Contributed by Gary Chau, Lawyer and Daniel Butler, Director, DBA Lawyers
We have had numerous queries about the proportioning rule over recent times. A common query is how does the proportioning rule apply and how do you calculate the tax-free and taxable components in a superannuation benefit. This article is to assist you understand the fundamentals of this rule.
As a starting point, think of the proportioning rule as a sort of integrity measure that prevents the “cherry picking” of the tax-free and taxable components when a payment is made from superannuation. At its core, the proportioning rule provides that the tax-free and taxable components of a benefit are taken to be paid in the same proportion as the tax-free and taxable components of the member’s interest from which the benefit came (s 307-125(2), ITAA 1997).
You can refer to CCH Books’ latest Superannuation Guide and Legislation books for more in-depth information and insights.
Terminology — key definitions
To be able to fully understand the proportioning rule, you first need to know the meaning of the following terms that are used in s 307-125 of ITAA 1997: “superannuation income stream”, “superannuation interest”, “superannuation benefit”, “tax-free component” and “taxable component”.
Please note these terms can have different meanings in other legislation. We have primarily focused on the definitions of the terms used in s 307-125 of ITAA 1997 from a taxation perspective and where relevant, we will also discuss each term’s meaning in superannuation law.
Superannuation income stream
Broadly, the term “superannuation income stream” in ITAA 1997 means “a pension for the purposes of the Superannuation Industry (Supervision) Act 1993 (SISA) in accordance with reg 1.06(1) of the Superannuation Industry (Supervision) Regulations 1994 (SISR)”. For ease of reference, we will use the term pension under the SISA to also refer to “superannuation income streams”.
The term “superannuation interest” is a tax concept in ITAA 1997 and essentially refers to either a member’s accumulation or pension interests. More technically, ITAA 1997 provides that “every amount, benefit or entitlement that a member holds in a self managed superannuation fund (SMSF) is to be treated as superannuation interest in the superannuation fund” (reg 307-200.02, Income Tax Assessment Regulations 1997 (ITAR)). For reference, most SMSF members only have one interest in an SMSF, ie their accumulation interest. However, this definition can get tricky when you consider the superannuation definition. For instance, the SISR provides that an amount that supports a pension is treated as a separate superannuation interest — meaning each pension gives rise to a separate superannuation interest. Another way to explain it is as follows, each SMSF member will have one interest per pension and one accumulation interest.
The term “superannuation benefit” means a payment from a superannuation fund to a member (eg broadly this refers to payments from a superannuation fund to the member in the form of a lump sum or pension payments) (s 307-5, ITAA 1997).
Generally, each superannuation interest of a member in a superannuation fund consists of the “tax-free” and “taxable” components (although in some cases, the proportioning rules do not apply where one component may be nil and the other 100%).
The “tax-free component” includes the contributions segment and the crystallised segment. The contributions segment generally includes all contributions made after 30 June 2007 that have not been, and will not be, included in your fund’s assessable income. The contributions segment is made up of what is commonly known as non-concessional contributions (and also includes the CGT exempt component, superannuation co-contribution benefits, and contribution splitting benefits). Whereas, the crystallised segment broadly includes numerous tax-free components that existed prior to 30 June 2007 and are becoming increasingly uncommon.
The “taxable component” is broadly the total value of the member’s superannuation interest less the value of the tax-free component. Contributions that would form part of the taxable component are generally amounts included in the assessable income of the fund. Broadly, the taxable component consists of concessional contributions and earnings and capital appreciation from investments in the fund.
When do you calculate the tax-free and taxable components?
The value of the superannuation interest and the amount of tax-free and taxable components of the member’s interest is determined as follows:
- Determine whether the benefit is a lump sum or a pension.
- Work out the total value of the superannuation interest and the proportion of tax-free and taxable components as at the applicable time, which means:
- if the benefit is a lump sum — just before the benefit is paid, or
- if the benefit is a pension — on the date the pension commences. (In other words, you lock in the proportion of the tax-free and taxable components on the date the pension commences, and future growth and earnings are shared proportionally between these components.)
