ECPI legislation passes – clarifies more flexibility for SMSF trustees

By William Truong, Technical Services Manager

Income that a superannuation fund derives from assets held solely to support retirement phase income streams is exempt from income tax. This income is also known as ‘exempt current pension income (ECPI)’. To be eligible for ECPI, the retirement phase pension must meet the superannuation pension standards (most notably to pay minimum pensions).

There are two methods of determining ECPI – the segregated method and unsegregated method (or proportional method). The method used or allowable to be used is important as it may impact the fund’s tax liability. 

Segregated method

Assets supporting the income streams are physically held separately from assets supporting accumulation accounts. The ECPI is identified as income that is derived from the assets that are held separately and wholly supporting income streams. The assessable income of the fund is identified as income that is derived from the assets that are held separately and supporting accumulation accounts (and transition to retirement accounts). Assets supporting retirement phase pension accounts are called segregated current pension assets. Assets supporting accumulation accounts and transition to retirement pension are called segregated non-current pension assets.

Where a fund sells a segregated current pension asset the capital gains tax event is disregarded. This also results in capital losses not being carried forward to offset capital gains in future years.

Proportional method

When assets supporting the income streams are not distinguished from assets supporting accumulation accounts the proportional method is used. An actuarial certificate is required to determine the ECPI percentage based on the average member interests in the retirement phase throughout the year relative to the average total member interests. This is the most common method of calculating ECPI in SMSFs.

Where a fund using the proportional method sells an asset, the ECPI percentage is applied to the capital gain to determine the exempt amount, the remainder is taxable. Where a fund using the proportional method sells an asset that results in a capital loss, that loss can be carried forward if it is not used to offset a gain in that year. Capital gains are offset against capital losses before the ECPI percentage is applied.

Background

In the 2019/20 Federal Budget, the Government announced the following changes to seek to reduce costs and simplify reporting for superannuation funds for the calculation of ECPI: 

  1. For funds with disregarded small fund assets, in cases where all the assets of the fund are solely supporting retirement phase pensions throughout the entire income year, remove the requirement for the fund to obtain an actuarial certificate to claim 100% ECPI.
  2. Allowing trustees to choose their preferred method of calculating ECPI, in cases where a fund is fully in retirement phase for part of the income year, but not for the entire income year. 
All assets are wholly supporting income streams throughout the entire income year. 

Legislation1 has already passed stating that from 1 July 2021 and future years, an actuary certificate is not required to claim ECPI during an income year.  

The disregarded small fund asset rule was introduced as an integrity measure to require funds to use the proportionate method if:

  • The fund has a retirement phase pension during the year
  • Any fund member has a total super balance of $1.6 million or more at the previous 30 June
    • Where the total super balance is in all funds
  • That member has a retirement phase pension at the previous 30 June
    • The pension can be in any fund.

The measure was designed to ensure that funds were not able to move assets between the tax-free earnings in retirement phase and the taxable earnings in accumulation phase.

However, because the test relates to a member’s interests in all funds, you could have a situation where an SMSF has a single member who has a $1 million pension in a government fund and a $900,000 pension in the SMSF. Even though the SMSF has 100% of its assets solely supporting a retirement phase pension, because the fund has disregarded small fund assets, an actuarial certificate is required. The actuarial certificate will of course provide an ECPI percentage of 100%, however without the actuarial certificate, no ECPI could be claimed.

The legislative change means that the actuarial certificate is no longer required for a fund that has disregarded small fund assets, but the small fund’s assets are 100% supporting retirement phase pensions. 

All assets that are held separately and wholly supporting income streams 
for part of an income year but not for the entire year. 

In the case where funds have member interests in both accumulation and retirement phases at one time, and only retirement phase interests at another time during an income year, the Government has recently passed law2 to allow certain SMSF trustees to choose their preferred method of calculating ECPI for the whole year. This rule applies from the 2021/22 income year and later income years. 

This is in line with historic industry practice for trustees as it is expected that allowing this choice will minimise complicated ECPI calculations and associated costs which arises where the SMSF may be required to use different methods to calculate ECPI for different periods even in the same income year.

How does this choice work?

