2011 SMSF National Conference Session 1A: The Latest in Reserving Strategies Robert ODonohue Partner, HWL Ebsworth Lawyers.

2011 SMSF National Conference

Session 1A:

The Latest in Reserving Strategies

Robert O’Donohue Partner, HWL Ebsworth Lawyers


When can an SMSF use a reserve? Section 115 of SIS Act - Trustee may maintain reserves

unless governing rules prohibit

Broad administrative powers in most trust deeds

Ideally, trust deed specifies power to create reserve and details what types of reserves may be created

If unsure trustee should seek legal advice


What must you do in creating and maintaining reserves? Section 52(2)(g) of SIS Act – Trustee agrees to formulate and

give effect to strategy for prudential management consistent with investment strategy and capacity to discharge liabilities

Defence to an action for loss (s.55(6)) Strategy should state:

purpose of reserve target level of funds for purpose how funds invested (refer to fund inv strategy) policy as to distributions intervals for review


How are distributions treated for tax purposes?

General Rule - distributions from reserves are concessional contributions unless:

1) allocated in a “fair and reasonable” manner to every member (or class of members) and

2) Together with other distributions for financial year (if any), less than 5% of member’s account at time of distribution

If 1 and 2 above satisfied distribution is neither a concessional, nor a non-concessional contribution


How are distributions treated for tax purposes?

• Rule does not apply to two reserves:

– Distributions from Contributions Reserves

amount allocated from contributions reserve generally retains character of contribution made to fund i.e. concessional or non-concessional contribution

– Distributions from Pension Reserves

to allow for pension commutations, pension payments and death benefits greater than 5% of members account


When is a distribution “fair and reasonable”? Explanatory Statement to ITAR 1997:

“In determining what is fair and reasonable...it would ordinarily be expected that the allocation would be in proportion to the existing interests of the members so that particular members are not favoured over others”

ATO in NTLG Superannuation Tech. Subgroup meeting of 8 September 2009

“To be fair and reasonable the Tax Office considers that the allocation of an amount from a reserve should be allocated to each member’s interest in proportion to that interest in the superannuation fund”


When is a distribution “fair and reasonable”? APRA agrees with ATO Proportionate approach can lead to unfair results:

Example Tom has a $1 million account in his family SMSF Tom’s wife Katie has a $100,000 account Trustee has retained $1,000 p.a. from each of them in an Expense

Reserve to administer the fund If the trustee distributes any surplus from the Expense Reserve

back to Tom and Katie in proportion to their accounts Tom must receive 10 x Katies distribution for it to be considered “fair and reasonable”

Need clearer regulatory guidance


How are reserves treated for super benefit purposes? Accumulation members

If up to 5% limit and fair and reasonable o taxable component because not a contribution

If 5% or above or unfair or unreasonable o arguably part of tax free component because deemed a

“concessional contribution” and because not assessable in fund could form part of tax free component

o Critical issue – whether deemed concessional contributions are “contributions” – not defined in ITAA or ITAR


How are reserves treated for super benefit purposes?

o ATO considers that deemed concessional contributions are not to be regarded as ‘contributions’ because do not increase the capital of the fund (NTLG Superannuation Technical Sub-Group meeting of 8 September 2009)

o Therefore ATO view is that deemed concessional contributions comprise taxable component of a members interest.

– This means all reserve distributions form taxable component of accumulation members unless a Court determines otherwise


How are reserves treated for super benefit purposes? Pensioners

ATO confirmed allocations of reserves to pensioners will be comprised of the same proportions as the components of the pension when the pension commenced (NTLG Super Technical Sub-group Meeting of September 2009)


So what is a reserve? Seems no-one is entirely sure but crucial definition

No definition in SIS Act, ITAA or ITAR despite references

SIS Regulations definition meaningless

APRA and ASIC Acknowledge no definition APRA – “reserves in superannuation funds can be regarded as

monies which form part of the net assets of a fund and which have been set aside for a clearly stated purpose” (Draft Prudential Practice Guide - SPG 235 – Use of Reserves in Superannuation Funds)


So what is a reserve? APRA excludes ‘suspense accounts’ used to record contributions,

provisions for administration expenses, tax, management or service provider fees

APRA view nonsensical – if contributions ‘suspense account’ is not a reserve why does it need to be exempted from the rules relating to distributions from reserves in ITAR?