- Apply the same proportions to the amount of benefit paid (this part is the essence of the proportioning rule).
Consequences of the proportioning rule
Proportioning rule when a pension is commenced
In an accumulation interest, the tax-free component is normally comprised of a static amount (ie the crystallised segment and the contributions segment). Whereas, the taxable component can change every day as the investments supporting the superannuation interest fluctuate with investment markets and earnings (or losses) accrue in some cases on a daily basis.
However, when a pension is commenced with a certain proportion of a tax-free component and the pension assets increase over time, the tax-free component will effectively grow. This is because at the time of paying pension benefits, the proportioning rule will use the same proportion of tax-free component that was locked in at the commencement of that pension.
To illustrate how the proportioning rule works, in practice, in respect of pensions, look at the following example:
In January 2017, Christopher is 66 years old, still working and is a member of an SMSF. In his SMSF, Christopher’s superannuation interest consists of a tax-free component of $300,000 and a taxable component of $200,000. His total superannuation balance is $500,000. This means the proportion of his superannuation interest that consists of the tax-free component is 60% and the taxable component is 40%.
Christopher commences an account-based pension with just $250,000 of his total superannuation interest. At the commencement of this pension, the tax-free component is $150,000 (or 60%) and the taxable component is $100,000 (or 40%) since his total superannuation interest before commencing the pension was 60% tax-free component and 40% taxable component.
If the value of the assets supporting the pension were to rise, the percentages representing the tax-free and taxable components do not change. Thus if Christopher’s pension balance, which started at $250,000, were to rise to $400,000 after three years due to his savvy investment decisions, his tax-free and taxable components would retain the same proportion as at the pension’s commencement and will be as follows: a tax-free component of $240,000 (or 60%) and a taxable component of $160,000 (or 40%).
Of course, if the value of the assets supporting the pension were to fall to say $100,000, then the proportion of the tax-free and taxable components will still remain the same as at commencement (ie $60,000 tax-free and $40,000 taxable).
Accordingly, the following general rules should be noted:
- where assets are going to increase in value, the tax-free component is maximised by commencing a pension sooner rather than later (locking in the tax-free component to grow proportionately)
- where assets are going to decrease in value, the tax-free component is maximised by commencing a pension later rather than sooner (allowing the decrease in assets to erode the taxable component).
Proportioning rule with an accumulation interest
To illustrate further the above general rules about the proportioning rule, consider the following:
Again, same facts as above, in January 2017, Christopher is 66 years old, is working and is a member of an SMSF. In his SMSF, Christopher’s superannuation interest consists of a tax-free component of $300,000 and a taxable component of $200,000. His total superannuation balance is $500,000. This means the percentages representing the proportion of his superannuation interest that consists of 60% tax-free component and 40% taxable component.
Let’s focus on his accumulation interest this time. Recall, Christopher commenced his pension with $250,000 of his total superannuation interest, he therefore has $250,000 remaining in his accumulation interest. That $250,000 in accumulation would comprise of a tax-free component of $150,000 (or 60%) and the taxable component is $100,000 (or 40%). Like his pension interest, the value of his accumulation interest rises to $400,000 after three years due to his savvy investment decisions. Unlike his pension interest, his tax-free component remains static and the proportion of his taxable component increases. Christopher’s tax-free and taxable components in respect of his accumulation interest is now as follows: a tax-free component of $150,000 (or 37.5%) and a taxable component of $250,000 (or 62.5%).
As the above example shows, there is no change to the tax-free component if investments in the accumulation interest increase in value. Hence, the decision to commence a pension with some or all of a member’s benefits at the right time can make a significant difference to a member’s interest over the course of time.
A sound understanding of the proportioning rule is important as it is forms the basis of many strategies that leverage off it. For example, where there is a significant tax-free component, the pension should generally be commenced as soon as practicable for a member where the fund expects to see some growth in the value of its assets. Further, when a member is contributing or rolling back a pension into accumulation, stay alert to the effect on what will happen to the tax-free and taxable components — since these two components cannot be separated to maximise each client’s position once these amounts are mixed together.