Failed pensions – the next chapter

The update to Taxation Ruling 2013/5 means trustees are faced with a range of decisions and issues to deal with if they fail to meet the minimum pension payment requirement. Lyn Formica explores some of the dilemmas they now face.

In Issue 50 of selfmanagedsuper, Craig Day wrote an excellent article on the dilemma facing trustees, accountants and advisers when an SMSF fails to meet the minimum pension requirements.

As so often happens, there was even more to say than Craig’s word limit would allow. So I thought I would pick up where he left off and explore some of these issues in more detail, adding the SMSF administrator’s flavour.

A quick recap first

The industry’s bible for dealing with pension underpayments has been a taxation ruling (TR) first issued by the ATO back in 2013 – TR 2013/5.

This was the ruling that for the first time presented the ATO’s views on when pensions start and stop. It also specifically enshrined the concept funds failing to pay the minimum amount required from an account-based pension during a particular year would cause that pension to stop, for tax purposes, from the start of that financial year.

Importantly, that meant no exempt current pension income (ECPI) – the magical tax break page applying to retirement-phase pensions whereby income earned on super pension accounts is exempt from tax.

After that ruling, the widespread industry interpretation was while ECPI would be lost for the entire 12 months in the year of failure, it would restart from the following 1 July as long as the trustee paid the right amounts in future.

For example, a pension that failed in 2023/24 would start earning ECPI again from 1 July 2024 as long as the minimum payment requirements, and all the other rules for pensions, were followed throughout 2024/25.

However, the ruling was updated and reissued in late June 2024. Some small wording changes made it clear the ATO had a very different view to the general industry practice. In particular, the ATO view we now know is:

• a failed pension will never be entitled to ECPI again – it will be considered a failure forever,

• the only way to get ECPI in the future is to formally commute the tainted pension and start a new one that does comply with the rules, and

• failed pensions effectively get mixed in with the member’s accumulation account – they don’t remain a separate superannuation interest (tax law language for a separate member account).

This obviously has a host of consequences, many of which Craig covered in his article. For example:

• SMSF members with both a failed pension and an accumulation account, or even multiple pensions that have failed, will find the careful planning they’ve done to create accounts with different tax components will end up scrambled together. And like eggs, they can’t be unscrambled.

• Transfer balance account entries are a bit more complicated. For example, if a pension fails in 2024/25, there will be a debit to the member’s transfer balance account on 30 June 2025, the end of the year of failure. This is the transaction that reduces a member’s transfer balance to reflect the fact the pension they used to have has lost its status as a retirement-phase income stream. In the past, the industry would have reported a new transfer balance credit to reflect the pension’s return to retirement phase on 1 July 2025. Since the amounts would have been the same, it wouldn’t have made any practical difference to the member’s transfer balance cap. But now the credit won’t occur until the failed pension is formally terminated and a new pension starts in its place. The member’s account balance might have changed a lot in that time.

All in all, bad news.

What more is there to say?

The dangers of taking too long Often, pension failures aren’t discovered until the annual accounts are prepared for the SMSF. That will often be many months after the end of the financial year. The longer the process takes, the more time will elapse before the failed pension, with no ECPI, is stopped and a new income stream, with ECPI, is started. The more time that elapses, the more ECPI is lost.

Doubling up of accounting work

A truly weird outcome of all these shenanigans is our tax law requires trustees to calculate the transfer balance debit value for failed pensions as if it hadn’t failed at all. In other words, if a pension fails in 2024/25, the trustee tells the ATO it stopped being in retirement phase. For transfer balance cap purposes only, it tells the regulator this happened on 30 June 2025, this is despite the fact the failure is backdated to the start of the year for everything else. When the value of the pension at 30 June 2025 is determined, the trustee pretends the pension account is still separate to the accumulation account and also pretends it’s still receiving ECPI.

But a completely separate set of calculations is required for determining the new pension’s value when it commences (this would be done correctly, that is, assuming there was no ECPI in 2024/25 and however much of 2025/26 has elapsed already).

It’s feasible to imagine the trustees and their poor accountants would be processing a fund multiple times just to get all the numbers right.

What about commutations during the failed year?

It is unlikely, but sometimes pensions are partially commuted during the year of failure. This might happen because the member made an in-specie benefit payment, which has to be a commutation, and didn’t realise this did not count towards meeting the minimum payment standards.

