Now for the 'heavy lifting' with CGT relief

Most SMSF members impacted by the introduction of the transfer balance cap (TBC) on 1 July 2017 are eligible to apply the CGT relief if they simply meet the requirements of PCG 2017/5 by 30 June 2017.

This allowed members with more than $1.6 million in retirement (pension) phase to deal with the excess via a written request to the trustee and trustee acknowledgement with the actual commutation being processed at the time of preparing the fund’s financial statements and annual return.

Here’s a brief recap, looking at some tips and traps.

Eligibility

- There must be a clear connection with the objective of CGT relief, i.e. to comply with the TBC, or there must be a transition to retirement pension (of any value).

- Applies only to assets held continuously from 9 November 2016 and 30 June 2017.

- Must make an irrevocable election in the fund’s 2017 annual return – thus, the reason for this recap now.

Also, assets on which CGT relief is applied must be subject to CGT. Assets taxed on revenue accounts such as those classified as traditional securities are not eligible to have relief applied.

Be aware, the ATO may apply anti-avoidance provisions of Part IVA to trustees abusing CGT relief.

It’s critical to know the fund’s method of determining its exempt current pension income as at 9 November 2016 as it determines the approach used to apply CGT relief.

Segregated method

This is where a fund was entirely in pension phase, or in both pension phase and accumulation phase with formal segregation of assets.

To qualify, the segregated pension asset on 9 November 2016 must have ceased to be segregated before 1 July 2017. An asset ceased to be segregated when:

-the pension was partially or fully commuted back to accumulation phase, noting PCG 2017/5 discussed above — thus, a fund is ineligible for CGT relief where the trustee failed to commute the pension before 1 July 2017 to comply with the TBC, or

-a contribution was made to a fund fully in pension phase and there was no formal segregation of that contribution.

With the segregated method, there are two options to qualify for CGT relief.

1. Asset(s) reallocated from pension phase to accumulation phase and segregation continued (to 30 June 2017). In this case, CGT relief applies only to the asset(s) reallocated.

2. Adopt the proportionate method. This may be more appealing as it allows CGT relief to be applied to all assets that ceased to be segregated current pension assets.

The deemed sale and repurchase at market value occurred immediately before the asset ceased to be a segregated current pension asset, i.e. just before the asset was reallocated from pension phase to accumulation phase (option 1), or the proportionate method applied (option 2). Either way, any resulting gain (or loss) is disregarded as the asset was a segregated current pension asset at the time of deemed disposal.

With the segregated method, you are generally better off applying CGT relief to assets with unrealised capital gains. However, be mindful with the cost base reset that the acquisition date for the 12-month holding period for CGT discount is also reset.

So, if the asset has been sold since it ceased to be a segregated current pension asset, or will be sold within 12 months of that date, consider the loss of the discount on the capital gain before applying CGT relief.

Example

On 1 July 2016, Don (63) and Eva (62) had account-based pensions (ABPs) in their SMSF of $2.3 million and $1.2 million respectively. On 1 March 2017, Don made a $540,000 non-concessional contribution (NCC) while still eligible. He immediately commenced a second ABP to take advantage of the tax-free pension environment until 30 June 2017.

On 30 June 2017, Don fully commuted this ABP and partially commuted his first ABP to meet the TBC.

Assuming the NCC was not formally segregated and fund assets were held continuously from 9 November 2016 to 30 June 2017, the cost base reset of relevant fund assets must be done on 1 March 2017 (or earlier, but not before 9 November 2016). This is because the segregated current pension assets at 9 November 2016 ceased to be segregated on 1 March 2017.

Proportionate (unsegregated) method

This is where a fund was in pension phase and accumulation phase with no formal segregation on 9 November 2016.

Here, CGT relief can apply to any or all fund assets provided they were not segregated current pension assets at any time between 9 November 2016 and 30 June 2017. Thus, a fund is ineligible for CGT relief if it moved entirely into pension phase during this period.

With the proportionate method, the deemed sale and repurchase at market value occurred on 30 June 2017, regardless of when the pension was actually commuted. The deemed sale triggers a notional capital gain (or loss), part of which is assessable. This notional capital gain is brought to account in 2016-17, or an irrevocable election can be made to defer it until the year the asset is actually sold.

The gain carried forward is the net capital gain otherwise included in the fund’s assessable income ignoring any current year capital gains or losses, or prior year unapplied capital losses. The deferred notional gain, ignoring losses, is reduced by both the 1/3 CGT discount (if eligible) and the applicable pension exempt proportion. The deferred gain is then brought to account in the year of actual sale.

Importantly, you must maintain accurate records if deferring. Deciding to apply CGT relief can be complex, as you need to compare the fund’s tax exempt proportion in 2016-17 to the likely tax exempt proportion in the future when the asset is sold.

If it is likely to reduce – e.g. a new member joins in accumulation phase – you are generally better off applying CGT relief on assets with unrealised capital gains as it resets the cost base to market value and locks in assessable gains based on the higher exempt proportion applying in 2016-17.

However, if it’s likely to increase – e.g. member retires and starts a pension – the fund may be better off not applying CGT relief.

If a capital loss is triggered, the deemed loss is not disregarded and is brought to account in 2016-17, unlike with segregated funds. So, consider the current benefit of applying the deemed loss to reduce any realised capital gains now compared to the potential cost of having a larger capital gain in the future.

Conversely, crystallising the loss now when the fund has a higher pension exempt proportion reduces the benefit of the loss, compared to realising the loss in the future when the fund is subject to higher tax by virtue of the reduced balance in retirement phase.

Unit trusts trap

CGT relief applies to the cost base of units held by an SMSF in a unit trust only and not to the underlying assets of the trust. Thus, there can be a ‘CGT relief mismatch’.

For example, on 1 July 2010, a 13.22C trust was established to buy a $750,000 commercial property. An SMSF acquires units in the trust along with the fund member.

The SMSF progressively acquires the member’s units – financed via contributions over the years – and ends up owning 100 per cent of the units.

On 30 June 2017, the property is valued at $1 million.

If CGT relief applies, the cost base of the units is reset to $1 million. However, the cost base of the property remains at $750,000. Subsequently, the property is sold and the $250,000 capital gain is distributed as trust income to the SMSF and is assessable.

A solution, if practicable, may be to wind up the trust in the same financial year and offset the capital gain with the capital loss on cancellation of units, i.e. $750,000 - $1 million = ($250,000).

Colin Lewis, SMSF specialist