FINDING SENSE (AND DOLLARS) IN THE TRANSITIONAL CGT RELIEF ELECTIONS

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1 1 David Barrett, Macquarie Group David Barrett is Division Director, Head of Macquarie Technical Advice Services at Macquarie Banking and Financial Services. With more than two decades of experience in the financial services industry, David Barrett heads up Macquarie s technical services and advice design teams. David originally joined Macquarie in 1997 and has held positions elsewhere in technical services, financial planning and insurance. David s expertise extends to areas including superannuation and related tax legislation, personal international taxation and retirement systems. His practical expertise is built on a broad education base. Qualifications: BSc LLB LLM DipFP CPA CTA SFFin SSA FINDING SENSE (AND DOLLARS) IN THE TRANSITIONAL CGT RELIEF ELECTIONS David Barrett Finding sense (and dollars) in the transitional CGT relief elections The transitional capital gains tax (CGT) relief election associated with the 2017 super reform measures is a generous concession offered to super fund trustees. It protects assets which have appreciated in value prior to 1 July 2017 in the tax exempt pension/retirement phase from retrospective CGT, and the election removed the incentive for trustees to sell down and repurchase assets prior to 1 July However, although simple in concept, the operation of the CGT relief is very complex in practical application. The complexity exists due to the number of variables which may influence the decision to reset an asset s cost base. Self-managed superannuation funds (SMSFs) which used the proportionate method to calculate the fund s exempt current pension (ECPI) throughout 2016/17 can be especially challenging. The issues associated with SMSFs which used the segregated method are somewhat simpler, but there are a number of nuances nonetheless. Part 1: SMSFs using the proportionate method Part 1 provides a framework for financial services professionals to analyse the impacts of cost base resetting for those SMSFs which used the proportionate method. Part 2 will cover those funds which used the segregated method. SMSFs using the proportionate method Generally those SMSFs using the proportionate method throughout the pre-commencement period (9 November 2016 to 30 June 2017 inclusive) will have the option of resetting the cost base on all eligible assets owned by the fund throughout the pre-commencement period. To exercise the option, a transitional CGT election must be made, generally by 30 June The cost base reset is a deemed sale and repurchase for CGT purposes. As a result of the deemed sale, additional assessable may be taxable in the 2016/17 where the asset is in a capital gain position. However, a subsequent election can be made to defer that assessable to the year in which the eligible asset is actually sold. In addition, resetting the cost base of eligible assets in a capital loss position may be considered.

2 2 The quote The transitional CGT relief effectively allows a superannuation fund to reset the cost base of an eligible asset to its market value on a particular date. Table 1: Three decisions to consider 1 Reset the cost base of eligible assets in a capital gain position 2 Defer the assessable (if any) from 1. above to the year in which the asset is actually sold 3 Reset the cost base of eligible assets in a capital loss position Case study: Annette and Paul On 30 June 2017 Annette and Paul s SMSF held $1 million of assets which supported Annette s $500,000 transitional to retirement stream (TRIS) and Paul s $500,000 accumulation account. They are planning to retire on 1 July As Annette s TRIS will be subject to taxation on its earnings from 1 July 2017 due to the super reform measures, transitional CGT relief is available to the fund. The fund was using the proportionate method to calculate ECPI throughout 2016/17 and all assets were held throughout the pre-commencement period. The SMSF s assets and illustrative valuations as at 1 July 2018 and 