is formalised. George may end up with all Jane s super, if her Binding Nomination is still valid and they are not divorced. Judy and Elroy may end up with all Jane s super if her Binding Nomination is still valid and a divorce is formalised. Fred and Elroy may end up with all Jane s super if the Binding Nomination is not valid or binding. Providing Fred with a life interest in Jane's super Can a life interest be paid to Fred out of Jane s super? Under the super laws a death benefit can be paid in several possible ways: The provision of a Superannuation Lump Sum. This can be paid either in cash or the distribution of an asset in specie, and directly to a SIS dependant or to Jane's personal Estate; The payment of a Superannuation Income Stream. This can only be paid to someone who is both a SIS dependant and a tax dependant; and The payment of a Reversionary Superannuation Income Stream. This must also be paid to a SIS dependant and tax dependant. This is the continuation of an existing Superannuation Income Stream that was payable to Jane prior to her death. So Jane is entitled to direct the payment of a superannuation income stream (or pension ) from her super interest.

16 15 Is Fred entitled to receive a pension from Jane's super interest? In order to receive a Superannuation Income Stream from Jane's super: The Super Deed must provide for the payment of such benefits; and Fred must qualify as both a 'SIS dependant' and a tax dependant. The following table summarises these definitions: As a de facto partner, Fred qualifies as both a 'SIS dependant' and a tax dependant'. How would the pension be set up? Jane could provide the Galaxy Fund with a Binding Nomination for an Income Stream Benefit to be established for Fred from the Galaxy Fund following Jane's death.

17 16 If Jane was in pension phase by the time of her death, she could nominate Fred as the 'reversionary beneficiary' in the pension itself. Rather than a reversionary pension, she may wish for the capital to revert to accumulation, and then be used to establish an Income Stream Benefit for Fred. In this manner, greater control could be imposed over the benefit, keeping Jane's pension simpler. [See later in relation to how the capital is to be dealt with.] Limiting Fred's rights over the super balance Issues arise as to what happens: If Fred tries to commute the pension prior to dying, and withdraw the money? or If Fred dies and nominates his own beneficiary to receive the capital value supporting his pension. There are two possible approaches to ensuring that the capital value is available for Jane's intended beneficiaries when Fred dies: Adopt a binding 'Death Benefit Rule'. Under this approach the Death Benefit Rule would provide that: o Fred cannot commute the pension; and o On Fred's death, the capital balance is to be paid to Jane's children, or into Jane's Estate. Provide for any capital balance to pass into Fred's Estate on his death, but enter into a 'Deed of Mutual Wills' with Fred. Under this approach Fred would contractually agree with Jane (and her successors) to leave the capital balance on trust for Jane's children in Fred's Will. The law in this area is not well settled, and there is little case law to rely on. A combination of these two strategies is often advisable. Adopting a Death Benefit Rule Under this approach Jane would enter into a Binding Death Benefit Rule with the Galaxy Fund. The Super Deed would need to provide for the giving of such rules by the member, and the acceptance of such rules by the fund. Often this is not the case in the formal document, because they are based on industry fund templates. This is an issue that should be addressed in the Super Deed update. The Binding Death Benefit Rule would require the Galaxy Fund to establish a super income stream benefit for Fred during his lifetime. This would specify such matters as: The form of the payment as a pension benefit; The monetary limits of the pension. This could include overall and annual limits; The duration of the pension. In this case, for Fred's life but it could be stated to end at an earlier time or on an earlier event; The fact that the pension benefit is not commutable;

