Beware the ECPI implications

One of the significant benefits of starting a retirementphase pension is the tax-free status of the income associated with the pension, referred to as exempt current pension income or ECPI. While the rules for how an SMSF can calculate and claim ECPI have changed from the 2022 income year, an SMSF that has ECPI needs to be aware of the effect a claim for this pension income exemption may have on fund income tax deductions.

Where an SMSF claims ECPI, the expenses it incurs in deriving this type of income are not deductible. Many fund expenses will be incurred in deriving both assessable and exempt income and consequently must be apportioned so only the portion relating to the derivation of assessable income is claimed as a tax deduction.

Some fund expenses, particularly those that have specific income tax provisions, can be claimed in full, despite a portion of the fund’s income being treated as exempt. The ATO sets out in its Taxation Ruling (TR) 93/17 the income tax deductions available to superannuation funds, including the methods to apportion expenses between deductible and non-deductible, where the fund has derived exempt income.

ECPI will also have an effect on any broughtforward tax loss. A brought-forward tax loss must be first reduced by net ECPI before being applied against fund assessable income.

Expenses claimed under the general deduction section 8-1 of the Income Tax Assessment Act 1997 (ITAA) are required to be apportioned. Where there is a specific provision in the ITAA, reference must be made to the specific provision to ascertain if there is a requirement to apportion the specific deduction where the fund derives exempt income.

Deductible fund expenses can be categorised as follows in relation to whether they need to be apportioned where the fund derives exempt income (see Table 1). Common SMSF expenses can be classified as in Table 2.

Table 1

Apportioned Not apportioned

Section 8-1 general expenses Section 25-5 tax-related expense

Division 40 capital allowance Section 295-460 insurance premiums (depreciation)

Division 43 deduction for capital works Section 295-470 future service liability deduction

Section 70B (1936 act) loss on traditional securities (also refer ATO ID 2014/26)

Table 2

Section 8-1 general expenses Section 25-5 tax-related expenses

Accounting and administration fees Tax agent fee

Audit fees Actuarial fee for ECPI tax certificate

Bank charges ATO SMSF levy

Investment costs and management fees Tax advice fee

Cost to amend SMSF trust deed Legal fees (complying with income tax obligations)

ASIC annual return fee

When claiming general expenses, under ITAA section 8-1, that have been incurred partly in gaining assessable income and partly in gaining exempt income, you can again refer to TR 93/17 for guidance on apportioning expenses. This type of situation can arise when an SMSF has a member or members with both retirement-phase interests and non-retirement-phase interests.

Paragraph 7 of TR 93/17 states: The correct method for apportioning expenditure between assessable income and non-assessable income depends on the particular circumstances of the case. If there is a single outlay in respect of a thing or service, only part of which is used for gaining or producing assessable income, then the following principles apply:

1. If a distinct and severable part of the thing or service is devoted to gaining or producing assessable income and part is not, the expenditure can be apportioned according to the ratio of those parts, and

2. If an outlay serves both objects indifferently, another method must be used to apportion the expenditure which gives a fair and reasonable assessment of the extent to which it relates to assessable income.

In relation to expenditure of an indifferent nature, the ruling provides two apportionment methods.

1. Apportionment for expenses incurred in deriving investment income only: Expenditure x (assessable investment income/ total investment income).

From a practical perspective, this is commonly referred to as the actuarial method and effectively apportions the total expense by first deducting the actuary’s ECPI percentage from 100 per cent and applying the result to the total amount of the deductible expenditure. For example, if the ECPI percentage is 70 per cent and the fund incurred total investment expenses of $200, the portion of the total deductible expense that can be claimed is $60, being 30 per cent (100 per cent less 70 per cent) of $200.

2. The income ratio method for apportionment of expenses that are general in nature: Expense amount x (assessable income/ total income).

Assessable income, for the purpose of the above formulae, includes all contributions to the fund (assessable and non-assessable) and rollovers (refer to paragraphs 9 & 9A of TR 93/17).

Example

The following example demonstrates that simply utilising the actuary ECPI percentage to claim such general expenses will result in an underclaimed tax deduction.

A fund was notified by the actuary its ECPI is 70 per cent and has:

• $3000 of investment expenses,

• $5000 of general expenses,

• $17,100 of assessable contributions,

• $200,000 of non-concessional contributions,

• $1,239,000 rollover into the fund, and

• $11,494 of assessable interest income. Claim for ECPI will be $8046 (70% x $11,494).

Claim for investment expenses will be $900 applying the actuarial method: ((100% - 70%) x $3000).

Claim for general expenses will be $4973, using the income ratio method in Table 3.