1 July 2020 are shown in Table 2 below. If the assets are not sold prior to retirement, Scenario 1 do nothing is the most attractive option as the total CGT liability is nil. However, if Scenario 1 is adopted, and the assets are sold down prior to retirement, a large CGT liability results ($31,000). A better outcome is achieved by resetting the cost base of the assets and deferring the assessable (Scenario 3) where the CGT liability is $20,500. Note that Scenario 2 provides a similar outcome, but Scenario 3 is preferred because of the deferral of the $10,500 CGT liability from 2016/17 until the assets are actually sold. In Annette and Paul s case, an important parameter in the decision to make the transitional CGT election is the likelihood of holding the eligible assets until retirement. The time remaining before retirement (slightly more than 2 years for Annette and Paul) is therefore a crucial issue the longer the timeframe, the lower the likelihood, in general. Also crucial is the number and type of assets held by the fund. A diversified portfolio involving a large number of assets may be more likely to result in asset sales prior to retirement than in Annette and Paul s situation where there are only three assets. Table 2: Annette and Paul s SMSF asset position Valuation at 30 June 2017 Unrealised CG 30 June 2017 Illustrative valuation at 1 July 2018 (both still working) Illustrative valuation at 1 July 2020 (both retired) 1 375, , , , , , ,000 50, , , , ,000 35, , ,000 Total: 790,000 1,000, ,000 1,100,000 1,300,000 Two of the three decisions listed in Table 1 are relevant to Annette and Paul s SMSF. The outcome of these decisions is dependent on the ECPI of the fund when the assets are ultimately sold, relative to the ECPI of the fund in 2016/17 (50 per cent). If the assets are sold prior to retirement, the ECPI of the fund is assumed to be zero per cent. A decrease in the ECPI favours resetting the cost base on assets in a capital gain position. On the other hand, if the assets are sold after retirement when Annette and Paul have commenced accountbased pensions (ABPs), the ECPI is assumed to be 100 per cent. An increase in the ECPI favours not resetting cost bases in 2016/17. Figure 1 shows the capital gains tax (CGT) outcomes of the two decisions In relation to the timing of the sale of the assets, either pre-retirement on 1 July 2018 or postretirement on 1 July Capital losses complicate the picture Consider now a different case study involving Harry and Sally. They have a SMSF which on 30 June 2017 held $3 million of assets supporting their respective interests. Harry s interest was an ABP valued at $2 million, and Sally had an accumulation account valued at $1 million. Harry commuted $400,000 from his pension to comply with the super reform measures (the $1.6 million transfer balance cap) on 30 June Harry and Sally s SMSF uses the proportionate method to calculate its ECPI. In 2016/17 the ECPI was 67 per cent ($2,000,000 / $3,000,000), and will decline to approximately 53 per cent ($1,600,000 / $3,000,000) in 2017/18. Harry and Sally s SMSF assets as at 30 June 2017 and illustrative valuations as at 1 July 2022 are shown in Table 3. Similar analysis as shown above for Annette and Paul s SMSF would apply to Harry and Sally s SMSF assets that are in a capital gain position (assets 1 and 2). However, the potential to reset the cost base on asset 3 requires more analysis. For each of the three scenarios in Annette and Paul s case ( do nothing, reset, no deferral and reset + deferral ), there is an additional decision to reset (or not) the cost base of asset 3. This means there are three decisions (as shown in Table 1) with six possible scenarios - see Figure 2 The CGT impact of each scenario has been calculated based on the asset valuations assumed as at 1 July 2022 depending on whether or not Sally has retired and starts an ABP with the funds in her accumulation account ($1 million). If Sally starts an ABP, the fund s ECPI is assumed to increase from 53 per cent to 87 per cent ($2,600,000 / $3,000,000).