18 17 The fact that the terms of the pension benefit cannot be amended without the consent of both the pension recipient (to protect Fred), and the future beneficiaries of the capital (to protect the children and grandchildren); The fact that Fred does not gain an interest in any capital - but merely has a right to the pension payments during his lifetime; and That Fred is not able to amend the terms of the Super Deed to alter the terms of the pension (without appropriate consents). Under this scenario we would argue that the super interest represented by the remaining capital is Jane's following Fred's death, i.e. it reverts back to her account. Jane's Binding Death Benefit Rule would then need to provide what happens on the cessation of Fred's pension. The choices are for the capital to be paid directly to one or more of Jane's 'SIS dependants', or to be paid into Jane's personal Estate. One issue is that Fred may outlive Jane's SIS dependants (i.e. Judy, Elroy and BamBam). This is problematic because the SIS Act provides that the benefits can only be paid to the member s dependents or the member's personal Estate - and Jane's grandchildren (or the estate of any of her deceased children) do not qualify as a 'SIS dependant'. To avoid this issue, the rule would need to provide that the capital is paid to Jane's personal Estate, and is then dealt with via the terms of her Will. In this manner, the pension terms and Jane's Will need to interact with each other. Jane could then make provision via her Will for any default superannuation proceeds to be passed on to the relevant persons. The result being that Jane's nomination ends up looking more like a 'Will' with various default scenarios being covered. The alternative interpretation is that Fred becomes the relevant 'member', and the capital balance would revert to Fred's accumulation account, and need to be paid to Fred's SIS dependants (or to Fred's estate). 2 If this view is adopted, then the role of the Deed of Mutual Wills becomes central to achieving the intended outcome. These issues need to be addressed carefully in the wording of the Super Deed, the Binding Nomination, the Pension Terms and Jane s Will. Deed of Mutual Wills A Deed of Mutual Wills is a document that creates contractual and equitable obligations between the parties to the deed. It can require a survivor to act in a certain way, and to do agreed things with 'family assets'. We use these quite often to deal with disparate family groups, which include entities that do not form part of a personal Estate, and therefore cannot be effectively dealt with through a standard Will. A number of scenarios could be accommodated using a Deed of Mutual Wills: Jane and Fred could agree that Jane will grant Fred a lifetime pension, on the condition that Fred leaves any capital balance to Judy, Elroy and BamBam (if a capital balance reverts to Fred). 2 Under the SIS Act, a pensioner is a 'member' in a SMSF, but not in an industry fund.

19 18 This would keep the capital in the super environment during Fred s lifetime, but would likely result in benefits tax being payable when the capital is paid to the children on Fred s death. Jane and Fred could agree that Jane will distribute her super to Fred directly, on the condition that Fred agrees to preserve the capital, and to include in his own Will provisions to pass the capital to Jane s intended beneficiaries. This would avoid benefits tax on the payment of the super benefit, because it would go to Fred on Jane s death, and Fred qualifies as a tax dependant. However, the assets would then be outside of the super environment, and exposed to tax on future income and gains, and at risk to Fred s creditors 3. Furthermore, Jane would need to rely on Fred to act in accordance with the terms of the Deed of Mutual Wills. Assets remain in super Income stream Benefits tax Galaxy Fund Fred (60) Jane (51) DECEASED Capital payment No benefits tax Jane s descendants Fred (60) The best approach will depend on a number of circumstances, including the extent of taxable benefits in Jane s fund. If Fred changed his Will to try and defeat the agreed intention, one or more of the intended beneficiaries of his original Will could bring an action to enforce Fred's undertaking. This strategy may be used in conjunction with a Binding Death Benefit Rule. How the pension will be taxed The components and elements of the pension The tax treatment of a death benefit super income stream depends on: The age of both the deceased and the age of the recipient; and The components and elements from which the pension is paid. An income stream benefit may consist of a: A 'tax-free component'; and Assets pass out of super A 'taxable component' which includes an element 3 Although there may be an argument that the capital is subject to an equitable charge.