Table 3

($5000 x (($11,494 + $17,100 + $200,000 + $1,239,000) - $8046))) / ($11,494 + $17,100 + $200,000 +$1,239,000) = $4973

If you applied the actuarial method to the $5000 of general expenses, the deduction would be only $1500. An underclaim of expenses may not concern the ATO, but the SMSF client may not be too pleased. Obviously, where an SMSF does not have any non-assessable contributions or rollovers in an income year, the effective deductible portion applicable to expenses claimed under the ITAA section 8-1 general deduction provision will be the same under both the actuarial and income ratio method.

For an SMSF that claims ECPI under both the segregated and proportionate method in the same income year, this presents a challenge when apportioning expenses in order to claim an income tax deduction. This would apply where the SMSF does not have disregarded small fund assets and does not make the choice for assets held during a period of deemed segregation not to be treated as segregated current pension assets.

When apportioning expenses, the basic principle to apply is that any method used is fair and reasonable. The following approaches to apportioning expenses, where an SMSF claims ECPI under both methods, can be considered:

Expense relates to asset during period not deemed segregated (an investment expense):

• Expense x (100% - ECPI%) – the actuarial method. Expense relates to asset solely to deemed segregated period (investment expense):

• Expense not deductible

Expense relates to asset during both unsegregated and deemed segregated periods (investment expense):

• Expense x (100% - ECPI%) – this is actually not appropriate as it only applies to the unsegregated period. Actuaries may include on the ECPI certificate an expense percentage that can be used to apportion expenses that relate to assets (investment expenses) for periods when the asset was deemed segregated and other periods the asset was an unsegregated asset.

Expense not related to particular asset or income type (general expense):

• Income ratio method from TR 93/17.

Example

The Friendly Family Super Fund is an SMSF. It starts the 2022 income year with two members, one in retirement phase and the other not. The non-retirement-phase member commences a retirement-phase pension on all of their benefits in the SMSF in October 2021. Consequently, from that time the SMSF consists wholly of retirement-phase interests. However, at the start of February 2022, the fund admits four members who roll over their benefits into the SMSF. These benefits remain in accumulation, that is, nonretirement-phase interests.

The SMSF does not have disregarded small fund assets and has not made the choice to treat assets held during the period of deemed segregation not as segregated current pension assets. Consequently, it will claim ECPI using both the segregated and proportionate method for the 2022 income year. The fund has acquired the relevant actuarial certificate to cover the periods of unsegregated assets, which includes an ECPI percentage of 71.07 per cent and a deductible percentage to apply to expenses that can’t be attributed to solely producing assessable or exempt income of 22.048 per cent.

In additon to the assessable income for each period, as outlined above, during 2021/22 the fund has received total assessable contributions of $6500 and total rollovers of $956,800.

The fund has incurred expenses of which some relate to income earned from investments and some relate to the fund as a whole. Let us consider how those expenses are apportioned.

Depreciation of $15,650: related to income from investment assets and covers entire income year:

• deductible per division 40 of the ITAA 1997 and requires apportionment where there is derived exempt income,

• relates to fund asset, being the rental property, and

Use actuarial provided deductible portion of 22.048 per cent that has been calculated taking into consideration the whole income year.

• $15,650 x 22.048% = $3450

If an ECPI percentage of 71.07 per cent was used to apportion the expense, this would result in an amount of $4528 being claimed, which is greater than the above amount of $3450. This would be an incorrect (over) claim for depreciation as the 71.07 per cent only applies to the unsegregated periods and does not take into account the period of deemed segregation. When the period of deemed segregation is taken into consideration, this increases the ECPI percentage and conversely decreases the deductible proportion of the expense.

Accounting fees of $2320: Not related to any income from fund assets plus covers entire income year. Apply income ratio method (see Table 4).

Rental property expenses of $1200: related to income from investments and covers deemed segregated period only. Deductible portion = $0 – incurred during period of deemed segregated, all incurred in earning exempt income, and non-deductible.

Rental property expenses of $2600: related to income from investments and cover both unsegregated periods.

Deductible portion – apply actuarial method using ECPI per cent applying for that period. $2600 x (100% - 71.07%) = $752.

Rental property expenses of $2950: relates to income from investments and cover entire income year.

Deductible portion – apply actuarial provided deductible portion of $22.048 per cent. $2950 x 22.048% = $650.

Table 4:

$2320 x [($6500 + 0 + $956,800 + $153,345) – $122,595] / ($6500 + $0 + $956,800 + $153,345) = $2065

Note: ECPI claim calculation is [(($47,054 + $59,237) x 71.07%) + $47,054] = $122,595

It is the responsibility of the preparer to determine whether this proportion is fair and reasonable for each relevant fund expense. This will include understanding how the SMSF administration platform treats expenses when an SMSF has ECPI, how expense accounts should be set up in the platform to ensure apportioning is only applied to those expenses where it is required, and where apportionment is required, the relevant apportioning approach is applied.