Market linked pension commutations still in limbo

In late June this year, the industry was pleased to see amendments made to the calculation of a transfer balance debit that arises on the commutation of a pre 1 July 2017 market linked pension (MLP).  However, the retrospective application of the new formula continues to leave the industry in limbo and the ATO has acknowledged there are some challenges with applying the new formula and that more guidance is required.

The Government’s rational for a retrospective application date was that all affected taxpayers would benefit from the new law in comparison to the original law which resulted in a ‘nil’ debit value and effectively lead to the double counting of benefits for Transfer Balance Cap (TBC) purposes. Although this may be true, this rationale is flawed as it is based on the notion that members were aware of the nil value issue from 1 July 2017. The reality is that it was almost a year after the law was introduced before the ATO confirmed its interpretation of the law and the unintended consequences of the original calculation. It was then a further eight month wait before draft law was released, alerting industry to a proposed formula that was materially different to the treatment of any other income stream subject to the TBC. Overall, it took nearly three years before we had a new calculation.

It is the culmination of these delays and the fundamentally different outcome delivered by the new formula when compared to the original calculation, that make the retrospective application of this law tricky. Since the introduction of the new formula, the SMSF Association has been engaged with the ATO in an effort to ensure that the new legislation is effective, not overly complex, and fair particularly to those taxpayers who in good faith, based their calculations on the original formula.

The good news is that earlier this week, the ATO announced that it would defer the need for any retrospective reporting of any post 1 July 2017 MLP commutations until November 2020, pending further guidance.

In the interim, the ATO updated its web content to provide clarity on its interpretation of parts of the law. Newly published material confirms that if a MLP is fully commuted, the debit value is calculated as the original “credit” for the pension reduced by the total of actual pension payments drawn from the MLP in the years prior to the year of the commutation, as far back as 1 July 2017.

The ATO also confirmed that in the financial year in which the commutation takes place, the amount included in the debit calculation will be the greater of either the actual pension payments drawn that year, or the pro-rated minimum amount required to be paid prior to the commutation taking place. The new web content also makes it clear that in any year, the relevant minimum amount can be adjusted by 10% as permitted by the SIS Regulations.

Although the SMSF Association applauds the ATO’s efforts to provide some clarity and defer the administrative pressure of reporting these commutations until further guidance is finalised, we feel the Regulator will come under pressure to do more. The crux of the matter is that the longer the ATO takes to publish guidance, the more excess transfer balance earnings continue to accrue for those affected.

Given all the genuine reasons why a member may have chosen to commute their MLP, we believe that pressure will mount for the ATO to consider appropriate relief for members, who relied in good faith on the original MLP formula to restructure their MLP, before the new formula was law. For example, a member might have opted to reset the term of their pension to change their pension drawdowns, or they may have wanted to add or remove a reversionary beneficiary.

Another example is where a member may simply have wanted to wind up their SMSF and opted to commute their MLP to rollover to a different super provider. This scenario also raises the practical dilemma a trustee of a wound up SMSF will face should they be required to retrospectively report a MLP commutation.

As a starting point, the ATO need to address the imposition of any excess transfer balance tax. We do not believe it is appropriate to impose an excess transfer balance tax greater than 15% on the basis that the excess has been triggered by a single event and it is the sheer nature of the MLP that limits a member’s ability to commute any excess. To impose excess transfer balance tax on excess MLP balances in the second and subsequent income years indefinitely, at the penalty rate of 30%, would arguably be unreasonable.

In fact, the SMSF Association is keen to achieve a more sensible solution, a solution that altogether avoids triggering any excess for those affected. In the absence of such a solution, a member in excess would be required to pay excess transfer balance tax on a daily notional earnings amount indefinitely.  

One solution put forward to the ATO by the SMSF Association is to explore the ATO’s regulation making powers which are designed to address unforeseen issues that arise under the TBC. The SMSFA believes that the current situation warrants a closer look at these powers.

The use of these powers could potentially give rise to a new ‘debit’ to effectively write off any unintended excess, using similar processes that the ATO adopted back in July 2017 to ensure that members with only non commutable income streams, did not trigger an excess.

The alternative solution of advocating for a legislative fix to amend the SIS Regulations to allow a trustee to commute a restructured MLP to remove any excess, is not considered viable given the lengthy delays to date and the other priorities faced by Government amidst the COVID pandemic.

We believe the use of the ATO’s regulation making powers present the most effective mechanism to mitigate the imposition of a tax in perpetuity, particularly for those members who acted in good faith in applying the original formula. They also provide an administrative solution to reduce the burden on the ATO to have to manually issue excess transfer balance determinations to members indefinitely.  

Whilst there may be frustration across industry as we wait for the ATO’s guidance, the SMSF Association plans to make the most of this opportunity to continue to advocate for the ATO to use their regulation making powers to overcome the undesirable consequences of the retrospective application of the new formula.

Although this article only focuses on MLPs, we acknowledge that this law also applies to complying life expectancy pensions.