20 19 o 'taxed in the fund'; and/or o 'untaxed in the fund'. The super funds must calculate these components at the time the super interest is allocated to support the pension. The 'proportioning rule' applies at the time the pension is established, so that the super interest supporting the pension comprises a proportionate amount of each component and element. Taxation of the pension The following table summarises the tax position for a recipient of an income stream benefit: Given that Fred is 60, the tax-free component and the taxed element of the pension payment will be tax free. Any untaxed element will be subject to tax at Fred's marginal rates, with a 10% tax offset. Who will be in control of Jane s/fred s benefits? In the absence of any change, Fred and Elroy will have control of the Galaxy Fund while Fred is receiving his pension. Fred (60) Elroy (23) Galaxy Fund

21 20 Elroy's involvement may provide some protection against Fred commuting the pension or withdrawing the capital prior to his death. Consideration should be given to the possibility of Elroy dying before Fred. If this were to occur then Fred would have unfettered control over the Galaxy Fund. Another term of the Death Benefit Rule may be to have Judy appointed to replace Elroy, should Elroy die before Fred. Consideration could also be given to having Judy join as a member of the Galaxy Fund from the outset. If this was to occur, consideration would need to be given to preventing Judy and Elroy ganging-up on Fred and defeating his life interest. A term of the Super Deed may be that a change could not be made to his pension without his consent. Trustee Company Independent Fred Elroy Judy Galaxy Fund Consideration may also be given to appointing a company as the trustee of the Galaxy Fund, and dealing with these appointments via directorships. This would save on administrative costs and asset transfers. Furthermore, the governing terms could be incorporated in the company's constitution. 4 Summary of outcomes Fred will receive a super income stream during his lifetime. Fred will not be able to commute the pension or otherwise access the capital. The other super trustees (directors) will provide a check-and-balance against Fred s unilateral actions. No tax will be payable on fund earnings, or on the receipt of the pension benefit by Fred. On Fred s death, the underlying capital will be available to fund the benefits to Jane s children and grandchildren. 4 According to the ATO report, around three-quarters (74%) of SMSFs had individual trustees rather than a corporate trustee, as at 30 June 2011.

22 21 Passing the capital balance to Judy, Elroy, BamBam and the grandchildren Judy, Elroy, BamBam and Jane s grandchildren are to receive the benefit of the capital when Fred dies. How can the payments be made? This capital may be paid to them either: Directly from the Galaxy Fund - provided they each qualify as SIS dependants; Through Jane's personal Estate; or By way of a combination of the above two options. Payment directly from the super fund to the beneficiaries A direct payment by the super fund to the individuals will only be possible if: The Super Deed allows a direct lump sum payment to the individuals, i.e. if they qualify as potential beneficiaries under the Super Deed; and If each individual qualifies as a 'SIS dependant'. Judy and Elroy will automatically qualify as a SIS dependant, as they are Jane's children. Jane and Fred are not married, and therefore BamBam would not ordinarily be considered a 'step-child' of Jane. However, the definition of 'SIS dependant' is wider to include 'a child of the person's spouse' at the time of death (the definition of spouse includes de facto). BamBam may also qualify as a SIS dependant on the basis of his financial dependence on Jane. In this context, the Tax Office takes the view that the mere provision of financial support is not enough - it must be a particular type of financial support. The person must be dependent on the deceased for their day to day living expenses, not just

23 22 nice things to have. This can be difficult to apply in practice, because a basic standard of living is relative. BamBam's share could default to Jane's Estate, and be dealt with via her Will. This would get around the SIS issue. Jane's grandchildren will not qualify as SIS dependants. Accordingly, any benefit intended for grandchildren will need to be paid to Jane's personal Estate and left to the grandchildren through Jane's Will. Payment via Jane's Will A payment of benefits via Jane's Will raises fewer SIS issues than a payment directly to the individuals from Jane s super fund. In the case of Jane's grandchildren, this is the only way that super can be applied to meet Jane's wishes. Furthermore, by routing the payment via her Will, it is possible to impose a greater degree of control over the amount, e.g. by incorporating testamentary trust terms on the capital that govern how the income and capital is to be applied. Taxing Jane s descendants The tax components of a lump sum death benefit are the same as for an income stream benefit, i.e. a 'tax-free component', and a 'taxable component' (with potential 'taxed in the fund' and 'untaxed in the fund' elements). The super fund must calculate these components for each benefit at the time the benefit is paid. The 'proportioning rule' is applied to calculate the tax-free and taxable components of a benefit. This means that each benefit carries with it a tax-free and taxable component in the same proportions as those components make up the super interest from which the benefit is paid. How the components will be taxed The basic rule is that the lump sum will be: Tax-free to a 'tax dependant'; and Only the taxable component will be taxed in the hands of a non-tax dependant. So in practical effect, tax only needs to be considered if the recipient is not a tax dependant. The rate of tax applying to the taxable component is as follows: 16.5% for the taxed in the fund element; and 31.5% for the untaxed in the fund element. The tax dependant status of the recipient of a benefit applies irrespective of whether the benefit is paid directly from the fund, or if the benefit passes through the deceased's personal Estate.

