Clarifying the new segregation rules

Sometimes, even when you think you're on top of things, it turns out you're not.

A few weeks ago I wrote a piece – Pension cap elevates the segregation option – about taxation in super and an upcoming decision that those with more than $1.6 million in their pension fund were going to have to make.

That decision was around choosing what assets to keep in the pension fund and what assets to leave in accumulation – otherwise known as "asset segregation" for SMSFs.

The piece was based on the prevailing 'logic' in the financial advice industry, that a $1.6m pension cap was going to require segregation of assets in a SMSF, between accumulation and pension. However, the logic had already been overturned (my apologies) with legislation.

It seemed likely to become a major plank of investment strategies going forward. That is, one of the investment decisions you would need to make as trustee was to choose, based on your own personal risk and return requirements, what assets you would leave in your $1.6m maximum 'transfer benefit cap' for your pension and what assets would be transferred back to accumulation.

However the legislation that was eventually passed, bringing in to force the Coalition's big super shakeup, actually outlawed segregation for tax purposes inside a super fund.

The government does not want you to be able to use segregation to manage your tax situation in your pension fund. It is, in fact, banning segregation for tax purposes.

Instead, a proportionate method will be used for tax purposes. Simply, all of the assets of the fund will be taxed based on the proportion that is in pension and the proportion that is in accumulation (which will be worked out by an actuary). If you have $2m in super, with $1.6m in pension and $400,000 in accumulation, then 20 per cent of gains will be taxed at accumulation rates and 80 per cent will be taxed at pension rates.

Segregation historically

Segregation has always been available to SMSFs from a tax perspective, but has not been widely used, largely because pension funds were allowed to contain an unlimited amount of funds. As a result, most people would generally have their entire super balance in pension, making segregation somewhat irrelevant.

Or they would use the proportionate method anyway, as it is administratively easier (and generally preferred by accountants).

But segregation certainly had its uses and potential benefits. For example, in two-member funds, where only one person was in pension, it might have made sense to have purposefully chosen assets backing the pension for tax reasons, and other assets backing the other member's accumulation account.

(Note: you will still be able to segregate assets for investment strategies for individual members, but not for the tax paid on earnings by the fund in super/pension.)

With the July 1, 2017 changes coming in to focus, it had been assumed by many that members or trustees would need to choose which assets were backing the pension and which went back to accumulation.

"But it sounds like they (the government) were listening to the chatter," says Aaron Dunn from the SMSF Academy. "They were listening to what was being said and decided that's not what they wanted. So, they took away that option."

Banning segregation from a tax perspective will take away a lot of guesswork, or a lot of crystal ball gazing, from what was likely to be the lot of SMSF trustees post July 1, 2017.

But using segregation did pose opportunities. And despite what the government appears intent on trying to achieve, segregation is unlikely to be dead.

It might have to take a different form.

Beating the segregation ban

Have two SMSFs.

Under the current legislation, the Government/ATO is aiming to stop SMSF trustees from using segregation within a fund to avoid paying taxes.

But it is difficult to understand how the ATO could stop segregation being used effectively across multiple funds (under current reporting requirements).

Aaron Dunn took me through the following example.

Let's take a member with $2.6m currently in pension in SMSF1, which includes a property worth $1m. In time for July 1, 2017, the trustee takes the $1m property and transfers it to a second SMSF (SMSF2).

There has been a CGT event, as it would be considered a disposal by SMSF1. But the transfer occurs while SMSF1 is in pension phase, so there would be no tax to pay.

SMSF1 now has $1.6m in pension. It then rolls back $1m from pension to accumulation. The member then has only used $600,000 in pension, of the $1.6m cap.

It then turns on a pension for the $1m property in SMSF2. This property is now the only asset in the SMSF and is, therefore, effectively segregated. If this is likely to be a high income, or high growth asset, and you've chosen it for that reason, then the segregation – according to what the experts currently believe – would have been achieved.

This would appear to be allowable under the new rules. But it's early days and something that will require extra consideration by the experts.

There will be some extra costs in setting up and running the second SMSF. But if the trustees believe that it will deliver dividends in excess of those costs, then it could be worth it.

Dunn said that it is too early to tell how all this will work in regards to reporting (to the ATO) the movements in and out of pension phase for SMSF1 and SMSF2.

So the strategy comes with a 'kids, don't try this at home' warning. At least not yet. There's no great rush to, as the new rules don't hit for six months. But the best brains in the business are still trying to work their ways through the new laws.

What are the potential downsides?

If the asset being transferred is property, then a potential downside is stamp duty in some states. This is something to check, state by state (potentially with your SMSF accountant). Dunn said that some states will not charge stamp duty, when the beneficiaries remain the same, but other states will charge it.

So even though there might not be any capital gains tax, having to pay up to around 5.5 per cent in stamp duty, if applicable, could turn a good idea into a marginal one.

The information contained in this column should be treated as general advice only. It has not taken anyone's specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is a licensed financial advisor, a mortgage broker and an expert on self-managed super funds. He is a regular contributor to Eureka Report. To contact Bruce, please click here.