Why you shouldn’t believe the latest super horror story

Superannuation headlines have been dominated over the past week by a shock-horror story purporting that a new draft tax ruling will apply retrospectively to expose many self-managed super funds to huge amounts of extra tax following the death of a member.

The Australian Financial Review spearheaded the press coverage with a front page article on July 22 which would have disturbed countless SMSF members and the families of deceased members.

“The Australian Taxation Office has issued a new draft tax ruling that means spouses and children could face six-figure tax bills on the death of a parent or partner, while throwing estate planning arrangements into chaos,” the AFR article breathlessly claimed.

“The extra taxes must be paid on top of the 16.5% death benefits tax in cases where the beneficiary is an adult child.”

And the Self Managed Super Fund Professionals’ Association (SPAA) further stirred things up a press release stating that the ruling would apply respectively from July 2007.

But reality is that the draft tax ruling changes nothing. It simply confirms the Tax Office’s long-held view on existing law. And the ATO’s interpretation, love it or hate, has also long been widely understood by some of the most respected and experienced tax and superannuation professionals.

In short, the draft ruling states that in the ATO’s view, a superannuation pension ceases when the pensioner or reversionary pensioner (typically a surviving spouse) is no longer automatically entitled to the pension. Under the ATO interpretation, the automatic entitlement ends – along with the highly significant tax-free status of assets backing the payment of a super pension – with the death of the pensioners.

Some of the over-wrought reactions to the draft ruling may have led thousands of fund members to mistakenly fear that their super has suddenly become exposed to a new tax regime. Their concerns would have been compounded by the large sums potentially involved and the older ages of many SMSF members.

SMSFs hold about $435 billion in assets and more than 20% of their 800,000-plus members are over 64.

Meg Heffron, co-principal of SMSF administrator Heffron, succinctly explains the consequences of the draft is confirmation of the ATO’s legal interpretation that “when a [superannuation] pensioner dies, capital gains tax will be payable on the sale of the assets to pay the lump sum benefit”. It’s as straightforward as that.

“… the gain will be worked out based on the original purchase price of the asset rather than its value at the time of death,” she adds. “There is no mechanism for stripping out the gains which built up while the fund was in the [tax-free] pension phase.”

The draft ruling applies mainly to SMSFs. This is because large funds with their continual stream of new members and contributions may not have to sell assets to pay super death benefits.

Heffron says the opposing view to the ATO’s interpretation among some members of the superannuation industry is that the superannuation income streams or pensions only ceases when all of a fund’s obligations, including an obligation to pay lump sums, are met.

Interestingly, Heffron suspects that the controversy engulfing the draft ruling over the past week is that most people, including Heffron, had hoped the ATO would reach a different conclusion. “Ultimately, however, the real mischief here simply may be that the law says something the vast majority of the community wish it didn’t,” she adds.

Heffron says that anyone “beating up on the ATO” over the conclusion of the draft ruling is probably picking the wrong target. She says if the community feels that tax law is wrong, its arguments should be directed to the Parliament and Treasury. And if it was believed the ATO’s much-considered interpretation was wrong, it would be a matter for a court to decide.

“If you think don’t like the law, just arguing with the ATO won’t change the law,” she says. She believes that both the ATO and critics of its draft ruling have strong technical arguments to support their contrasting positions.

Sydney tax lawyer Robert Richards says the some of the heated reaction to the ATO’s draft ruling has been misinformed. “The draft ruling says nothing extraordinary,” says Richards. “It only reiterates the law.”

Richards points out that superannuation law requires a regulated super fund to cash out its benefits as soon as practical after a member dies – with one of the exceptions being if a reversionary pension is being paid.

As Richards explains, the need to pay out super benefits upon the ceasing of the pension means that CGT will be payable on assets being sold to pay out the death benefits. And if those benefits are paid to a non tax dependant, 16.5% tax is payable by the beneficiaries on the “taxable component” of lump sum benefit – in addition to any amount already paid in CGT. (The taxable component includes salary-sacrificed and compulsory employer contributions, and fund earnings.)

“It is said that a lot of superannuation advisers are surprised by the draft ruling,” Richards says. “But far too many superannuation advisers act on the basis of LORE rather than law. A lot of advisers have been going around telling me what they think the law should say rather than what the law does say.”

Richards suspects that many SMSFs have not paid CGT on the sale of assets after a pension has ended because of advice that the tax is not payable.