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How to escape double taxation

John Wasiliev

After years of uncertainty about the tax treatment of superannuation death benefits, especially for do-it-yourself funds, the government has introduced some clarity that will provide welcome relief for many retirees who are taking pensions from their super.

Death benefits spared

The clarity is in the form of a tax regime that will see any super death benefits spared the prospect of potential double taxation where a benefit must be paid out of a fund on the death of a member.

The double taxation has existed in the form of a 10 per cent capital gains tax on any investment assets sold by the fund to pay out the benefits, plus a 16.5 per cent tax on certain benefits if they happen to be inherited by a beneficiary who wasn’t financially dependent on the late member, such as an adult child.

In its mid-year economic review, the government foreshadowed it will eliminate as from July 1 this year any obligation on super funds to pay CGT where a super pension is cashed out to pay a death benefit.

The decision effectively means that a tax exemption on investment earnings allowed to super funds paying pensions can continue following the death of a fund member until the member’s benefits have been paid out.

The decision is a welcome development, says superannuation technical adviser Darren Kingdon of Kingdon Financial Group, given the stress for many super retirees caused by opinions expressed by the Australian Taxation Office in a draft tax ruling issued last year that focuses on the treatment of pension death benefits.

Uncertainty clarified

The major issue of uncertainty has been whether the tax exemption on super pension investment earnings ceased as soon as a member died. Prior to the draft ruling, many advisers expressed the view that so long as a fund wound up a pension as soon as practicable following a member’s death, the tax exemption on investment assets could continue where assets were sold to pay out a death benefit.

In this week’s decision, the government has clarified that where a death benefit is paid out of the fund as soon as practicable the change will assist the beneficiaries of deceased estates by allowing superannuation fund trustees to dispose of pension assets on a tax-free basis to fund the payment of death benefits.

According to Kingdon, the uncertainty raised by the draft ruling has caused a great deal of anxiety for many super retirees, and prompted a swag of strategies to deal with this issue.

The strategies have included making sure assets with embedded capital gains are sold during the pension phase to ensure they benefit from the tax-exempt treatment pensions enjoy.

Or where an older member has become seriously ill, winding up their DIY super pension account so that investments supporting the pension don’t face the prospect of tax on any net capital gains. Such timing is not always possible, such as when a member dies unexpectedly. It has also caused anxiety when a fund is invested in assets such as a unit trust that owns property that can’t be easily unwound.

Kingdon says this uncertainty has led to confusion and distortions in the investment strategies that DIY funds may pursue in the pension phase of their existence, such as a reluctance to own growth assets like shares and property.

Given that many super funds with reasonable savings could be paying a pension for decades, the tax uncertainty has been another challenge.

Three taxes reduced to two

Kingdon says the ATO ruling highlighted up to three potential death tax imposts on certain super benefits.

One is a 16.5 per cent tax on taxable super benefits paid to beneficiaries who weren’t financially dependent on the late member. This tax impost remains.

The only super fund beneficiaries entitled to tax-free death benefits paid from funds are a member’s spouse or someone who was financially dependent on the late member, such as an adult child with a disability.

The other tax is the CGT on investment assets sold to pay out the death benefit, while a third is stamp duty on property assets that can’t be sold in time to pay out the death benefit.

The government’s decision has at least reduced this to two taxes, he says.

Kingdon says the decision is a significant development, given the ATO’s view that a pension ceases when a member dies has been a controversial issue for some years.

Some experts even suggested that if the draft ruling went ahead, it might have been challenged in court in a tussle that might have gone on for years.

It might have been argued that just because a member died it did not automatically mean the pension ceased because there could have been other pension liabilities that continued after a member’s death.

This might allow the tax treatment of investments to continue until they had been sorted out.

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