Death Benefit Pensions: Recent ruling undermines cashing restrictions

One would have thought that issues relating to SMSF pensions are relatively well settled.  However, two private binding rulings have been recently issued which have upset the neighbourhood.  The first relates to the consequences of rolling over a death benefit pension paid to a spouse.  The second will be discussed in the next article.

The ATO was asked, via a private binding ruling application, whether a taxpayer, aged under 60, and in receipt of a death benefit pension would, if the pension was rolled over to an SMSF, be entitled to a tax rebate which normally applies to death benefit pensions.  The answer was surprisingly “No”:  the new pension payable from the SMSF would not be entitled to a tax rebate.

The application of the Ruling raises a number of issues.

The pension was a death benefit pension paid to the spouse of the deceased member.  The pension is necessarily an account-based pension and the superannuation interest supporting the pension consists entirely of the unrestricted non-preserved component (as death is an unrestricted cashing restriction).

As the deceased member must have died before age 60 and the spouse is currently under age 60 (if either was not the case, then the pension payments would have been tax free and so the question raised in the private binding ruling application would not have arisen).  As the pension is taxable, a pension rebate of 15% applies to each pension payment made before the spouse attains age 60.  The rebate is calculated as 15% of the taxable component of the pension.

The pension had been payable for a number of years.  

The spouse was dissatisfied with the current fund and wished to move to an SMSF.

Issue:  Can a pension be transferred from one super fund to another super fund?  Strictly no.  Neither the SIS Act nor the taxation legislation permit the transfers of pensions.  However, the pension could be commuted and the superannuation lump sum arising from the commutation transferred to another superannuation fund from which a new pension can be commenced.  For technical reasons this does not apply to child pensions.

Issue – Will the new pension have the same SIS and taxation attributes as the old pension?  Based on the reasoning of the PBR the answer is no.  The Ruling held that the superannuation lump sum arising from the commutation was a superannuation member benefit (and not a superannuation death benefit) and consequently, the new pension was no longer a death benefit pension but an ordinary account-based pension.  For this reason the spouse ceased to be entitled to claim the 15% tax rebate.

Planning consequences:  Death benefits must be paid out either as a superannuation lump sums or used to commence a death benefit pension (or a combination of both).  The death benefit cannot remain in the fund and simply be transferred from the deceased member to the spouse.  What if the spouse did not want a pension but preferred to retain the benefit in the superannuation system?  

Before this ruling the spouse either had to take a pension (which may generate cashflow issues for the fund if the fund has lump assets) or take a superannuation lump sum, pay tax on the lump sum and then return the lump sum to the super system by way of a fresh contribution (which would be subject to the SIS contribution acceptance rules and the contribution caps).

As a result of this Ruling the spouse now has a third option:  commence a pension (which would be death benefit pension) and then commute the pension but only after more than 6 months have elapsed from the date of death of the deceased member (or 3 months after the grant of probate of the will of the deceased member – whichever is the longer) and then commute the pension.  By running the pension for more than the 6 month/3 month period, and then commuting the pension, the superannuation lump sum arising from the commutation will now be a superannuation member benefit.  This lump sum can be transferred to another superannuation fund and kept in accumulation phase.  The payment to the other fund will not trigger contribution cap issues, will generally not give rise to any tax on the transfer (there is an exception) and the acceptance of the payment by the trustee of the other fund is not subject to the SIS contribution acceptance rules.  

Alternatively, the superannuation lump sum arising from the commutation could be retained in the current superannuation fund.

The exception as to the no tax on the transfer does not apply if the superannuation payment contains an untaxed element of the taxable component (this usually arises if the death benefit of the deceased member includes life insurance monies).  

Purely for technical reasons (there seems to be no policy justification) while child pensions can be commuted, the commutation amount cannot be transferred to another superannuation fund.  The commutation amount could re-enter the superannuation system as a new contribution (which means it would be subject to the contribution cap rules and the SIS contribution acceptance rules).

In essence, this Ruling undermines the policy that death benefits must be cashed either as a lump sum or used to commence a pension.  This Ruling shows that if the pension is paid for a minimum period (usually at least for 6 months after the death of the deceased member) it can then be commuted and the commutation amount changed into a superannuation member benefit (consisting entirely of unpreserved components) which can be switched back to accumulation phase.  As the benefit consists of unpreserved components, an account-based pension could be subsequently commenced at any time from the benefit.  Any earnings on the transferred amount would, however, be subject to the preservation rules.  

The downside of the strategy is that if a pension is commenced, the pension will not be a death benefit pension and so will not be entitled to a 15% rebate on the taxable portion of the pension payment.  It could be that the lack of entitlement to the rebate is of little or no significance – the spouse could already have attained age 60 or soon attain that age.  Alternatively, the lack of entitlement to the rebate may be little concern as the taxable portion of the pension payments are within the tax free threshold of the spouse.

Reference: PBR 1012913671211