Retirement-phase super splits

There are a number of ways the splitting of a superannuation benefit between a member and their spouse can be achieved, writes SuperCentral superannuation special counsel Michael Hallinan.

If a member’s entire superannuation interest is in retirement phase, is it necessary to formally split the interest when super splitting is necessary or desired? Surely, as the interest to be split is no longer subject to preservation standards, can’t the member simply cash out the benefit to the extent necessary and instruct the trustee to pay the cashed-out amount to the spouse? In a formal arrangement a splitting agreement must be entered into, or a splitting order granted, and the statutory entitlement of the spouse arising under that agreement or order needs to be converted into a family law superannuation payment in respect of the spouse. Seemingly so much effort and not to mention the legal fees.

Well, there could be situations where an informal split is appropriate. However, there are other situations where a formal split is absolutely necessary. The issue is to know when a formal split is required and when an informal split can be used.

If the superannuation interest to be split is constituted by a legacy pension, such as a lifetime pension (Superannuation Industry (Supervision) (SIS) regulation 1.06(2)), life expectancy pension (regulation 1.06(7)) or market-linked pension (regulation 1.06(8)), then a formal splitting process must be used as each of these income streams permits commutations to give effect to the entitlement of a spouse under a payment split. In contrast, if the legacy pension is a flexi-pension (regulation 1.06(6)) and so not subject to commutation restrictions, but is subject to the restriction that the commutation amount cannot exceed an amount determined by applying the pension valuation factors of Schedule 1B), it can be subject to an informal split.

If the superannuation interest is an account-based pension (regulation 1.06(9A)) or an accumulation interest, or a combination of account-based pensions and an accumulation interest, then informal splitting can be used. In this situation an informal split can be achieved by simply cashing out the pension or accumulation interests necessary to achieve the desired amount, with the member simply instructing the trustee to pay the resulting lump sum to the spouse. The lump sum arising from the cashing out is treated as a superannuation member benefit of the member, and therefore derived by the member, which will constitute non-exempt non-assessable income. The payment to the spouse will be a capital payment. Unless the terms of the superannuation fund provide otherwise, the payment of the lump sum to the spouse will not breach either the SIS payment standards or the SIS minimum benefits standards.

Given the above and assuming the relevant superannuation interest is constituted by account-based pensions or accumulation interests or both, why not informally split? There are two reasons not to take this option. The first and primary reason is the spouse may require the lump sum to constitute a family law superannuation payment. The less significant reason is the super fund may take advantage of a capital gains tax (CGT) exemption if, in order to pay the lump sum, CGT assets of the fund are required to be sold.

The primary reason for a formal split

The primary reason for a formal split is to generate a family law superannuation payment. By converting the statutory entitlement that arises from a superannuation splitting agreement or a splitting order into a monetary value for the spouse, the monetary entitlement can then be transferred or rolled over to a super entity chosen by the recipient. Such a transfer payment is a family law superannuation payment. As such, the payment is treated as a rollover superannuation benefit of the spouse. Consequently, the transfer payment is not subject to the non-concessional contribution cap and is also not subject to the SIS contribution acceptance regime.

Example

Consider Bill and Jane. Bill has a superannuation interest that consists of an account-based pension with a balance of $1.8 million. It has been agreed Jane will be paid $1.2 million from Bill’s superannuation interest.

This division of Bill’s superannuation interest could be achieved informally by Bill simply requesting a partial commutation of two-thirds of his account-based pension with a direction the trustee pay the resulting lump sum amount directly to Jane. This action means Bill is simply bound by the agreement to exercise his commutation rights and agrees to direct the trustee to pay the resulting lump sum to Jane. In this case, Bill’s account-based pension account is now $600,000 and Jane has a bank account balance of $1.2 million.

However, the $1.2 million in Jane’s bank account is non-superannuation money. If she wished to transfer all or a portion of that balance into the superannuation system, she would be subject to the contribution caps as well as the SIS contribution standards. These requirements will frustrate her plan to contribute all or most of the $1.2 million into super.

If the division of Bill’s superannuation is done formally, then there must be either a splitting agreement or a splitting order. The content of the agreement or order could be either a base amount split, where a specific dollar amount is allocated as the base amount, which would be $1.2 million or, alternatively, a percentage split where the percentage would be 66.6 per cent. While in the case of Bill and Jane there may not, on the face of the matter, be a difference as to whether it is a base amount split or a percentage split, nevertheless there is a difference.

A base amount allocation will give Jane a statutory entitlement to $1.2 million, which will be adjusted by a prescribed interest rate for the period from the operative date until the payment is made. This means any investment loss is borne by Bill and Jane is guaranteed an investment return of the prescribed interest rate. Bill will be entitled to any investment earnings above the prescribed interest rate. If he was to make additional contributions to the superannuation after the operative time, Jane would not be entitled to any portion of those additional contributions.

A percentage allocation will give Jane a statutory right to be paid two-thirds of each splittable payment made from Bill’s superannuation interest. In this situation if the superannuation interest declines due to negative movements in the market value of the assets of the super fund, the decline will be borne by both Bill and Jane in the proportion of onethird to Bill and two-thirds to Jane. Also, if Bill were to make any superannuation contributions to the super fund after the operative time, Jane would benefit from two-thirds of those additional contributions.