From 1 July 2021, if no choice is made, the default position is that: 

  • the segregated method would be used to calculate ECPI during any period when all of the SMSF’s assets are solely supporting retirement phase pensions, and 
  • the proportional method would be used to calculate ECPI for any other periods in the year where the SMSF holds a combination of retirement phase pensions and accumulation and/or transition to retirement accounts. 

The above rules must continue to be used for income years before 1 July 2021 (ie no choice allowed for funds in the same situation).

Also, the SMSF trustee could make this choice: 

  • at the time the SMSF’s annual return is prepared – this means the SMSF trustee could choose whichever approach gives them the best result, and 
  • on a year-by-year basis.

The choice would not be a formal election and would not need to be submitted to the ATO – the choice would simply need to be made before submitting the fund’s income tax return. However, it is expected that trustees would keep a record of any choice they make and the details of the calculations used. The general rules for amending income tax returns would apply in relation to calculation of ECPI meaning that if a fund makes an error, they are able to amend their return after it has been lodged.

 Case study: Illustration of choice allowable

Tina is the only member of her SMSF and has no other super funds.

At 30 June 2021, she only had an account based pension, valued at $600,000 and no accumulation account. On 1 February 2022, Tina made a $200,000 non-concessional contribution which remained in accumulation for the rest of the year. 

On 30 June 2021, while she has a retirement phase pension, her total super balance was below $1.6 million (non-indexed limit), and hence her SMSF does not have disregarded small fund asset. Accordingly, she is not required to use the proportional method for 2021/22. 

As the fund has member interests in both accumulation and retirement phases at one time, and only retirement phase interests at another time during an income year, the recent law change allows Tina to make a choice to use the proportional method for the whole income year (ie. the actuary will calculate one ECPI percentage to apply to all transactions throughout the year). In this case, the tax exempt percentage would be around 87%.

If she does not make a choice to apply the single ECPI percentage for the whole year, then the default method would apply and Tina’s SMSF would claim ECPI in 2021/22 as follows:

  • 1 July 2021 – 31 January 2022: the segregated method is used, because all of the assets of the fund were solely supporting retirement phase pensions. All investment income earned during this time would be exempt from tax. Capital gains and capital losses would be ignored. 
  • 1 February 2022 – 30 June 2022: the actuary will calculate the ECPI percentage that applies during this period. In this case, the relevant ECPI percentage would be around 75%. That is, 75% of all income earned in the last 5 months of the year would be exempt from tax and the remaining 25% would be taxable. 

Which approach to adopt may depend on the timing of the fund’s income.

1)  For example, if Tina’s SMSF earned its income on a regular basis (let’s say $5,000 per month).

Using the default option (if the election is not made), the following income would be exempt from tax: 

  • all of the first 7 months’ income ($5,000 x 7 = $35,000), and 
  • 75% of the last 5 months’ income ($5,000 x 5 x 75% = $18,750). 

In total, approximately $53,750 would be exempt from tax and the remaining $6,250 would be taxed. 

If the trustee of Tina’s SMSF chose to apply the single ECPI percentage for the whole year, the taxable income would be 13% x 12 months x $5,000 = $7,800. The default option provides $1,550 less taxable income.

2)  Alternatively, let’s say all of the SMSF’s income ($60,000) is earned in November 2021 (for example, if it came from a capital gain). 

If Tina’s SMSF does not make a choice to apply the proportional method for the whole year, the following income would be exempt from tax: 

  • all of the first 7 months’ income ($60,000), and 
  • 75% of the last 5 months’ income ($0 x 75%) = $0). 

Total exempt income = $60,000 and nil would be subject to tax.

If the trustee of Tina’s SMSF chose to apply the single ECPI percentage for the whole year, the taxable income would be $60,000 x 13% = $7,800. 

As the default option results in no taxable income, compared to the proportional method, it will result in $7,800 less taxable income for the fund.

Not making a choice to apply the proportional method for the whole year means Tina’s SMSF would not pay any tax.

Conclusion

The decision to make the choice to use the proportional method may depend on the costs for the actuarial services.

SMSF trustees should contact their fund actuary to discuss the services and options available.

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1 Treasury Laws Amendment (2021 Measures no.6) Act 2021
2 Treasury Laws Amendment (Enhancing Superannuation Outcomes For Australians and Helping Australian Businesses Invest) Act 2021


More information

If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.

Disclaimer
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.