If the four short paragraphs about ECPI had been included in the 2016-17 Federal Budget, the Government could have saved actuaries and software providers hundreds of thousands of dollars in software development costs and saved the sanity of accountants and advisers!
Sadly they didn’t and their proposed changes will achieve the desired effect of reducing red tape a few years too late.
Nonetheless, we welcome the announcements as part of the solution to simplifying ECPI.
Exempt current pension income, ECPI, is the name given to investment income that is exempt from tax because the fund is providing a retirement phase pension. As a general rule, if all of the member accounts in the fund are retirement phase pensions, all of the fund’s investment income is ECPI. If only a proportion of the accounts are retirement phase pensions, then only part of the fund’s investment income is ECPI.
The Government proposed two changes as part of the 2019-20 Federal Budget. Both changes are due to take effect from 1 July 2020, ie the 2020/21 financial year.
Proposed Change 1
Under current law, some superannuation funds are entirely in pension phase all year (providing only retirement phase pensions). Logically, they should be able to claim all investment income as ECPI. Due to a quirk in the law, some of these funds still need an actuarial certificate to do so. The Government proposes to remove the requirement to obtain an actuarial certificate under these circumstances.
Proposed Change 2
Under current law, ECPI can be extremely complex for funds that move between different phases such as:
- entirely providing retirement phase pensions for part of the year, or
- providing a combination of retirement phase pensions and other accounts (eg accumulation accounts) for other parts of the year.
The complexity lies in the fact that some funds are currently required to claim their ECPI using two different methods for those different parts of the year:
- the “segregated method” when the fund only has retirement phase pension accounts, and
- the “proportionate method” at any other time.
The calculations are tricky, the results are confusing and it is generally a case of overengineering the tax rules.
Our understanding of the Government’s proposal is that they will remove the complexity by giving trustees a choice:
- stick with the current system of using both methods when applicable, or
- use the “proportionate method” all year.
The latter was common practice in the past until 2017-18. Generally, the two choices provide much the same tax result but there can be a difference (discussed further below).
There are a number of points to note about Proposed Change 2.
First, under current law not all funds are actually allowed to use the segregated method to claim their ECPI. What is unclear from the announcement is whether this second complication (some funds can segregate and some funds cannot) will also be removed. We speculate it will not be changed – if it was removed, Proposed Change 1 above would not be required.
Those that cannot use the segregated method have never faced the complexity of having to use different methods for different parts of the year – they have always been required to use the proportionate method all year. Presumably their position will therefore be unchanged.
The proposed change will, however, be very useful for funds that are allowed to use the segregated method and have a period during the year when they are entirely providing retirement phase pensions.
(Read our blog 'Segregating in SMSFs Beyond 1 July 2017' to understand which funds are currently allowed to claim their ECPI using the segregated method and which ones are not).
Second, the wording in the Budget papers is not particularly precise but we expect this choice will:
- be made yearly – rather than once and locked in forever,
- also apply for funds that, for example, have no retirement phase pensions for the first 6 months of the year and then move entirely to retirement phase pensions for the remainder of the year. In other words, quite simple cases rather than only the complex situations outlined earlier.
We do not know whether the choice will need to be made in advance or whether it can be made at the end of the year. There are practical challenges either way:
- if the choice is made retrospectively, it may be possible to use it as a means of optimising the fund’s tax outcome (and neither the Government or the ATO likes anything that allows their tax revenue to be minimised), but
- if the choice must be made in advance, it is easy to imagine situations where the trustee would find it difficult to predict that they needed to make a choice early enough to make one.
As a general rule, this change is all about simplifying compliance with the tax law. Regardless of the choice they make, some funds will end up paying more or less the same amount of tax. However, it is possible for differences to emerge.
This is perhaps best explained using an example.
Sally is the sole member of her SMSF and has been receiving a pension since she retired. At 30 June 2020, her retirement phase pension was valued at $1m and she had no accumulation account. On 1 April 2021, she made a $300,000 non-concessional contribution which remained in accumulation phase for the rest of the year.
Sally has no other superannuation. Her fund is allowed to claim ECPI on the segregated method.
If no changes were made to the law, Sally’s fund would claim her ECPI as follows:
- 1 July 2020 – 31 March 2021 : the segregated method. All investment income earned during this time would be exempt from tax. Capital gains and capital losses would be ignored.
- 1 April 2021 – 30 June 2021 : the proportionate method. The actuary for Sally’s fund would calculate the proportion of the fund’s income which is ECPI. In this case, the relevant % would be around 77%. In other words, 77% of all income earned in the last three months of the year would be exempt from tax and the remaining 23% would be taxable.
Under the proposed change, Sally could ask the fund’s actuary to calculate a % that applies to all income for the whole year. In this case, the figure would be around 93%.
If Sally’s fund earned its income on a very regular basis (let’s say $10,000 per month), it would make very little difference which choice she made.
Using the current rules, the following income would be exempt from tax:
- All of the first 9 months’ income ($10,000 x 9 = $90,000)
- 77% of the last 3 months’ income ($10,000 x 3 x 77% = $23,100)
In total, $113,100 would be exempt from tax and the remaining $6,900 would be taxed.
Alternatively if she simply used the proportionate method all year, the tax exempt income would be 93% x 12 x $10,000 = $111,600. This is very close to the amount of $113,100 above.
More substantial differences will emerge if Sally’s fund earns income unevenly.
Let’s say ALL of the fund’s income is earned in January 2021. (This could happen, for example, if it came from a capital gain).
If Sally’s fund uses both methods (ie the current law) to calculate the ECPI, the fund will pay no tax because the income was earned at a time when the fund was using the segregated method.
If, on the other hand, Sally’s fund uses the proportionate method all year, tax will be paid on some of that $120,000 (93% of it will be exempt but 7% will not).
This change will certainly simplify compliance for some funds. We welcome it on that basis but would continue to encourage the Government to remove the major complexity currently in place for ECPI – the fact that some funds are allowed to operate on a segregated basis and others are not. Here’s hoping that’s exactly what is intended and it is simply unclear from the Budget Papers.
A final point: note that we expect both the changes to ECPI will only relate to funds that are providing account-based or market linked pensions. Funds with defined benefit pensions have quite different actuarial certificate rules.
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