New standards to note

There are numerous issues for trustees to face now when they do not satisfy the minimum pension payment obligations. Colonial First State head of technical services Craig Day details the serious ramifications resulting from a compliance breach of this nature.

Since 2013 and the ATO’s release of Taxation Ruling (TR) 2013/5 on when account-based pensions (ABP) start and stop, the industry has been well aware of the tax implications of a super fund failing the pension standards. However, in a recent update of that ruling, the ATO clarified several issues, which could have much broader impacts and change the way funds that have failed the standards need to be administered.

Recap on failing pension standards

Where a fund paying an ABP fails the pension standards in the Superannuation Industry (Supervision) Regulations, most commonly by failing to pay the required annual minimum amount or by not complying with the ABP commutation rules, the pension will be taken to have stopped for tax purposes at the start of the relevant income year. This means the fund will be ineligible to treat any income derived from the assets used to support the pension as exempt current pension income (ECPI).

Note, in some limited circumstances, the ATO may allow an ABP that failed to pay the minimum to continue. For the purposes of this article, it is assumed those concessions do not apply. For more information, please see ‘Exceptions to minimum pension payment requirements’ on the ATO website.

In addition, since 1 July 2017, failing the pension standards will also require the fund to report a transfer balance account (TBA) debit for the member. However, the timing and value of the debit will instead be based on when it is possible to determine the fund failed the standards.

For example, where an SMSF failed to pay the minimum pension amount in a year, the ABP would be treated as having stopped for tax purposes at the start of that year. However, the trustee would not be required to report a TBA debit until after the end of the year, that is, by the following 28 July 2025, as it wouldn’t be possible for them to know the fund would fail the standards until immediately after the end of 30 June. In this case, the value of the debit would then be based on the value of the member’s ABP account at the end of 30 June.

How funds fixed the problem

Previously, where a fund failed the pension standards, the commonly accepted industry practice to fix the problem was to treat the relevant ABP as having stopped for tax purposes, but not for superannuation purposes. This was on the basis the trustee still had an ongoing contractual obligation to pay an income stream to the member. In this case, the trustees would then treat the ABP as having restarted for tax purposes on 1 July at the start of the following financial year.

This had the following advantages:

• the income from the assets used to support the pension would only lose its ECPI status for a maximum of 12 months, and

• the TBA credit for the new pension would be reported as commencing on 1 July, limiting any TBA debit and credit potential mismatch. However, the recent update to TR 2013/5 will require trustees and administrators to rethink how they deal with these situations.

So what changed in the updated ruling?

When the ATO re-released TR 2013/5 in late June 2024, it included additional wording not present in an earlier consultation draft that questioned the validity of the industry’s method of addressing this issue. Specifically, the updated TR clarified that once an ABP has ceased for tax purposes, it cannot recommence satisfying the pension standards in a future year, regardless of whether the fund treated the ABP as continuing for super purposes or complied with the pension standards in that subsequent year. Instead, the member will need to fully commute their existing income stream entitlement, which has already ceased for tax purposes, and commence a new ABP that satisfies the pension standards.

Due to this, the industry’s previous approach will no longer comply with the ATO’s requirements and affected members will need to fully commute to recommence a new ABP as soon as they become aware their pension fails the standards. However, depending on the situation, this may not happen until many months after the end of the year, in turn extending the period the fund will be ineligible to treat the income from the assets used to support the pension as ECPI.

Additionally, this will require the member and the fund to expend time and resources to start a new ABP in the fund part way through the year. This process may require the trustees to revalue the fund’s assets and prepare an interim set of accounts to accurately calculate and document the new pension details and TBA credit.

What else did the ruling say?

The ATO also clarified several other matters in the ruling, which, when combined with other ATO positions, could create additional complexities for funds, as well as members and their beneficiaries. These issues are outlined as follows.

Merger of member benefits

In the ruling, the ATO restated the tax rule that where a superannuation income stream is payable, the amount supporting that income stream is always to be treated as a separate interest. However, it then went on to confirm a superannuation income stream will cease to be payable once it is taken to have stopped for tax purposes. This is important as it means, where an ABP fails the pension standards in a year, the interest that supported the income stream in question can no longer be treated as a separate interest from the start of the year and will merge with any other accumulation interests the member held in the fund at that time. This will then impact how the tax components of any benefits taken from that accumulation interest will be calculated.

For example, if an SMSF member had two ABPs of equal value, one consisting of a 100 per cent taxable component and the other a 100 per cent tax-free component, both would merge into a single accumulation interest if they both failed the pension standards in the same year. Where the member then immediately took a benefit from that merged interest, the tax components would be calculated as 50 per cent tax-free and 50 per cent taxable.

While this would generally have no tax impact for members aged 60 or over, as any benefit they take from this interest would be tax-free regardless of the tax components, it could effectively significantly increase the death benefits tax payable by any non-dependent beneficiaries as it will no longer be possible to direct death benefit payments to them from the ABP wholly made up of a tax-free component, effectively undoing any complex and expensive estate planning advice the member may have received.

