The proposal to include unrealised capital gains in calculating income subject to the additional 15% tax rate on super fund balances over $3 million should lead to an effective cap on balances of $3 million. (The additional personal tax involved is referred to in the draft legislation as Division 296 tax liability). If the administrative costs to individuals of complying with this change, and the cash flow problems of making such tax payments, are as large as critics have argued, no one will want to hold assets above $3 million in super.
In that case the deterrent effect of this change will mean that such taxation never needs to be applied. And the mark of a good deterrent is that it is so effective in affecting behaviour that it never needs to be applied. Individuals will transfer assets above $3 million out of super accounts into their personal account.
A better approach
But there is an alternative, simpler, approach which could be used, and which would mitigate some of the difficulties which holders of SMSFs will argue arise from the current proposal. Such difficulties relate to the current holdings of large, indivisible, assets such as properties, businesses and farms in SMSFs.
But, and this is the crucial point, while the assets may be indivisible, there can be multiple claims on the assets. So, for example, an asset worth $5 million could have one claim worth $3 million and another of $2 million on it. The $3 million claim could be held in an SMSF and the $2 million held on the individual’s personal account. A notional change of ownership, where the ultimate beneficiary remains the same is all that is needed.
Of course, that leaves unanswered how the income generated by the asset is split between the two claims. And it would raise a massive backlash if the income on personal account for division 296 personal tax were to be measured to include unrealised capital gains. So maintaining the current method for calculating income for tax purposes would seem necessary.
There are many ways in which splitting the income between the two claims could be equitably achieved. But giving the SMSF an equity style claim of a share of income would run the risk of it effectively growing beyond the $3 million cap and getting preferential taxation on that excess.
Using the example from before, suppose the asset generated $0.5 million income in the year. If both claims were equity style, the SMSF would have income of three-fifths of $0.5 million (ie $0.3 million) before tax. This would be taxed (possibly at the usual super tax rate) and the SMSF would need to distribute the after-tax amount to the beneficiary to maintain the SMSF asset value at the $3 million cap.
But suppose the asset also grew in value, so that over several years there were $10 million of unrealised capital gains, not included in the measured income. When the asset is ultimately sold the realised capital gains in that year for the super fund would be three fifths of $10 million ($6 million). Unless some differential higher tax rate were applied to these capital gains, the SMSF beneficiary would have achieved gains from having concessional tax on the undeclared SMSF asset level of over $3 million over the preceding years.
So the alternative would be to make the $3 million in the SMSF a fixed value claim, with all earnings on the asset then accruing to the $2 million claim in the individual’s personal account. Of course, unless some adjustment is made the individual would be getting no concessional taxation benefit from the SMSF with all earnings on the asset being taxed at the owner’s personal tax rate.
To maintain some super subsidy on the $3 million in the SMSF, one approach would be as follows. Calculate an appropriately weighted average of the 15% super tax rate (or zero if the super fund is in retirement mode) and the individual’s relevant personal tax rate to apply to those earnings. (For example, in this case, if the personal tax rate is 40%, the weighted rate if the SMSF is in accumulation mode would be 3/5 x.15 + 2/5x.4 = 0.25. If in retirement mode, the weighted rate would be 3/5 x 0 + 2/5 x 0.4 = 0.16).
Alternatively, to avoid complications from other income sources affecting the individual’s personal marginal tax rate, the personal taxable income from the asset could be calculated after deducting some imputed amount for the cost of the non-earning $3 million in super. That could be calculated, for example, by using the average return on super funds in that year applied to the $3 million. If that return were, for example, 10%, then a deduction of $0.3 million would be allowed in calculating personal taxable income.
There are likely to be other approaches for enabling the individual to obtain the concessional tax treatment otherwise available on assets in super.
Downsides to this method
What are the flaws in this alternative approach? The asset(s) involved may not have a readily available, observable, market value. Individuals could rort the system by claiming that the asset in an SMSF is worth less than $3 million, and so not shift part ownership to personal account so as to obtain concessional super tax treatment on eventually realised capital gains. Some special tax rules would be needed to offset this.
Also individuals would need to possibly incur costs of getting a market value for such assets to check it is no higher than $3 million in order to comply with the regulation. But incurring (probably tax-deductible) costs to gain the benefits of a tax concession is not something which is likely to be seen by legislators (or other taxpayers) as a major impediment to such an approach.
Kevin Davis is Emeritus Professor of Finance at The University of Melbourne.