APRA & ASIC distinguish between a reserve and a provision. Reserves are amounts for contingencies, provisions are for specific obligations from past events i.e. tax expense

ATO SCR 1999/1 – Commissioner deems any “unallocated amounts” as

reserves being the excess of the net market value of assets over members accounts


So what is a reserve?

Much broader than APRA and ASIC Divided unallocated surplus amounts into three general

reserves:o Investment Reserveo Contribution Reserveo Miscellaneous Reserve

Need clear legislative/regulator guidance on what a reserve is


What is the maximum amount allowed in reserves? SIS legislation – no maximum stipulated

APRA and ASIC – any excess over amount required for purpose of reserve should be allocated to members

Competing obligations – requirement to distribute excess reserves v. best interest of members not to incur excess contributions tax

Need regulatory guidance

ATO indicate 15% maximum for investment fluctuation reserve in SCR 1999/1


What reserving strategies are available to SMSFs?

• Contributions Reserve Used to hold contributions until allocated to member’s

account Must allocate to member within 28 days after month when

contribution received (SIS Regulation 7.08(2)) Strategy available because of defect in ITAA 97 S 292-90 of ITAA 97 – non concessional conts = conts made

for a person not included in income of fund PLUS any amount allocated in accordance with regulations

This includes amounts distributed from a contributions reserve


Contributions Reserve Cont’d

Technically counted as non-concessional cont twice: Once when contributed to fund; and Secondly when allocated from contributions reserve

ATO have agreed to count only once when distribution made from the Contributions Reserve if done within SIS Reg timeframe (ignores 1 month timeframe in s 1017E of Corps Act)

Means contributions can be made on 1 June of financial year but not counted for cap until following financial year when allocated by 28 July


propertyB + H

Super Fund

Contributions Reserve Cont’d Case Study - Useful for in specie contributions

1. Bill & Hillary contribute commercial property to their SMSF on 15 June 2011 ($1.3 Million M.V.)

2. 2010/11 - Non-concessional caps - $300k counted ($150k each);

- Concessional caps - $100k (50k each)

3. Remaining portion held in contributions reserve and allocated to member accounts on 15 July 2011

4. 2011/12 - Non-concessional cap – 900k ($450k each) (bring forward rule)



Case Study - Useful for managing cap overflows George’s employer contributes his super under a salary

sacrifice arrangement each year up to the conc. cap Agreed with employer that this will be done on 28

September, 28 December, 28 March and 28 June At the end of 2010/11, it is realised that George’s employer

paid the June 2010 contribution late in July 2010 The contributions received by the fund in 2010/11 for

George are therefore $6,250 more than the 25k cap



Utilising the contributions reserve the trustee of Georges SMSF retains the June 2011 contribution in a contributions reserve and allocates it to George’s account in July 2011

This prevents George from breaching the concessional contributions cap for 2010/11 because the excess is allocated to 2011/12 year

Faster and easier than getting Commissioner discretion


Self Insurance Reserves

Used to fund salary continuance, death and TPD benefits

SMSF essentially self insures members – pay proceeds to member if event occurs

Actuary should determine level of reserves required to fund claims (annual review)

Is reserve subject to 5% rule? No exception so technically, it appears so (March 2010 NTLG Super meeting) – watch this space


Self Insurance Reserves Cont’d

Why self insure? Some members can’t be insured externally or terms of insurance

too restrictive

Fund can claim a tax deduction for either1. insurance premiums reasonably expected to otherwise pay (actuarial

opinion required); or2. Amount of benefits paid where event occurs x members future service

days (eg to age 65)/total service period (once chosen this option applies to all future years)

Death and TPD insurance not deductible outside of super


Anti-detriment Reserves

Used to pay out “anti-detriment” benefit These are an additional payment made by fund on top of death

benefit to compensate for contributions tax paid by deceased Benefit is a lump sum reflecting extra amount that would have

been paid had contributions tax not been payable Fund effectively refunded benefit paid due to tax saved from

tax deduction Payment must be made first to get deduction so creates cash-

flow issue and therefore need reserve in an SMSF


Anti-detriment Reserves Cont’d Caution needed - September 2009 & March 2010 NTLG Super

Technical Sub-group Meeting - ATO confirm anti-detriment payment will be a concessional contribution if funded from reserve b/c generally more than 5% of members account

ATO approach could mean excess contributions tax payable on distribution at 31.5% (possibly 78% if non-conc. cap exceeded)

ATO consulting with APRA on the issue

Possibly use Pension Reserve to avoid b/c not subject to 5% rule or possibly use “provision” rather than “reserve”?