So given the pension gets cancelled from the start of the year, are these really commutations for transfer balance account purposes or just lump sums from accumulation accounts?

In our view, they are still commutations so will reduce the amount of the transfer balance cap that a member has used up. This is because at the time they occurred the fund hadn’t yet failed the pension rules. For example, at any point up until 30 June 2025, they might have met the rules for 2024/25. That means a commutation in March 2025 is still a commutation.

What about pro-rata pension payments before commuting a failed pension?

Normally whenever a trustee commutes a pension, they must ensure a minimum payment is made first. For example, a pension that is fully commuted 90 days into a 365-day financial year must make a payment of 90/365 of the normal minimum before doing so. But will we still need to do this with a failed pension? Arguably no. The worst has already happened as the pension has lost its ECPI. However, we would suggest clients do make this extra payment. Our logic here is that the trustee has committed to meeting certain rules. The fact they’ve failed to meet them in one year isn’t a free ride to ignoring them in another year. However, this is something the ATO has chosen not to clarify.

What about the 1/12th rule?

This is the rule that allows trustees to self-assess and let themselves off the hook if the pension failure meets certain criteria. To use it, the payment shortfall has to be less than 1/12th of the full amount. Nothing has changed here. The option still exists and works in the same way. A pension that meets the criteria here is treated as if it never failed in the first place, so none of the issues above apply. For example, there is no loss of ECPI, no need to combine accumulation and pension balances, no need to formally commute the old pension, et cetera.

It should be noted the size of the payment, that is, less than 1/12th of the required amount, is just one of the rules necessary to legitimately self-assess. There are others which must also be followed, such as making a catch-up payment within 28 days of discovering there is a shortfall.

Those who don’t meet the requirements to self-assess can still present their case to the ATO and ask for specific permission to overlook the shortfall. But that’s just become a bit trickier.

Asking for ATO discretion

Fortunately, the ATO eventually recognised the view expressed in its updated ruling was quite different to the long-held industry view. As done occasionally in these circumstances, it agreed to adopt a no compliance action approach to failures in 2023/24 and earlier years.

In other words, it committed to not proactively look for cases where historical pension failures had not been dealt with in accordance with its view. This prevented the necessity for accountants and advisers to go back over the last 10 or more years, find failed pensions, relodge tax returns for the intervening years removing any ECPI claims in relation to those pensions for every year since the failure, adjust all the tax components for any payments taken during that time and other such administrative actions.

But taking no compliance action isn’t the same as saying it will accept the industry view for these historical failures.

Importantly, if asked to look at a particular fund, or if the fund was chosen for an audit for some other reason, the ATO would apply a compliance approach consistent with TR 2013/5 as it stands now. This places trustees in a very difficult position for funds with failures in 2023/24. Sometimes there are good reasons for the failure and it’s reasonable to ask the ATO to exercise its discretion to formally overlook it. But what if the ATO says no to a request to use this discretion for 2023/24? The real risk now is that if it says no, the regulator will also insist on its view applying for 2024/25 and beyond.

A pension failure in 2023/24 where no discretion is sought is a contained problem. This means the old industry view can apply from 1 July 2024 and the pension automatically refreshes its status as a retirement-phase pension from that date. ECPI is safe in 2024/25 and beyond (as long as the rules are followed).

But a pension failure in 2023/24 where the ATO is asked to exercise its discretion and the regulator says no, creates a whole different set of problems. For a start, the pension will lose its ECPI in 2023/24, 2024/25 and 2025/26 until the income stream is formally commuted and a new one commenced.

It also makes asking for discretion far more challenging in the future. Will trustees doing this choose to formally commute potentially failed pensions anyway just in case to hedge their bets?

For example, imagine a trustee discovered in September 2025 a pension had failed the minimum payment rules in 2024/25. Let’s also imagine the ATO will be asked to exercise its discretion. In this situation the trustee would be well advised to formally commute the pension now anyway. Just to make sure, at the very worst, everything is resolved from this point onwards. If the trustees wait six months for the ATO to make up its mind, they may find another six months of ECPI is lost if that discretion isn’t forthcoming.

To be honest, there is even more to say on this topic than I’ve been able to cover here. And lots of issues are still unclear. Given the ATO does not seem inclined to provide any more guidance, it’s likely things will stay that way for some time.