By Philip de Haan, Partner and Aimee Riley, Lawyer, Thomson Geer Sydney
In our article last week, we discussed the new law relating to the $1.6m transfer cap and its effect on existing estate planning strategies involving an income stream (called a “pension”) being paid to a spouse. This article discusses the impact of the transfer balance cap rules on the payment of a pension to a child on the death of a parent. This article deals only with account-based pensions and children of the deceased member aged under 18 at the time of the member’s death. It also does not deal with transition to retirement pensions.
Strategies under the current law
Under the current law, the main strategies relating to the death of a member with a child beneficiary are for the trustee of the superannuation fund to pay:
- • A lump sum death benefit to the child, or more likely a trustee on behalf of the child. The payment should be tax-free, and income derived by the child or trust should not be subject to the child penalty tax under Div 6AA Pt III of the Income Tax Assessment Act 1936 (ITAA 1936).
- • A pension to the child. The superannuation fund should be tax-free, at least in part. The pension would be tax-free or concessionally taxed (depending on the age of the deceased and the type of fund) and the pension should not be subject to the child penalty tax under Div 6AA.
Impact of the new law on current strategies
The new law will not affect lump sum payments (ie the first dot point above).
However, the new law will impact upon pensions payable to child beneficiaries, as those pensions will be subject to the transfer balance cap rules.
A child recipient receiving a pension on the death of a parent is subject to a modified transfer balance cap regime. A child’s transfer balance cap is the sum of the child’s “cap increments”. Very broadly, a cap increment is the value of the parent’s superannuation that is taken into account in determining what can be paid as a pension to the child.
For an adult starting a pension, continuing a pension after 30 June 2017, or receiving a pension on the death of their spouse, the transfer balance cap (general transfer balance cap) is $1.6m (ignoring indexation). A pension payable to the adult is measured against this cap to see if it will breach the cap. However, for a child, their transfer balance cap is the sum of their cap increments. This may not be $1.6m. It can be more than, equal to or less than $1.6m. It can even be zero. This is discussed below.
The child’s modified transfer balance account will cease when they commute the pension (eg on or before they turn 25) or the capital is exhausted. The purpose of this rule is to ensure that receiving a child pension will not affect that child’s personal transfer balance cap when they retire (Explanatory Memorandum (EM) para 3.266).
The application of the new law on pensions paid to children is, however, complicated. Different outcomes arise depending upon:
- • When the child starts receiving the pension (ie before 1 July 2017 or on or after 1 July 2017).
- • Whether or not the parent had started a pension after 30 June 2017, or continued a pension after 30 June 2017, and dies after 30 June 2017.
- • Whether the pension payable to the child is sourced from the parent’s accumulation and/or pension account, where the parent had started a pension after 30 June 2017, or continued a pension after 30 June 2017, and dies after 30 June 2017.
The application of the new law will often mean that less superannuation can be paid to a child as a pension on the death of their parent after 30 June 2017 than is currently the case.
Any estate planning strategies that involve pensions to children should be reviewed, particularly if such pensions are compulsory (eg reversionary pensions or binding death benefit nominations providing that pensions must be paid to children).
The best way of understanding how the new law applies is to consider a hypothetical example, and apply that example in different scenarios. In our hypothetical example:
- • The father, John, has $3.2m in an SMSF.
- • The father has two children under the age of 18, Simon and Debbie, and no spouse.
- • The father dies.
- • The trustee of the SMSF wants to pay as much of John’s superannuation as possible as pensions to Simon and Debbie.
Pensions to children commencing before 1 July 2017
For pensions commencing to be paid to a child of a deceased parent prior to 1 July 2017, the child’s cap increment at 1 July 2017 is $1.6m. This applies to each child. So in our example, the $1.6m cap would not be split between Simon and Debbie.
Say at 1 July 2017, the value of the pension account for each of Simon and Debbie is $1.6m. They would each not exceed their relevant caps. So none of their pensions would need to be commuted.
In this example, the children between themselves have $3.2m of cap. If John had not died and was receiving a pension at 30 June 2017 with a pension account value of $3.2m (eg he had met a condition of release such as retirement), he would be forced to commute half of the pension to a lump sum. He could keep the commutation amount in the superannuation system, or take it out as a lump sum.
Pensions commencing to be paid to a child on or after 1 July 2017 when the parent never received a pension on or after 1 July 2017
If the parent is not receiving a pension at 1 July 2017 and has not started one on or after 1 July 2017, then the parent at the time of their death would not have a “transfer balance account”. This is because a person has a transfer balance account on starting a pension (or on 1 July 2017 if the pension started before then and was being paid then).
When the parent does not have a transfer balance account, the child has a transfer balance cap equal to the general transfer balance cap (ie $1.6m, ignoring indexation). However, if there is more than one child beneficiary, the cap for each child is the proportion of the general transfer balance cap that corresponds to the deceased’s superannuation interests. That is, the cap is shared between the children.
So in our example, if John had never started a pension and there was $3.2m of his superannuation to go to Simon and Debbie, they could each only receive a pension with a value of $800,000, assuming they were to be treated equally. So in this example, half of John’s superannuation must be paid out as lump sums, ie $800,000 to each of Simon and Debbie, or more likely trustees on behalf of Simon and Debbie.
In this example, it would not be possible to pay a pension with a value of $1.6m to one child and a lump sum of $1.6m to the other child (or trustee on behalf of the other child), even though this appears to be within the cap. This is because the proportion of the general transfer balance cap that would correspond to each child’s share of John’s superannuation interests would be $800,000 for each child.