3 3 Table 3: Harry and Sally s SMSF asset position Table 4: Total CGT outcomes for six scenarios based on Sally s retirement Unrealised capital gain (loss) 30 June 2017 valuation Updated cost base (if reset) Illustrative valuation at 1 July 2022* Scenario Reset assets with capital gains Defer assessable from cost base reset Reset assets with capital losses Total CGT paid if assets sold and Sally hasn t retired (ECPI 53%) Total CGT paid if assets sold and Sally is retired (ECPI 87%) 1 1,130, ,000 1,900,000 1,900,000 2,424, , , , , , , ,000 35, , ,000 Total: 2,240, ,000 3,000,000 3,000,000 3,828,000 1 No - No 75,000 21,000 4 No - Yes 75,000 21,000 2 Yes No No 62,000 39,000 5 Yes No Yes 64,000 36,000 3 Yes Yes No 58,000 35,000 6 Yes Yes Yes 44,000 16,000 Figure 1.Decision tree and outcomes (assets with CGs only) Figure 2. Decision tree (CG assets + CL assets)

4 4 The total CGT paid in relation to assets 1, 2 and 3 under each of these six scenarios is shown in Table 4 below. Broadly, Table 5 shows that it is in Harry and Sally s best interest to reset the cost bases on those assets in a capital gain position if the assets are sold in a year where the ECPI of the is lower (that is, prior to Sally retiring) than the ECPI in 2016/17. If the ECPI in the year of sale is higher (because Sally has retired), it may be detrimental to reset the cost bases in 2016/17. However, Scenario 6 is attractive whether or not Sally is retired when the assets are sold. This is the case because the capital loss of $170,000 in 2016/17 is assumed to be carried forward and used to offset the deferred assessable of $204,600 (election 2) from the deemed sale of assets 1 and 2 ($930,000 gross capital gains, reduced by the 1/3rd CGT discount and 67 per cent ECPI in 2016/17). When capital losses are used to offset the deferred assessable that results from the transitional CGT relief elections, the use of those capital losses is maximised relative to other alternative uses of the capital losses, and can reduce the fund s tax liability by $15 per $100 of capital loss. Table 5: Harry and Sally, Scenarios 2, 5 and 6 Scenario 2 reset CG,no deferral CGT in 2016/17 Scenario 5 reset CG & CL, no deferral CGT in 2016/17 Scenario 6 reset CG & deferral CGT in 2016/17 Gross gain 930, , ,000 CL + CGT on deferred in year assets 1 and 2 sold Deferred gain 204,600 Less loss (170,000) (170,000) Gain/(loss) 930, , ,000 34,600 Less 1/3 discount (310,000) (253,333) (310,000) Discounted gain 620, , ,000 34,600 ECPI 67% (415,400) (339,467) (415,400) Taxable gain 204, , ,600 34,600 15% 30,690 25,080 Nil 5,190 To illustrate, consider Harry and Sally s position. Scenario 2 involves resetting the cost base of assets 1 and 2 (assets in a capital gain position), and results in CGT of $30,690 payable in relation to 2016/17. Scenario 5 involves also electing to also reset the cost base on asset 3 (asset in a capital loss position). The capital loss reduces the tax payable in 2016/17 by $5,610 the value of the capital losses is $3.30 per $100 of capital loss. Scenario 6 involves resetting the cost bases on all assets, and deferring the assessable caused by the resetting of the cost bases of assets 1 and 2. The $204,600 of assessable that was taxable in Scenario 2 is not taxable in 2016/17 in Scenario 6. As a consequence, the capital loss which results from resetting the cost base of asset 3 is carried forward to the next year because there is no capital gain in 2016/17 to offset, so there is a net capital loss position. If this capital loss continues to be carried forward (because there are no other capital gains realised in the interim) until the year in which assets 1 and 2 are sold, then the capital loss may be used to offset the deferred assessable ($204,600) from 2016/17. The capital loss of $170,000 reduces the $204,600 to only $34,600 of assessable, and only $5,190 of CGT is payable. This is a saving of $25,500 compared to the tax paid in 2016/17 in Scenario 2, and $19,890 compared to Scenario 5. Part 2: SMSFs using the segregated method Part 2 looks at some of the advice considerations relating to the transitional CGT relief for SMSFs that were using the segregated method to calculate ECPI as at 9 November SMSFs using the segregated method Broadly, there are two ways in which an SMSF will be segregated for tax purposes. For SMSFs that have both pension and accumulation accounts, the fund will be segregated if the trustee has allocated specific assets to support the pension accounts ( segregated current pension assets ) and separate assets to support the accumulation accounts. Alternatively, if the SMSF is solely paying pensions, the Australian Taxation Office s (ATO) view is that the fund is segregated by default, as all the fund s assets are supporting the pension accounts