24 23 The tax status of Jane s descendants As noted above, the tax consequences for Jane s intended beneficiaries will dependent on the source of their benefit and whether they qualify as tax dependants. The tax status of Jane's beneficiaries is as follows: Judy is not a tax dependant. This is because she is over 18 and not financially dependent on Jane. Elroy will currently be a tax dependant, if he can establish sufficient financial dependence on Jane. But this may change before Jane dies. BamBam may be a tax dependant. In ATOID 2011/77 the Tax Office expresses the view that the child of a de facto partner cannot be a 'step-child' and that the step-child relationship ends when the marriage between the child s natural parent to the step-parent ends either by divorce or by death of the natural parent. On this view, BamBam will only be a tax dependant if he was financially dependent on Jane at the time of her death. This may be established by the fact that Jane has been meeting his day to day living costs. In ATOID 2002/731 the Tax Office expresses the view that the test to apply to determine whether there is financial dependence is would the person be able to meet their daily needs if the financial support was withdrawn (i.e. the person s normal standard of living is affected)? This is quite a narrow definition of financial dependence. In our view there is no need for one person to be wholly dependent upon another for that person to be a 'dependant' for the purposes of the payment standards they only need to be substantially or materially dependent on the support to maintain their normal standard of living. The recipient should not need to show a need for the money in order to qualify as a dependant. It is the trustee's responsibility to decide whether such a person was financially dependent on the member at the time of death. Managing the tax liability on benefits paid to Jane s descendants There are three possible strategies to reduce the tax burden on Jane's Estate: The first strategy is to pay a higher proportion of super benefits to Elroy and BamBam, with Judy's share being made up from other non-super assets; The second strategy is to establish two separate superannuation interest, and then have the Galaxy Fund pay to tax dependants, and the 'Galaxy II Fund' to pay to non-tax dependants; and The third strategy is to consider paying Elroy and BamBam a pension, rather than a lump sum. Using non-super assets to pay entitlements Jane has $3,055,000 of super benefits and $1,245,000 of assets outside super. If each of Jane's intended beneficiaries receives a proportion of each class of asset, then the tax outcome would be as follows:

