The recent release of regulatory bulletin SMSFRB 2018/1 highlights what will spark the ATO’s interest where an SMSF is using reserves. The bulletin was issued in light of the 2017 super reform and the ATO’s concern that some SMSFs are implementing reserving strategies designed to circumvent restrictions imposed under the new law.

Overall, the Commissioner considers that the small membership nature of SMSFs means that the need to maintain reserves in SMSFs is distinct from the need to maintain reserves in APRA regulated superannuation funds. Consequently, the Commissioner expects the use of reserves by SMSFs to be extremely limited and, where an SMSF does hold reserves outside of such limited circumstances, the Commissioner will consider whether the trustee is acting in accordance with their obligations under the sole purpose test (section 62 of the Superannuation Industry (Supervision) Act 1993 (SISA)), the investment strategy of the SMSF and the anti-avoidance provisions (Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936)).

 

What arrangements are concerning the ATO?

The types of arrangements concerning the ATO include (but are not limited to) the intentional use of a reserve to reduce:

    • a member’s total superannuation balance:
    • to enable them to make non-concessional contributions without breaching their non-concessional contributions’ cap; or
    • to fall below $500,000 in order to allow the member to access the catch-up concessional contributions arrangements; or
    • to fall below $1.6 million in order to allow the SMSF to use the segregated method to calculate its exempt current pension income; or
    • a member’s transfer balance account to fall below the member’s transfer balance cap to allow the member to allocate a greater amount to retirement phase and thereby having a greater amount of earnings within the SMSF being exempt current pension income.

To help withstand ATO scrutiny, SMSF trustees using reserves should:

    • have a clearly articulated purpose for the reserve;
    • use the reserve in a way that adheres to the sole purpose test (section 62 of the SISA) and the requirement to formulate, review regularly and give effect to a strategy for the prudential management of reserves consistent with the fund’s investment strategy and its capacity to discharge liabilities (section 52B(2)(g) of the SISA and regulation 4.09 of the Superannuation Industry (Supervision) Regulations 1994);
    • not use reserves as a means of circumventing restrictions imposed by the 2017 super reform measures (which were brought in to help ensure the system is not used for wealth accumulation, tax minimisation or as an estate planning vehicle)
    • not use reserves as a step in a scheme to achieve potential tax benefits to which Part IVA of the ITAA 1936 may apply.

 
What reserves are allowed and not allowed by the ATO?

The ATO has provided examples of types of reserves that the Commissioner is prepared to allow and not allow for SMSFs. An SMSF that purports to maintain a reserve not allowed by the ATO may be required to demonstrate that the use of the reserve is not part of a strategy employed for the primary purpose of circumventing restrictions in the law and obtaining a tax advantage to which Part IVA of the ITAA 1936 could apply.

Type of reserve ATO response Further ATO comments
Administration NO This describes a reserve being used to fund future administration and operational expenses.
For an SMSF, administration and operational costs should be met from the net assets of the fund as the costs arise.
Investment NO This describes a reserve being used to smooth the impact of market fluctuations.
Reserves for investment smoothing are considered to be unnecessary in SMSFs as investment gains and losses should be reflected in the members’ accounts in the years they occur.
Operational NO This describes a reserve used to meet a registrable superannuation entity’s Operational Risk Financial Requirement (ORFR) target amount.
Operational risk reserves are not necessary in SMSFs as the trustee is not required to meet the ORFR target amount set by the Australian Prudential Regulatory Authority.
Contributions YES This describes the suspense account used to hold contributions pending their allocation under Division 7.2 of the SISR to an accumulation interest of a member.
SMSF trustees are able to accept contributions to these accounts pending allocation to the relevant member in accordance with Division 7.2 of the SISR
Pension YES SMSF trustees are able to maintain ‘pension reserve accounts’ while the SMSF continues to pay:

  • a complying lifetime pension (described in regulation 1.06(2) of the SISR);
  • a non-complying lifetime/flexi pension (described in regulation 1.06(6) of the SISR); and
  • a complying life expectancy/fixed term pension (described in regulation 1.06(7) of the SISR).

The amounts in these accounts comprise an amount available to the trustee, not the member, to satisfy the trustee’s liability to pay the complying pension.
A pension reserve account cannot be maintained to support an account-based pension (described in regulation 1.06(9A)(a) of the SISR).
Some further concessions exist in relation to flexi-pensions.

Self-insurance NO This describes a reserve used in funds that are permitted to self-insure.
Self-insurance reserve should not be maintained in an SMSF because of the prohibition imposed by regulation 4.07E of the SISR (subject to certain circumstances that had a start date before 1 July 2016).
Insurance cover NO An SMSF trustee should refrain from taking out an insurance policy over a fund member in circumstances where the premiums from the insurance policy are sourced from a reserve and the proceeds from the insurance policy are paid into the reserve.
Anti-detriment NO The anti-detriment deduction is no longer available for lump sums paid on or after 1 July 2019 or where the deceased member died on or after 1 July 2017. As the deduction has been removed, there is no longer a need to create this type of reserve from 1 July 2019.

 

What action should your clients take?

The ATO has reported that it will not apply compliance resources to review arrangements entered into by SMSFs before 1 July 2017 provided that the reserve:

      • was permitted by the law (section 115 SISA);
      • was permitted by the governing rules of the SMSF; and
      • was not used as a means to circumvent the 2017 super reform (this will be determined according to the facts and circumstances of each case).

Additionally, the ATO will continue to monitor the use of reserves by SMSFs.  Any unexplained increases in new or existing reserves or the allocation of amounts from a reserve directly into the retirement phase will likely attract scrutiny from the ATO.

An amount allocated from a reserve before and after 1 July 2017 will generally be counted as a concessional contribution unless otherwise excluded because certain conditions are met. If existing reserve levels need to be progressively distributed to members, careful consideration should be given to the concessional contributions rules.

 

If you or your clients require any assistance in dealing with SMSF reserves, please contact Thalia Dardamanis or Patrick Cussen on 1300 267 529.

By Thalia Dardamanis