and are segregated current pension assets. Income from segregated current pension assets is generally tax exempt. Capital gains and losses from these assets are also disregarded. The CGT relief available under the transitional rules is implemented by a notional sale and repurchase of the asset at its current market value. Where the relief is applied to a segregated current pension asset, the capital gain or loss that is realised as a result of the notional sale of the asset is also disregarded. This differs from SMSFs using the proportionate method where a portion of the net capital gain is taxable. Table 6: Action by segregated funds in pre-commencement period Scenario Action by trustee s eligible for CGT relief* 1 Segregation maintained throughout s transferred from exempt pension pool pre-commencement period to taxed accumulation pool during pre- commencement period 2 Move to proportionate method at All assets in exempt pension pool some time during the pre- commencement period 3 Transition to retirement All assets that supported the TTR pension stream (not in retirement phase) continues past 30 June 2017 Note: * must be owned by the SMSF for the whole of the pre-commencement period. The transitional CGT relief effectively allows a superannuation fund to reset the cost base of an eligible asset to its market value on a particular date. For SMSFs using the proportionate method, the relevant date for the cost base reset is 30 June Where the segregated method was used, the date the asset ceased to be a segregated current pension asset is the relevant date. The relief applies to all eligible assets in a SMSF which used the

5 5 proportionate method. For those SMSFs using the segregated method, the assets to which the relief applies depends on certain actions, if any, of the trustee during the pre-commencement period (i.e. 9 November 2016 to 30 June 2017, inclusive), as shown in Table 6. Segregation maintained throughout precommencement period Case study: Neil Neil s SMSF consisted solely of an account based pension at 9 November 2016 and was using the segregated method. At 30 June 2017 Neil s account based pension was worth $2 million. To avoid exceeding his transfer balance cap of $1.6 million Neil commuted $400,000 to an accumulation account. Neil moved specific assets with a value of $400,000 from his pension account to an accumulation account, creating two distinct pools of assets. As the SMSF maintained segregation throughout the pre-commencement period, the CGT relief is available to those assets that were moved to a pool which supports the new accumulation account. The relief is not available for the $1.6 million of assets that continued to support Neil s pension account. The cost base reset is effective at the time the relevant asset ceased to be a segregated pension asset. As the asset is treated as being sold whilst it was a segregated current pension asset, any realised capital gain or loss as a result of the cost base reset is disregarded. From this we can establish that in applying the CGT relief to segregated funds, it may be in the fund s interests to: 1. Reset the cost base on assets that are in a capital gain position 2. Don t reset the cost base on assets that are in a capital loss position. As a capital loss from a segregated pension asset is disregarded, realising the loss provides no benefit to the fund. An exception to point 1 may occur where the asset is sold within 12 months of the reset date. Note that resetting the cost base on an asset also resets the date that is used to determine whether the fund is eligible for the one-third CGT discount. If assets are sold within 12 months of the reset date, further analysis may be required to determine if it is in the fund s best interests to reset the cost base. Factors that may impact the decision include whether the gain or loss has accrued since the cost base reset and the fund s ECPI percentage in 2017/18. However, as Neil has a total superannuation balance of more than $1.6 million and is receiving a pension, his SMSF will not be able to use the segregated method to calculate exempt from 1 July His SMSF will be required to use the proportionate method from that point, meaning that all assets of the fund will become pooled and proportionately subject to tax in the future. While any gains relating to Neil s accumulation assets will have been reset, any unrealised gains formally attributed to his pension assets have not been reset and may become proportionately subject to tax. Move to the proportionate method prior to 1 July 2017 Given Neil s SMSF is required to use the proportionate method from 2017/18 anyway, it may have switched to the proportionate method prior to 1 July If it had done this, the fund is able to apply the CGT relief to all