Pension payments treated as lump sums

In the updated TR, the ATO also confirmed any pension payments paid from an ABP in the same year that it ceased due to failing the pension standards must instead be treated as superannuation lump sum benefit payments. Unfortunately, this then creates significant administrative complexity for the fund, as well as resulting in potential compliance issues where the fund was paying a transition-to-retirement income stream (TRIS).

For example, the requirement to treat each pension payment as a lump sum could prove to be an expensive and complex headache for funds as the trustee will now need to calculate and record the tax components of each individual payment based on the tax components of the member’s underlying merged accumulation interest on the date they were paid. To do this, the trustees will need to revalue the fund’s assets and prepare an interim set of accounts for each individual payment instead of just applying the tax component proportions of the ABP that were set at commencement.

In addition, this could cause compliance and tax issues for a member/ trustee where the pension that failed the standards was a TRIS. For example, where the member had yet to satisfy a condition of release, which would have converted their benefits to an unrestricted nonpreserved component, the requirement to treat the payments as lump sums would result in the trustees breaching the preservation standards, in turn triggering potential trustee penalties. Further, the member would be required to include their previously exempt pension payments in their assessable income as required for benefits paid in breach of the preservation rules.

Additional transfer balance cap implications

As previously outlined, where an ABP stops due to failing the pension standards, it will trigger a debit in the member’s TBA. The timing of this debit is prescribed in the law and does not align with the ATO’s view on when the ABP is taken to have stopped for tax purposes.

This is because it will generally not be possible to know at the start of the year the ABP will fail the pension standards at some later time during that year. As a result, the transfer balance cap (TBC) rules state, for the purpose of determining the timing and value of this TBA debit, a fund is required to assume a superannuation income stream continued to satisfy the pension standards up until the time it is possible to determine it failed those standards.

For example, for an ABP that failed to pay the minimum in a year, this would be from the end of 30 June in that year. Importantly, this means that even though the pension will be taken to have stopped at the start of the year for other tax purposes, for TBC purposes it will only be taken to have stopped from the end of the year. As such, the TBA debit for failing to pay the pension minimum will then arise on 30 June and the value of the debit will be the value of the ABP as if it continued to satisfy the definition of a retirement-phase income stream up until that time.

Importantly, to calculate the debit, this means a fund, under a strict interpretation of the law, may need to complete two separate sets of accounts. One normal set for the fund’s annual return that assumes the ABP stopped at the start of the year for income tax purposes, and another set for TBC purposes that assumes the ABP continued to satisfy the definition of a tax-free retirement-phase income stream up until the end of the year. That is, under this interpretation, the value of the debit would be calculated as if the income from the assets used to support the pension continued to be exempt up until the end of the year.

It is also important to note, under the TBC rules, any TBA events occurring prior to an ABP failing the pension standards, such as a debit for a partial commutation, will continue to be valid as they occurred prior to the time the ABP did not satisfy the payment obligations. Conversely, the value of any pension payments that are required to be treated as a lump sum due to a pension failing the standards should not be reported as a TBC debit as they did not result from the member commuting their pension.

Finally, depending on the timing and commencement value of the new ABP, this could result in there being a significant mismatch between the TBA credit and debit values, which could then impact the amount of assets the member could use to start a new pension.

Implications for death benefit income streams

Where an income stream failing the minimum payment standards is a death benefit pension, such as one that reverted to a person because of the death of their spouse, a range of additional issues will need to be considered.

Failing the death benefit cashing rules

As previously discussed, where an ABP fails the payment standards it will be taken to have ceased at the start of the year. For a death benefit pension this results in the fund breaching the associated cashing rules from that time as the death benefit will no longer be cashed as a continuing superannuation pension that is in the retirement phase.

In this situation, the ATO has previously confirmed trustees will need to act swiftly to address the breach and that this could be done by:

• arranging for the interest that supported the death benefit pension to be cashed in the form of a new ABP, or

• cashing the interest that supported the death benefit pension in the form of a death benefit lump sum.

Where a trustee takes action to address the breach as soon as possible after becoming aware of the issue, the regulator has confirmed it is likely to be satisfied the fund is now complying with the death benefit cashing rules on a forward-going basis even though it cannot remedy the original breach. However, where a trustee fails to take prompt action to resolve the breach, significant compliance penalties could apply.

Death benefit interests must not be merged with the member’s own interests

As previously discussed, a member’s ABP will cease to be a separate interest and will merge with their other accumulation interests from the start of the year where it fails the pension standards. However, an important exception to this rule is where the ABP that failed the standards is a death benefit pension. In this case, the interest supporting the relevant pension must not be merged with the member’s own accumulation interests in the fund due to the requirement that a death benefit must continue to be treated as a superannuation interest of the deceased member and not the beneficiary.

As a result, an SMSF member could potentially end up with two separate accumulation interests in their fund in the same year where they were receiving two ABPs that failed the standards because one of them was a death benefit pension. In this situation, any pension payments from the member’s death benefit ABP prior to it failing the standards should be treated as death benefit lump sums. However, they should not be reported as a TBC debit as they did not result from the member commuting their income stream.

Conclusion

Given the significant tax consequences and administrative complexity associated with a fund failing the pensions standards, it’s now more important than ever for SMSF clients to understand the critical nature of complying with the pension standards at all times.