Taxation of income streams on death
The tax treatment of a pension on a member’s death has been settled, with legislation being passed that ensures that investment earnings on assets supporting pensions will continue to be tax exempt until a deceased member’s superannuation death benefits are paid either as a lump sum or pension to their dependants.
Impact of the Regulations
The provisions in the Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013 (Regulations) apply from 1 July 2012 and have the following impact:
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assets supporting a current pension liability will not trigger a tax liability if transferred or disposed of on the member’s death; and
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the taxable and tax free components of a deceased member’s superannuation interests, where amounts are held in accumulation phase and pension phase, will not need to be recalculated on death. This means that the taxable and tax free proportions of a pension will not be combined with the components of another pension or amounts in the accumulation phase. This is particularly important where a pension is comprised of predominately tax free amounts.
Importantly, the superannuation death benefit must be paid as either a lump sum or by way of the commencement of a pension using only an amount from the deceased member’s pension benefit. This means that the amount must be quarantined on the death of the member and paid as a discrete payment.
The exception to this provision is that investment earnings (including the proceeds of a life insurance policy held in respect of the member) and an anti-detriment amount can be added to the amount attributable to the deceased member’s pension.
Taxable and tax free components
The Regulations provide that the taxable and tax free components of the pension are maintained, but that any anti-detriment increase or proceeds from a life insurance policy effectively form part of the taxable component of the benefit.
This means that while investment earnings such as dividends are applied in proportion to the taxable and tax free components of the deceased member’s pension, any insurance proceeds will increase the taxable component.
For example, if a member has a pension of $500,000, comprising a $300,000 tax free component and a $200,000 taxable component, any investment earnings are ordinary allocated as 60% tax free component and 40% taxable component.
After the member’s death, the trustee determines to pay the pension balance to the member’s spouse. The following amounts are added to the pension amount:
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life insurance proceeds of $500,000; and
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investment earnings of $100,000 from dividends, interest and rent.
In this scenario, the superannuation death benefit is comprised of the following components:
| Pension amount | Tax free component | Taxable component | ||
| Pension benefit: $500,000 | $300,000 | 60% | $200,000 | 40% |
| Dividends, rent and interest: $100,000 | $60,000 | 60% | $40,000 | 40% |
| Insurance proceeds: $500,000 | Nil | Nil | $500,000 | 100% |
| Total: $1,100,000 | $360,000 | 32.73% | $740,000 | 67.27% |
Therefore, the above scenario gives rise to an effective taxable proportion of 67.27%, instead of the original proportion of 40%. While the taxable and tax free components may not change the tax treatment of a payment received by the spouse, this will impact on the tax treatment of superannuation death benefits received by adult children.
In light of this, succession planning around superannuation should take into account the different consequences if a pension is reversionary, or if a new pension is started for a beneficiary after a pensioner’s death. For example, if the pension automatically reverted to an eligible dependant on the member’s death, the insurance proceeds would be allocated in accordance with the underlying proportions of the pension as the modification to the proportioning rule would not apply (this assumes that the insurance premiums were funded from assets supporting the deceased member’s pension).
Thus, the superannuation death benefit would be comprised of the following components:
| Pension amount | Tax free component | Taxable component | ||
| Pension benefit: $500,000 | $300,000 | 60% | $200,000 | 40% |
| Dividends, rent and interest: $100,000 | $60,000 | 60% | $40,000 | 40% |
| Insurance proceeds: $500,000 | $300,000 | 60% | $200,000 | 40% |
| Total: $1,100,000 | $660,000 | 60% | $440,000 | 40% |
This ensures that the taxable and tax free proportions of the pension are maintained, and in the example above, increases the tax free proportion by $300,000. Ignoring any pension draw downs, if the reversionary beneficiary then died and their superannuation death benefit was paid as a lump sum to an adult child, the tax payable would be $74,800 (being 15% plus the Medicare levy of $440,000) instead of $125,800 (being 15% plus the Medicare levy of $740,000). This is a tax difference of $51,000.
Importantly, the Regulations in 307.125.02(i)(c) make it a condition that:
‘no amounts, other than investment earnings or an amount to fund an anti-detriment increase, have been added to the relevant superannuation interest on or after the deceased’s death.’
‘Investment earnings’ are defined for the purpose of the regulation as including ‘an amount paid under a policy of insurance on the life of the deceased…’
The insurance proceeds will not have been added to the pension of the reversionary beneficiary on or after the death of the reversionary beneficiary, and therefore the modification to the proportioning rule would not apply.
Taxation Ruling TR 2013/5
While a trustee is entitled to treat the pension as remaining on foot until the death benefits have been paid to the member’s dependants as either a lump sum or pension if a member dies in the 2013 income year, TR 2013/5 sets out the Commissioner’s interpretation of the law from 1 July 2007 until 30 June 2012.
The Commissioner takes the view that where a member dies and a reversionary beneficiary has not been nominated, the pension will cease on the member’s death. This will give rise to the tax consequences discussed in our update of 5 February 2013. Importantly, the Commissioner has advised that he will effectively take a ‘no compliance action’ approach to the issues set out in TR 2013/5 for years preceding the 2013 income year.
Nonetheless, the Commissioner may adopt a view consistent with TR 2013/5, where, for example, a fund is being audited and this issue arises. On this basis, we recommend trustees seek legal advice in this situation if there is a risk that TR 2013/5 could apply to the fund.
Contact
Andrew O’Bryan
Consultant
Andrew specialises in taxation law. He is a CPA Australia Fellow and Chairman of its Taxation Centre of Excellence.
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