25 24 No planning Taxable Taxable Tax-free Tax Taxed in the fund Tax Untaxed in the fund Tax Other assets Total Tax Value $1,705,000 $1,050,000 $241,380 $1,245,000 Judy Non-dependent $426,250 $0 $262,500 $43,313 $60,345 $19,009 $311,250 $62,321 $998,024 Elroy Tax-dependent $426,250 $0 $262,500 $0 $60,345 $0 $311,250 $0 $1,060,345 BamBam Tax-dependent $426,250 $0 $262,500 $0 $60,345 $0 $311,250 $0 $1,060,345 Grandchildren Non-dependent $426,250 $0 $262,500 $43,313 $60,345 $19,009 $311,250 $62,321 $998,024 $124,642 $4,116,738 However, if the tax dependants were given priority as to the receipt of super proceeds, then the tax outcome would be reduced to: Applying non-super assets Taxable Taxable Tax-free Tax Taxed in the fund Tax Untaxed in the fund Tax Other assets Total Tax Value $1,705,000 $1,050,000 $241,380 $1,245,000 Judy Non-dependent $263,214 $0 $202,022 $33,334 $37,264 $11,738 $622,500 $45,072 $1,079,928 Elroy Tax-dependent $589,286 $0 $322,978 $0 $83,426 $0 $0 $0 $995,690 BamBam Tax-dependent $589,286 $0 $322,978 $0 $83,426 $0 $0 $0 $995,690 Grandchildren Non-dependent $263,214 $0 $202,022 $33,334 $37,264 $11,738 $622,500 $45,072 $1,079,928 $90,143 $4,151,237 Establishing the Galaxy II Fund If Jane contributes the non-concessional amounts from the disposal of Sprocket Industries to the Galaxy Fund, then the Galaxy Fund will have a mix of tax-free and taxable components. Each recipient of a super benefit from the Galaxy Fund will get the same proportion of each component. A tax dependant recipient will not pay tax on either component. Whereas a non-tax dependant will pay tax on the taxable component. However, if Jane made the non-concessional contributions to a new fund - the Galaxy II Fund, all of the proceeds from this fund would be from a tax-free component. Jane could then direct that proceeds be paid to non-tax dependants from the Galaxy II Fund, and proceeds be paid to tax dependants form the original Galaxy Fund. The tax outcome would then be as follows: Using Galaxy II Fund Taxable Taxable Tax-free Tax Taxed in the fund Tax Untaxed in the fund Tax Other assets Total Tax Value $1,705,000 $1,050,000 $241,380 $1,245,000 Judy Non-dependent $502,500 $0 $0 $0 $0 $0 $622,500 $0 $1,125,000 Elroy Tax-dependent $350,000 $0 $525,000 $0 $120,690 $0 $0 $0 $995,690 BamBam Tax-dependent $350,000 $0 $525,000 $0 $120,690 $0 $0 $0 $995,690 Grandchildren Non-dependent $502,500 $0 $0 $0 $0 $0 $622,500 $0 $1,125,000 $0 $4,241,380 The potential impact of testamentary trusts on the tax status of super payments A payment of super paid directly to a beneficiary is not subject to any limitations. Accordingly, if Jane wants to imposed limitations and conditions on the use of the benefits (e.g. an education purpose for the grandchildren, or a deferred access for a child) she will need to route the benefits via her personal Estate and impose those conditions by means of establishing one or more testamentary trusts in her Will. If left on a testamentary trust, the tax status will depend on the breadth of the potential beneficiaries of the testamentary trust: If the potential beneficiaries are limited to tax dependants, then no tax should be payable.

26 25 If the potential beneficiaries include non-tax dependants, then tax will be payable by the recipient trustee of the testamentary trust on the taxable component. If possible, the class of potential beneficiaries may be limited to tax dependants. However, often this is not possible because at the very least, the default beneficiaries of the trust may fall outside this definition. Establishing one or more 'child pensions' Once the funds leave Jane's super fund any further income and gains will be subject to tax in the hands of the recipient beneficiaries, i.e. the tax advantages of super come to an end. Accordingly, strategies that prolong the time when the cash remains within super can be tax beneficial. This can also provide additional asset protection for the recipient. An income stream benefit can only be paid to a child of a member if, at the time of the member s death: The child is under 18; The child is between 18 and 25, and is financially dependent on the deceased at the time of their death; or The child has a disability. At this point in time both Elroy and BamBam qualify. Accordingly, Jane may consider leaving their entitlements in the form of an income stream benefit. This would maintain the assets within super, and minimise tax on the ongoing income and gains. When Elroy reaches 25 the pension will need to be commuted, with the capital value paid out to Elroy. However, this restriction will not apply in relation to BamBam's pension, because he suffers from a disability. Depending on the wording of the pension, there is no harm in structuring the benefit in the form of a pension as the children may (subject to any pension term to the contrary) elect to commute the pension and take a lump sum. Who will be in control of Jane's benefits? Elroy will be the sole surviving trustee if both Fred and Jane have died. Under this scenario, Elroy may seek to exclude Judy, BamBam and the grandchildren from any benefit. If there is a Binding Nomination in place, then Elroy will be obliged to follow Jane's directions. But there may still be some flexibility and discretion required to achieve the best tax outcomes. An alternative would be to have Judy appointed as a co-trustee with Elroy. A further option would be to have an independent person appointed to protect BamBam's interests. Once again, appointing a company trustee is also an option worth considering.

