This deferred tax provision is a result of the 2017 super reforms when the transfer balance cap and retirement phase pension concepts were introduced. Those changes meant that many members had to reduce their pension balances to no more than $1.6m at 30 June 2017 and many members chose to do so by commuting some or all of their pension(s) and rolling money back to accumulation phase. In addition, from 1 July 2017 income from fund assets supporting transition to retirement income streams (TRISs) where the TRIS is not in retirement phase is no longer exempt from tax.Sign up to our newsletter
Without any special “grandfathering” rules, these changes would have resulted in many funds ultimately paying tax on the capital gains they had built up prior to 30 June 2017 whereas these gains would have been partially or fully exempt from tax under the old rules. To ensure impacted funds were not disadvantaged, transitional “CGT relief” was introduced. Hence why you’ll often see this tax provision also called a “provision for deferred tax (transitional CGT relief)”.
Under the transitional CGT relief rules, eligible funds could have irrevocably elected to reset the cost base of their eligible assets to their market value on a particular date – usually 30 June 2017. The effect of this election meant that the fund had disposed of the asset for CGT purposes at market value (thereby realising a capital gain) and then immediately reacquired the asset at market value (thereby resetting the cost base to market value) without actually selling/reacquiring the asset for cash. The resulting capital gain from this cost base reset was discounted by the usual 1/3rd CGT discount if the asset had been held for longer than 12 months at the time of the cost base reset, and then taxable according to the tax position of the fund in the 2016/17 year.
Now not all funds who elected to take up the CGT relief ended up with a tax liability at 30 June 2017.
For example, where all of the fund’s assets were supporting pension balances (including TRISs), the “reset capital gains” were disregarded.
But if the process of resetting the cost bases of the fund’s assets did trigger a tax liability (eg because the fund’s tax exempt % for the 2016/17 year was calculated using the proportionate method, and the tax exempt % was less than 100%), the trustee had a choice to make:
- They could have paid the tax on lodgement of the fund’s 2017 Annual Return. This was the default position and was common if the tax liability was only small.
- Alternatively, they could have further elected (irrevocably) to defer recognition of the taxable capital gains (ie the capital gains after applying the usual 1/3rd CGT discount (if applicable) and the tax exempt % for 2016/17) until the year the assets were eventually sold. This was often referred to as “deferring paying the tax”, hence the deferred tax provision you’ve identified in the fund’s financial statements.
You can confirm the fund elected to “defer the tax” by reviewing the fund’s 2017 CGT Schedule – there should be an amount at label G of question 8. This amount is the fund’s total deferred capital gains from resetting the cost bases of assets. The fund’s 30 June 2017 records should include a schedule breaking down this total deferred capital gain amount on an asset by asset, parcel by parcel basis.
When is the deferred tax payable?
The deferred capital gain amount attributed to each asset parcel needs to be recognised and the resulting tax paid when a “realisation event” happens to that parcel. This will usually be when the asset is sold.
- in the year the asset is sold, the fund is treated as having made a capital gain in that year equal to the “deferred” gain,
- the deferred gain is not reduced by the 1/3rd CGT discount in the year of sale (because the discount (if available) was already claimed in 2016/17),
- the deferred gain is not reduced by the fund’s tax exempt % in the year of sale (because the tax exempt % for 2016/17 has already been applied to the gain),
- if in the year the asset is sold, the fund has capital losses available for use at that time, then those capital losses could be used to reduce the amount of deferred gain, and
- any capital gain or loss accrued after resetting the asset’s cost base must be calculated separately to the deferred gain above and is subject to tax in the year of sale using the normal CGT rules (using the reset cost base, and the “reset” date as the acquisition date).
Other issues to consider
In our work assisting SMSF trustees and their advisers, we commonly see funds fall into the following traps:
- Not all SMSFs who elected to defer the tax included a deferred tax provision in their 2016/17 financial statements. This means many SMSF trustees (and their advisers) have forgotten this tax will be payable when the affected assets are sold.
- If members exit the fund, this future tax liability should be taken into account otherwise the remaining members may bear more than their fair share of the tax payable when the affected assets are sold.
- The deferred gains must be recognised (and the tax paid) when a “realisation event” happens. A realisation event for this purpose includes not only market sales but also less obvious events like some corporate actions (eg share buy backs, company restructures) or the transfer of assets from one fund to another as part of a relationship breakdown. Failure to take these less obvious events into account can lead to an unexpected tax bill or some members bearing more than their fair share of the tax payable.
- Some funds which were not entirely in pension phase in 2016/17 may now find they are worse off by having elected to claim CGT relief if their circumstances have not played out as expected.
For example, David was in receipt of a TRIS from his SMSF in 2016/17. His TRIS was not expected to be in retirement phase until around 2024 (when he turned 65). As his fund would no longer be entitled to a tax exemption on its investment income from 1 July 2017, David decided to fully commute his TRIS on 30 June 2017.
The fund’s tax exempt % in 2016/17 was 63%.
The trustees elected to reset the cost base of all assets that were in a capital gains position and apply the transitional CGT relief. The trustees did so because they believed the affected assets would ultimately be sold in a year when the fund’s tax exempt % would be less than 63%. The trustees also elected to “defer the tax” on the affected assets until the year a realisation event occurred.
Unexpected ill-health meant David was forced to windup his business in July 2019 and he commenced a retirement phase pension from his superannuation. He took the opportunity to review the fund’s risk profile as a result of his new circumstances and sold a number of affected fund assets in 2019/20 when the fund’s tax exempt % was 90%.
Even though the fund’s tax exempt % was 90% in 2019/20, the elections made when the fund’s 2017 Annual Return was lodged mean that the capital gains that had built up prior to 30 June 2017 remain only 63% exempt from tax. Depending on the amount of the capital gain involved, a better tax result may have been achieved if the trustees had not elected to reset the cost bases and apply the transitional CGT relief.
Note that as the CGT relief elections were irrevocable, there is nothing the trustees can do to prevent the recognition of any deferred capital gain.
SMSF administrators and advisers can play a vital role in ensuring impacted trustees are aware of this deferred tax liability and when it will be payable.