Pensions commencing to be paid to a child on or after 1 July 2017 when the parent received a pension after 30 June 2017
When the parent has commenced a pension on or after 1 July 2017 or continues one at that date, the parent has a transfer balance account. In this case, the application of the cap rules depends upon whether the pension payable to the child is sourced from the deceased’s accumulation or pension accounts. This is very important, and the application of this principle gives very different outcomes.
Pension to child-sourced from accumulation account when parent received a pension after 30 June 2017
If the pension is solely sourced from the deceased’s accumulation account, the entire value of the pension will be treated as being above the child’s cap. This is because the child’s cap increment is nil. This means that no pension can be paid to a child-sourced from the deceased parent’s accumulation account, irrespective of the balance that the deceased has in their transfer balance account (EM para 3.218). This is the case even if the deceased had exhausted their pension prior to death (EM para 3.218, example 3.48). It applies irrespective of the credit that was in the deceased’s transfer balance account (eg the deceased had only commenced a pension after 30 June 2017 with a value of $100,000).
So in our hypothetical example, if John was receiving a pension after 30 June 2017 that gave rise to a credit in his transfer balance account of $100,000, the pension was exhausted when he dies, and he has $3.2m in his accumulation account when he dies, no pensions can be paid to Simon and Debbie. All of the $3.2m must be paid out as a lump sum or lump sums.
This shows that between John, Simon and Debbie, they only used $100,000 of cap even though the policy behind the new law is to allow $1.6m of cap. It also shows that there would be an overall advantage for the family if John had used all of his available cap to commence a pension prior to his death (this is even more apparent when considering the next scenario).
Pension to child-sourced from pension account when parent received a pension after 30 June 2017
If the pension is solely sourced from the deceased’s pension account (ie the deceased’s superannuation interests that were in the retirement phase), the child’s cap increment is equal to the amount of the transfer balance credit that arises in the child’s transfer balance account in respect of the pension. That is, the child receives a cap increment equal to the amount of the parent’s pension account balance. This may be over $1.6m (eg the parent’s superannuation account was initially within their cap and increased due to investment performance).
Unlike pensions payable to children when the deceased was not receiving a pension at some time after 30 June 2017, the cap is not shared between the children.
So in our hypothetical example, if John was receiving a pension after 30 June 2017, with a value of $3.2m due to investment earnings and not an excess transfer balance, each of Simon and Debbie could receive their benefits as pensions. This is because they would each have a transfer balance credit of $1.6m, which is not above their cap.
In fact, the amount in John’s pension account would not be relevant. The child could never have a problem with the cap. So, in our hypothetical example, the whole $3.2m could be paid to only one of Simon or Debbie as a pension and would not exceed the cap.
Other issues that are relevant but are not discussed in this article include:
- • The application of the cap rules when both parents die and pensions from both parents’ superannuation are intended to be paid to a child.
- • The consequences when the parent dies and has an excess transfer balance at the time of death.
- • When the child is receiving a pension that was not payable because of the death of a parent, eg on disablement of the child and also receives a pension on the death of a parent.
- • The timing of credits to be taken into account.
- • Differences between reversionary and non-reversionary pensions.
- • When and how investment earnings derived after the death of a parent are taken into account in applying the cap rules to a pension payable to a child.
Summary of application of new law
Child’s transfer cap
Shared between children
Pension to child starting before 1 July 2017
Pension to child starting after 30 July 2017, no transfer balance account for parent
$1.6m (ignoring indexation)
Pension to child starting after 30 June 2017, transfer balance account for parent, pension to child paid out of accumulation account of parent
Nil (so not possible)
Pension to child starting after 30 June 2017, transfer balance account for parent, pension to child paid out of pension account of parent
Parent’s pension account going to particular child (so never will be an excess)
Tax implications for pensions payable to children
While this law has not changed, we consider it is worth summarising here as we believe that there is some confusion about the application of these rules.
A lump sum paid to or for the benefit of a child is tax-free, ie non-assessable non-exempt income, under s 302-60 of the Income Tax Assessment Act 1997 (ITAA 1997). The same result should apply if the death benefit is paid to the parents estate and the child benefits from the payment (ITAA 1997 s 302-10). The age of the parent is not relevant.
A pension will be tax-free only if the parent was 60 or over at the time of death (ITAA 1997 s 302-65: this is on the basis that there is no element untaxed in the fund). If the parent was under 60, the taxable component of the pension is subject to tax, with a 15% tax offset (ITAA 1997 s 302-75: this is on the basis that there is no element untaxed in the fund).
If any part of the pension is taxable, the child penalty tax provisions in Div 6AA will not apply as the pension payments will be characterised as “excepted assessable income” under s 102AE(2)(a) of ITAA 1936. This is because they would be “employment income” under s 102AF(1)(a) of ITAA 1936 which is defined to include “work and income support related withholding payments and benefits”. This is defined in s 6(1) of ITAA 1936 to include payment from which an amount must be withheld under a provision in Subdiv 12-C in Sch 1 of the Taxation Administration Act 1953 (TAA), even if the amount is not withheld. Section 12-80 Sch 1 of TAA imposes an obligation to withhold from superannuation income streams, and this is a provision within Subdiv 12-C.
As you can see, it is quite a journey to get to this result.
The application of the new law seems to give some surprising results to pensions payable to children. The results vary depending upon when the pensions start, whether the deceased parent had received a pension after 30 June 2017, and if so, whether the pension payable to the child is sourced from the parent’s accumulation or pension account.
It seems to us that any estate planning strategies involving pensions payable to children should be reviewed to see how the new law will apply.