eligible assets that were previously segregated current pension assets, so potentially all of the fund s assets are eligible for relief. If Neil s SMSF elects to switch to the proportionate method at the time he commutes $400,000 from his account based pension (i.e. 30 June 2017), the cost base reset is available on his whole SMSF portfolio of $2 million. The effective date for the cost base reset is 30 June Table 7 below shows the asset position for Neil s SMSF prior to switching to the proportionate method. The fund has six assets five have an unrealised capital gain and one has an unrealised capital loss. Table 7: Neil s SMSF asset position prior to switching to proportionate method Unrealised capital gain Current value 1 100, , , ,000 80, , , , , , , , ,000 (20,000) 100, ,000 60, ,000 Total 1,540, ,000 2,000,000 If the cost base is reset on all the assets in Neil s SMSF that have unrealised capital gains, but not for the asset with the unrealised capital loss, the cost base on his portfolio will increase from $1.54 million to $2.02 million. In doing this, the SMSF has realised $480,000 of capital gains that have accumulated prior to the cost base reset and will be exempt from tax. The impact of switching to the proportionate method and resetting the cost base on the assets in a gain position is shown in Table 8 below. Table 8: Neil s SMSF asset position after switching to proportionate method Reset cost base New cost base Unrealised capital gain Current value 1 100,000 Y 200, , ,000 Y 400, , ,000 Y 340, , ,000 Y 500, , ,000 N 120,000 (20,000) 100, ,000 Y 460, ,000 Total 1,540,000 2,020,000 (20,000) 2,000,000 Impact of contributions made during the precommencement period A further complication arises for SMSFs that were solely in pension phase at 9 November 2016 where a fund member made a contribution during the pre-commencement period. Assume that Neil made a non-concessional contribution of $540,000 on 1 April 2017 to an accumulation account in his SMSF. Prior to the contribution, the fund was solely in pension phase.

6 6 At the time the contribution is made, Neil s fund had two options: 1. Maintain segregation by keeping the contribution and any subsequent earnings separate from the fund s pension assets, or 2. Adopt the proportionate method whereby all of the fund s assets then supported both accumulation and pension accounts. If the contribution was kept separate from the SMSF s pension assets, then there is no change to the position outlined above. That is, Neil s SMSF is still eligible to reset the cost base of all assets that were supporting his pension interest when the fund switches to the proportionate method on 30 June However, if the contribution wasn t segregated, the relevant date for applying the CGT relief becomes 1 April 2017 when the contribution is received. This is the case even if Neil doesn t commute the $400,000 from his account based pension until 30 June 2017, as the trigger for applying the CGT relief is the date the assets ceased to be segregated pension assets on 1 April Impact of switching to proportionate method on ECPI calculation Where a fund switches between the segregated and proportionate methods during the financial year, the fund has two options for calculating its ECPI: 1. Apply two separate ECPI calculations for the year. For the first part of the year, the fund s ECPI is calculated using the segregated method, meaning for Neil s SMSF, all derived in this period is exempt from tax. For the remainder of the year, the fund s ECPI is calculated using the proportionate method, based on the fund s average pension liabilities in that period. An actuarial certificate is required to claim ECPI for this period. With option 1, all from 1 July 2016 to 31 March 2017 isnote that the ATO expects SMSF trustees to calculate ECPI in line with this option if the fund switches from the segregated to proportionate method in 2017/18 or a later financial year (refer to QC 21546: Requirements for claiming the tax exemption). 2. Calculate ECPI on a proportionate basis for the whole year. The ECPI is calculated using the fund s average pension liabilities over the year, divided by the average fund balance over the year. An actuarial certificate is required to claim ECPI. In relation to this option, the ATO has stated in QC 21456: we do not intend to specifically review ECPI calculations in the 2016/17 year (and prior) regarding calculations made on the basis of fund assets being unsegregated for the entire year, despite the fund being 100% in pension phase for part of the year. Table 4 below illustrates the impact of these two different calculations on Neil s SMSF, assuming that the fund has the following : Other of $100,000, of which $40,000 is derived in the period from 1 July 2016 to 31 March 2017 