27 26 Summary of outcomes Jane will use a combination of direct payments from super, super income streams and payments through her Estate to achieve the best outcome for her descendants. Jane s Binding Nominations/Rules, the income stream terms, and Jane s Will all need to work in concert to achieve her objectives. As a general rule, the following order of priority would apply: o Income stream benefit terms; o Lump sum benefit terms; o Will terms. What happens if Fred takes no action before he dies? Who controls Fred's personal Estate? Dying without a Will Fred will die 'intestate', as he does not have a Will. Jane would be a possible contender to be granted letters of administration over his Estate. However, Dino could also apply, and would also have a likely chance of success. Alternatively, the Public Trustee may be appointed, if a dispute arose between Jane and Dino. Statutory entitlements Jane would qualify as Fred's 'spouse' under the family provision laws, and would have an entitlement to some of Fred's Estate. Fred's Estate would therefore be divided between Jane and Fred's children, Dino and BamBam. Jane would be entitled to: Fred's personal effects; A statutory legacy base amount of $350,000 (indexed); and Half of the balance of Fred's Estate. The balance of Fred's estate would then be divided equally between Fred's children, Dino and BamBam. This is not what Fred intends. Who controls Fred's super entitlements? Jane and Elroy would control Fred's super benefits - because they would be the only remaining trustees of the Galaxy Fund. Dino and BamBam could well miss out - subject to a challenge under the inheritance family provision legislation.

28 27 Would things be different if Fred had his benefits in a public offer fund? The trustee of a public fund is likely to undertake a claim-staking procedure which means notifying all potential dependants and Fred s legal personal representative about the proposed distribution of Fred s death benefit, together with the amounts and proportions in which they will be paid. Recipients of the notice then have 28 days to respond. If no response is received then those persons are barred from bringing a claim before the SCT in relation to the distribution of the death benefit. If there are claims made in relation to the proposed distribution, then it is likely that the matter will end up before the SCT for determination. The SCT will only make a determination in place of the trustee if it determines that the decision of the trustee was unfair and unreasonable in its operation to the complainant. In this case, depending upon how the trustee makes its decision, it is likely that Jane or either of Fred's children could bring a claim. Binding Nomination in favour of BamBam In order to ensure that BamBam receives the benefit of Fred s super, Fred has a number of alternatives. He could: Make a Binding Nomination for his super to be paid directly to BamBam; Make a Binding Nomination for his super to be paid to his Estate, and then provide in his Will for the amount to be held on trust for BamBam; or Make a Death Benefit Rule for the super interest to remain within super and pay a pension to BamBam during his lifetime, with the capital then being paid to Fred s Estate (and then on-paid to Fred s nominated charity). Binding Nomination for lump sum benefit to BamBam A potential benefit of this approach is that no tax will be payable on the lump sum benefit, as BamBam will qualify as both a SIS dependant and tax dependant. A potential problem with this alternative is that BamBam would then be responsible for the management and ultimate disposing of the capital allocated to him from Fred s super. After Fred has died, BamBam is likely to have a third party guardian appointed to manage his personal and financial affairs. By making a lump sum payment directly to BamBam, Fred would not be able to impose the required conditions on the use and ultimate disposal of the capital proceeds. Payment through Fred s Estate An alternative would be for Fred to direct his super to be paid to his Estate, and then provide for how the money is to be applied through his Will, i.e. by means of a testamentary trust. By establishing a testamentary trust to hold and deal with these proceeds, Fred would be able to exert a significant degree of control over how the super proceeds and used and applied. For example, they may be used to support BamBam during his lifetime, and then any balance may be directed to Fred s intended charity.