Investment Fluctuation Reserves Used by funds to “smooth” investment returns on a year-to-

year basis

Example Investment objective = earnings of CPI + 2% pa To meet objective trustee retains 2% in IFR in years when fund

earns CPI + 4% Extra 2% distributed to accounts from IFR in years when only CPI

earned by fund

Superannuation Contributions Ruling SCR 1999/1 – should be limited to 15% of fund


Investment Fluctuation Reserves Cont’d

In distributing need to have regard to equity between members i.e. exited members may be paid further amount if reserve wound-up to compensate for time in fund

Should be careful if distribute 5% or more


Pension Reserves Holds “segregated current pension assets” to support pension

liabilities

Actuarial certificate required to determine assets required

Tax exempt (unless non arms-length) and allocations not concessional contributions if used to pay pension, rollover to another pension or fund a death benefit (reg 292-25.01(4)(b) of ITAR)

Very useful for funds with assets with large uncrystallised CGT liabilities


Pension Reserves Cont’d

Case Study – managing CGT liabilities• John and Janette SMSF - $4 million ($2 million

equities, $2 million commercial property)• Equities - $1.5 million capital gain, Property – no

gain• John 65 – wants to start an account based pension• Trustee decides to segregate equities to support

John’s pension – no CGT payable when shares sold


Pension Reserves Cont’d

ATO indicated that pension accounts may be “topped up” from distributions from reserves (NTLG Superannuation Sub-Committee Meeting - Sept 2009)

Reserve distributions added to pension account are in same tax free/taxable proportions as pension itself

Creates planning opportunities


Pension Accounts and Reserves

Case Study – managing tax components Brad and his partner Angelina are 55 and have their own SMSF Fund = $2.3 million in assets Brad’s Account = Tax free - $900,000

Taxable - $100,000 Ang’s Account = Tax free - $950,000

Taxable - $50,000 IFR = $300,000


Pension Accounts and Reserves Cont’d Both Brad and Ang decide to commence TRIS’s

After commencing pensions trustee decides to wind-up the 300k Investment Fluctuation Reserve and distribute it over a 3.5 year period (to prevent breaching 5% limit)

Result Brad - $135,000 is added to his pension account as tax free

component, 15k added as taxable component

Ang - $142,500 added as tax free component, $7,500 as taxable component


Pension Accounts and Reserves Cont’d

If the trustee had decided to wind-up the IFR in the accumulation phase (or distribute earnings directly) the whole $300,000 would have been taxable component (compared to just $22,500 whilst in pension phase)

ROT – always better to distribute from reserves when members in pension phase


Other Reserves

Expense Reserve – for administration expenses including accounting and legal fees, investment management fees, insurance and other expenses

In-house Assets Reserve – allows trustee to observe total in-house assets at a glance

Forfeiture reserve – generally only utilised by SMSFs with defined benefit pensions such as lifetime pensions where no RCV after member dies. Capital supporting pension re-allocated within the fund.


Asset Protection

Amounts in reserves (apart from a Contributions Reserve or Pension Reserve) more likely to be protected from family law claims as such amounts do not comprise a member’s superannuation “interest” for family law purposes

Investment fluctuation reserve, expense reserve, anti-detriment reserve and self-insurance reserve may assist in this respect


Conclusion Reserves may be utilised for:

Managing excess contributions Smoothing investment returns Eliminating potential CGT liabilities Managing tax components Insuring members who may not otherwise be insurable Accessing anti-detriment payments Asset protection

Residual issues - What is a reserve? What is a fair and reasonable distribution? Requirement to distribute surplus reserves v. potential conc. contributions if 5% or more? 5% rule and certain reserves?

2011 SMSF National Conference Session 1A: The Latest in Reserving Strategies Robert ODonohue Partner, HWL Ebsworth Lawyers.

Documents

contributions reserves

concessional contributions

pension reserves

members account slide

superannuation fund

itar slide

use of reserves

superannuation funds