and $60,000 is derived in the period from 1 April 2017 to 30 June 2017 Realised capital gains relating to the cost base reset of $480,000 (reduced to $320,000 after applying the one-third CGT discount) With option 1, all from 1 July 2016 to 31 March 2017 is exempt from tax. From 1 April 2017 to 30 June 2017, the ECPI of the fund is 78.7 per cent. This means 21.3 per cent, or $12,756, of the received is subject to tax. Using option 2, the fund s ECPI over the whole year is 93.7 per cent, meaning 6.3 per cent, or $26,489, of the assessable is taxable. This results in a tax liability that is $2,060 more than if ECPI was calculated using option 1. It should be noted that option 2 may not always result in a higher tax liability it depends on factors such as the timing of the switch to the proportionate method, the distribution of over the year and the capital gains realised as a result of the cost base reset. However, it is important for financial services professionals to be aware of the different calculation methods as this may impact on the advice provided to clients in relation to the transitional CGT relief. Table 9: Calculation of ECPI for Neil s SMSF Period ECPI method ECPI Option 1: Part year approach Assessable before ECPI exemption Taxable 1 July Segregated 100% $320,000 capital Nil March 2017 gain $40,000 other 1 April 2017 Proportionate 78.7% $60,000 other $12, June 2017 Option 2: Full year approach 1 July 2016 Proportionate 93.7% $320,000 capital $26, June 2017 gain $100,000 other Case study: Tim Tim s SMSF consisted of a non-retirement phase TTR pension and an accumulation account. The fund was segregated as it had set aside specific assets to support the pension account. At 30 June 2017, Tim s TTR pension was valued at $600,000 and his accumulation account was valued at $100,000. The assets supporting his pension account had unrealised capital gains of $100,000. If Tim continued his TTR pension until at least 1 July 2017, the SMSF is eligible to reset the cost base on the $600,000 of assets supporting his pension. The $100,000 capital gain that is realised as a result of applying the CGT relief will be exempt from tax as it relates to a segregated pension asset. From 1 July 2017, Tim s SMSF will cease to have segregated current pension assets and all and net capital gains will be taxable. Transition to retirement pensions The transitional CGT relief is also available for segregated funds in respect of non-retirement phase transition to retirement pensions, regardless of whether the pension was commuted prior to 1 July 2017 or continued into the 2017/18 financial year. Where the TTR pension was commuted prior to 1 July 2017, the CGT relief is applied according to whether the fund maintained segregation or switched to the proportionate method during the precommencement period. However, where the TTR pension was re-

7 7 tained and continued to be paid until at least 1 July 2017, the CGT relief is available to any eligible assets that were supporting the TTR pension. In this scenario, the asset is deemed to have been sold immediately before 1 July 2017 and repurchased at the start of 1 July Summary In general for those SMSFs using the proportionate method, the decision to reset the cost base of assets in a capital gain position is driven by whether the fund s ECPI when the assets are ultimately sold is likely to be higher or lower than the ECPI in 2016/17. If higher, it may be detrimental to reset, but if lower, if may be advantageous to reset. Large increases in ECPI are generally a consequence of the retirement of a member and the subsequent commencement of an ABP, so the timing of the sale of assets with respect to retirement of members are two crucial variables in the cost base reset decision. Capital losses can be used to offset the deferred assessable that is a consequence of the transitional CGT relief elections for SMSFs which used the proportionate method throughout 2016/17. It is attractive to do this as it reduces the amount of CGT that might otherwise be payable if the capital losses were not used in this way. By comparison, the application of the transitional CGT relief is relatively straightforward for funds that were using the segregated method to calculate ECPI in the 2016/17 financial year. As a general rule, trustees of segregated funds should consider resetting the cost base of eligible assets with unrealised capital gains (unless the asset will be sold within 12 months), but not resetting the cost base for assets with unrealised capital losses. Financial services professionals should also be aware of the different approaches to calculating ECPI for funds switching between the segregated and proportionate methods, as the method used may ultimately impact the fund s 2016/17 tax liability. fs