It is usually in the interests of both parties that a clean break be achieved in respect of the payment split and as quickly as possible. A clean break is achieved by converting the entitlement of the spouse under a splitting agreement or splitting order into a family law superannuation payment for the spouse and a corresponding reduction in the value of the super interest of the member.

Transfer balance account impact

As Bill is in retirement phase, the ATO will have established a transfer balance account for him. Assuming the accountbased pension commenced after 1 July 2017 with a starting balance of, say $1.6 million, his transfer balance credit would be $1.6 million. It is in Bill’s interest to have a partial commutation of his pension before the split is implemented, whether formal or informal. The partial pension commutation of two-thirds of his income stream will generate a transfer balance debit of $1.2 million that will reduce Bill’s transfer balance account to $400,000. Whether he can take advantage of this increased transfer balance cap space will depend on his current and future circumstances.

Formal conversion of payment splits

Unless and until a splitting agreement or splitting order is served on the superannuation fund trustee, either instruction has no effect on the super interest and does not bind the trustee of the superannuation fund. Once the splitting agreement or splitting order is served on the trustee, the agreement or order becomes effective and binds the trustee and attaches to the superannuation interest of the member whose super interest is adversely affected by the agreement or order on and from the operative time. In the case of splitting agreements, the operative time is three clear business days after the date of service. If the splitting agreement is served on the trustee on Monday, then the agreement will be effective on Friday, assuming a normal working week exists. In the case of splitting orders, the operative time is the date specified in the order, or if no date is specified, the date when the order is served on the trustee.

Once the splitting agreement or splitting order binds the trustee, the beneficiary will have a statutory right enforceable against the trustee to receive a specific portion of the first superannuation payment, subject to some exceptions that are not presently relevant, made from the member’s superannuation interest which occurs on or after the operative time. The statutory right arises under the Family Law Act 1975 and the Family Law (Superannuation) Regulations 2001. This statutory right overrides the terms of the superannuation trust deed and even the provisions of the SIS Act and Regulations.

The statutory entitlement of the spouse under a splitting agreement or splitting order can be likened to a floating charge over the superannuation interest of the member that crystallises when the first payment is made from the super interest of the member after the operative time.

The statutory entitlement of the spouse is the right to be paid a determinable portion in respect of the first splittable payment made after the operative time from the superannuation interest of the member.

The portion to be paid is, in the case of a base amount split, the base amount adjusted for the period from the operative time up to the date of payment but excluding the date of payment. If the first payment is equal to or greater than the adjusted base amount, the spouse is entitled to be paid an amount equal to the adjusted base amount with the member entitled to the balance, if any, of the payment. In this situation, the statutory entitlement of the spouse is satisfied and the payment split ceases to have any further effect on the superannuation interest. If the first payment is less than the adjusted base amount, the spouse is entitled to the entire payment and the right to the unpaid portion of the adjusted base amount is converted into a statutory right to receive a portion of each subsequent payment, being a splittable payment, from the superannuation interest until the date of payment.

In case of a percentage split, the entitlement of the spouse is a statutory right to receive the specified portion, in Jane’s case two-thirds, of the current payment and each subsequent splittable payment from the superannuation interest.

Conversion of entitlement to a family law super payment

To have a clean break in respect of the payment split, to reduce the investment risks borne by the member (in the case of a base amount split) and the spouse (in the case of a percentage split), it is necessary to convert the prospective or actual statutory entitlement of the spouse into a rollover superannuation benefit for them.

While the splitting legislation provides five methods of converting a payment split interest, only three methods are suitable for SMSFs.

The first method is provided by Division 7A.2 of the SIS Regulations. This method permits the spouse to convert the monetary value of the statutory entitlement into a new membership interest in the fund, to transfer the monetary value to another superannuation entity, or to have the monetary value paid out as a lump sum benefit. The new membership interest option may not apply if the rules of the SMSF expressly exclude this option. And of course the lump sum benefit payment option is only available if the spouse has satisfied an unrestricted release condition. The trustee is required to advise the spouse of their available options and is given by the issue of a payment split notice to the spouse. If the spouse does not select an option within 28 days of the receipt of the payment split notice, the trustee may transfer the monetary value of the entitlement to another superannuation entity they have chosen.

The second method is provided by Division 7A.1A of the SIS Regulations. Here the trustee initiates the conversion process by creating a non-member spouse interest in the fund. The value of this interest is the monetary value of the statutory entitlement of the spouse as at the date the interest is created by the trustee. The spouse then has 28 days in which to select an option of either retention of the nonmember spouse interest to become a full membership interest in the fund (as long as the terms of the fund have not excluded this option), transfer to another superannuation fund or (subject to the spouse having satisfied an unrestricted release condition) payment as a lump sum benefit.

The third option is to convert the statutory entitlement of the spouse into a transfer payment to a superannuation entity chosen by them or, if the recipient has satisfied an unrestricted release condition and if the spouse requests, a lump sum to their benefit. The conversion is achieved by exercising powers conferred on the trustee by the governing rules of the superannuation fund. The conversion is implemented by a deed executed by the trustee, the member and the spouse, with the deed constituting the relevant exercise of the powers.

As a general statement, conversion by means of the third option is generally the most convenient as it only requires one document to be signed by the relevant parties and once signed, the implementation is an administrative function.