Pension tax certificates – legislative changes to be aware of

• recent amendments to tax legislation which allow trustees a choice of the segregated or proportionate method of calculating ECPI in certain limited circumstances; and

• a 2020 Federal Court decision (the ‘Douglas Case’) which found certain superannuation invalidity pensions paid by two public sector schemes were not superannuation income streams for tax purposes – note this finding may also have implications for some other schemes (including non-public sector schemes).

Read on for more details, including pending updates to PS 406 and PS 409.

Choice of ECPI method

Amendments to section 295-385(9) of Income Tax Assessment Act 1997 (ITAA 1997) made in February this year will allow trustees to use their preferred method of calculating ECPI where the fund is fully in the retirement phase for part of the income year but not for the entire income year.

The choice is available for the 2021-22 and later income years and will mainly be relevant for self-managed superannuation funds (SMSFs) in the year that a pension commences. According to the ATO:

• Previously, trustees were required to use the segregated method when a fund was fully in retirement phase at any time of the income year. When a fund had members in both retirement phase and accumulation phase for part of the income year, and only retirement phase for another part of the income year, trustees may have been required to use both the proportionate and segregated methods to calculate ECPI.
  

• The new law allows superannuation trustees in these circumstances to now choose to treat their assets as not being segregated current pension assets. The fund is then able to use the proportionate method when calculating all of their ECPI for the income year.

The proportionate method was commonly used in these circumstances prior to 2017 when the ATO controversially adopted the interpretation that the segregated method must be applied for any period during an income year that a fund was fully in retirement phase, even where this was only for part of the year. The recent change in the law to (again) permit use of the proportionate approach in these circumstances followed strong representations to the Government by the SMSF sector and other bodies, including the Actuaries Institute.

The Douglas Case

In brief, the Court found that certain defined benefit invalidity pensions paid by two Commonwealth defence force superannuation schemes did not meet the requirements of SIS regulation 1.06 to be considered a superannuation income stream and hence were considered superannuation lump sums under ITAA 1997.

Essentially the decision arose because ongoing eligibility for these pensions was reviewable having regard to the current level of invalidity and the payment amount could be varied or cancelled. As a result, the Court found (inter alia) that these pensions did not meet one or both of the SIS regulation 1.06(2) defined benefit pension conditions that the fund’s rules ensure that:

1. the pension “is paid at least annually throughout the life of the primary beneficiary….”; and

2. “the size of payments of benefit in a year is fixed”, allowing for variation only as specified.

Note the Court also found, in the case of the two Commonwealth defence force schemes, that invalidity pensions which commenced before 20 September 2007 do meet the tax definition of superannuation income stream, due to grandfathering provisions in the legislation.

As a consequence, the Court found for the Douglas Case that, for relevant invalidity pensions of the schemes which commenced on or after 20 September 2007, the pension payments were subject to tax as lump sum superannuation benefits, rather than as superannuation income stream benefits. As well as affecting the tax to be deducted from future payments of these pensions, this meant the benefit tax deducted by the schemes from earlier payments (since commencement as early as 2007) was wrong. Some members were better off as result of the decision and some were worse off. The ATO and the schemes initiated an extensive re-reporting and remediation project (see the ATO website here for further information).

The Government announced in November 2021 that it would make retrospective amendments to tax legislation to “ensure these benefits are again treated as income streams rather than lump sums for tax purposes” and create a new tax offset so that invalidity pensioners from the impacted schemes who stood to benefit from the Court decision are not worse off.

However, the amendments remain outstanding and so it is unclear how other funds which provide invalidity pensions on similar terms may be affected. Also note that the two Commonwealth defence forces super schemes that the Douglas Case considered are untaxed schemes and hence the decision only had implications for the tax payable on the benefits by the recipients. For any taxed schemes with similar benefits, there may also be implications for their ECPI tax claims, as assets backing these liabilities would not be eligible for the tax exemption on investment earnings that applies to qualifying pensions in retirement phase.

Updates to PS 406 and PS 409

The Superannuation and Investments Practice Committee (SIPC) is currently finalising updates to Professional Standard 406 Unsegregated Superannuation Liabilities (PS 406) and Professional Standard 409 Segregated Superannuation Assets Certificates (PS 409) to reflect the legislative change above and to make reference to the potential need to consider the Douglas Case, along with other minor changes.

Given the technical nature of the changes, the SIPC does not propose to issue Exposure Drafts of the updates for consultation. However, it may be worth foreshadowing that the proposed updates to PS 406 include requirements for the certificate to include additional statements in certain circumstances, specifically:

• where the trustee has chosen under section 295-385(9) of ITAA 1997 to treat all of the assets of the fund as not being Segregated Current Pension Assets for the year (i.e. under the legislative change outlined above), a statement to that effect; and

• if the certificate has been prepared on the basis that the fund’s assets are Disregarded Small Fund Assets for the year under Section 295-387 of ITAA 1997, a statement to that effect.

The SIPC currently intends to seek Board approval of the updated Professional Standards in September, for issue in that month with commencement from 1 November 2022.

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