Accounting for expenses in SMSF with Exempt Pension Income

Where assets of a self managed super fund are un-segregated an actuary can only issue a certificate on how much income is exempt from tax, known as Exempt Current Pension Income (ECPI).

Expenses incurred in gaining or producing exempt or non-assessable non-exempt income, or expenses of a capital, private or domestic nature are not allowable deductions. If the fund has only expenses which the SMSF incurs in deriving only ECPI, they cannot be claimed anywhere on the SMSF annual return.

If the expense is incurred which relates to accumulation and pension income, the expense must be apportioned so that only the proportion of the expense relating to the production of assessable income is claimed.

If your SMSF is not just solely paying a pension, that is, there are members who are still in accumulation phase, you should clearly identify what expenses you have and how much is related to the income earned to pay pensions. The reason for this is, if you are entitled to a tax exemption on the income that is used to pay current pension liabilities you won't get a deduction for the expenses related to earning that exempt income and you can't claim these expenses as a deduction in the fund's income tax return.

For example, if the fund pension and non pension assets are un-segregated or they cannot be identified separately, then all expenses may not be deductible, you will have to apportion them.

Say Michael is 62 years old and has $500,000 in pension phase and his spouse Mary who is 52 years old is still in accumulation phase and has $250,000 in her accumulation account, there are no new contributions by any member. The Super fund owns one commercial property worth $700,000 and there is bank account with $50,000 since there is only one large asset, the fund cannot be segregated.

The fund has expenses such as insurance, strata, water rates etc relating to the commercial property for $6,000 – since Michael is on pension - the actuary determines that 66.66% of income is exempt; this means that the fund cannot claim $4,000 worth of common expenses. Only $2,000 worth of expenses can only be claimed by the fund which is 33% of the fund belonging to Mary.

Expenses which a SMSF incurs in deriving ECPI cannot be claimed anywhere on the SMSF annual return. This means that these expenses must not be included as part of the deductions claimed in the SMSF annual return and $4,000 will not be disclosed in the income tax return.

The cost of amending trust deeds are allowable as a deduction provided the expenditure is not of a capital nature (Taxation Ruling IT 2672). Supervisory levy for an annual return to the ATO is deductible as a tax-related expense; however, late lodgement amount of the levy is not deductible.

Taxation Ruling 93/17 guides on how specific expenditure such as actuarial costs, accountancy fees, audit fees etc can be apportioned which are incurred partly in producing assessable income and partly in gaining exempt income. If you have Total and Permanent Disability cover in your SMSF, you should read Taxation Ruling TR 2011/D6 for further information.

If some expenses which are deductible to accumulation account are specifically recorded and marked to accumulation account, like life insurance for Mary in the above example, then that life insurance expense is fully deductible to the fund. This means if one member has both, a pension account and an accumulation account in a self managed super fund, the fund must record expenses in such a manner that expenses which are 100% deductible are linked to accumulation account and are recorded accordingly and claimed fully.

Special income such as non-arm's length income includes income such as private company dividends (including non-share dividends) and certain distributions from private trusts. Non-arm's length income and assessable contributions are excluded from ordinary income and cannot be exempted from income tax.

One of the common strategies is to commence a transition to retirement pension as soon as the members reach their preservation age (usually 55 years). This can happen on the member’s birthday which can be any date other than 1st July in the year.

Advisor should add contributions from 1st July to the 55th birthday and prepare accounts of the fund and allocate income to all members, including unrealised gain or loss.

These interim (55th Birthday) accounts should also account for tax on income & contributions to date and credit (or debit) member accounts with growth (loss) in market value of all assets. Once the member balance is credited (or debited) with all realised and non-realized income & contributions a new member balance is determined for the accumulation account which is then converted to Pension phase.

This new member balance determines the amount of minimum pension withdrawal which the member must withdraw prior to 30th June to maintain pension standards. The minimum withdrawal amount is pro-rata for the balance number of days up to 30th June. The maximum amount which can be withdrawn for transition to retirement pension is not more than 10% of the pension commencement balance and is not pro-rata.

We strongly recommend proper pension documents to be drawn up and pension agreement to determine important issues such as commencement date of pension, tax free and taxable components of the member balance, percentage of accumulation account to be converted to pension phase, frequency and amount of pension payments, reversionary pensioner and what happens to the pension amount on death of the member etc.

Preparing income tax return for the fund which has commenced a pension during the year can be daunting. Any income from 1st July to the commencement date of pension and from commencement date of pension to 30th June is put together in the income tax return.

Whilst calculating actuarial percentage and exempt pension income deduction, the percentage of ECPI deduction is based on the assumption that income is earned consistently during the whole year. Hence it will be wrong to assume that any capital gain triggered and realized after the pension commencement date will be tax free. Any capital gain realized after the commencement of pension will be part of total income and the fund will be able to claim a deduction as per actuarial ECPI percentage.

If the intention is to sell assets after commencement of pension, it is of paramount importance that assets must be either segregated or the asset sold the following year. Trustees should take capital gain tax advice before selling any assets after commencement of mid-year pensions.

Similar problems are faced when a pensioner dies mid-year. The ATO has released a draft tax ruling TR 2011/D3 setting out its views on when pension commences and ceases on death. Note that pension balance of the member moves to accumulation phase unless an automatic revision is provided in pension documents or death benefit nomination.

Super funds can borrow. Due to “Super Negative Gearing”, it is possible for a SMSF to be in a revenue loss situation. These losses (not capital losses) can be used to offset other income of the fund including a tax shelter for concessional contributions. In the absence of any concessional contributions, these losses are carried forward to the following year.

However, if the fund has any exempt pension income any carried forward loss is reduced by Net Exempt Pension Income claimed by the fund. The net ECPI amount is ECPI less any expenses that were incurred in deriving ECPI (such expenses cannot be claimed as a deduction).

If the fund has carried forward losses and no member will contribute to the fund and the whole fund moves to pension phase, all losses including capital losses are practically lost.

This can be explained by an example:

Zanzibar Super Fund has two members; Kuku who has 80% assets on pension while Dodo has 20% who is still in accumulation phase. The fund has carried forward losses of $100,000 from previous years. The fund earned $60,000 interest income and incurred $1,000 bank fees. The assets of the fund are un-segregated. Since bank fees were incurred in earning both assessable income and exempt income, they have to be apportioned accordingly.

Exempt pension income deduction will be 80% of $60.000 or $48,000 only $12,000 will be assessable income. Out of the $1,000 bank fees, $800 (80% of $1,000) will not be claimed as a deduction. Hence Net ECPI is $47,200 ($48,000 less $800).

Since the carried forward loss is $100.000 only $52,800 ($100,000 less $47,200) can be used against taxable income of $11,800 ($12,000 less $200 deductible bank fees) and only $41,000 loss can be carried forward ($52,800 less $11,800) to the following year.

In other words, loss of $100,000 is now reduced to $41,000 after $59,000 (income $60,000 less $1,000 of bank fees) of income for the year.

If your SMSF has segregated current pension assets, you should ignore any capital gains or capital losses resulting from the disposal of these assets. Any such capital loss cannot be offset against any other capital gain earned by the SMSF.

However, if your SMSF has un-segregated current pension assets and the fund has a net capital loss, the loss can be carried forward each year until it can be offset against an assessable capital gain. Any net capital gain is added to the SMSF's assessable income before working out how much of income is tax exempt, as per the actuarial calculation for the relevant year.

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