Devil in the detail

The proposed new tax on total super balances above $3 million has been met with significant SMSF community trepidation. SMSF Association chief executive Peter Burgess details some of the alarming aspects of the measure already identified and why the government must consider changing its position on the matter.

It was the Spanish-born American philosopher George Santayana who famously said: “Those who cannot learn from history are doomed to repeat it.” In 1996, a 15 per cent surcharge levy on superannuation contributions when earnings exceeded $85,000 a year was implemented. It was abolished less than a decade later, the consensus being that it cost more to build and run than it had raised in revenue.

Nearly three decades later, a fresh superannuation tax is on the drawing board, this time a proposal to introduce a $3 million cap on super balances above which earnings will be taxed at a higher rate. Although this proposal will not be introduced until 2025, assuming it becomes law, it is sending palpable waves of consternation through the SMSF community.

At first glance, this might seem an overreaction. After all, it’s more than two years and a federal election away and, according to Treasury’s estimates, will only affect 80,000. But dig a little deeper, as the SMSF Association has done, and the likelihood of the law of unintended consequences being triggered becomes increasingly apparent.

It’s not just any unintended consequences. This proposal is ill-advised on many levels.

For starters, think complexity. Another cap will further complicate a system that already has contribution caps and caps on the amount that can be transferred to the pension phase. This amounts to cap upon cap.

Numerous inquiries into superannuation, the Retirement Income Review was the latest, have called for its simplification; yet it seems every government initiative adds more complexity. And the cost of change and complexity is high as it undermines confidence in super. Every time the goal posts are moved, fund members ponder what next. Our feedback to this change is that people are feeling increasingly vulnerable, and not just those immediately affected.

The proposed cap is often mentioned in the same breath as significantly large superannuation balances. This is misleading. Large super balances are a legacy issue, a product of historical policy settings by successive governments. The current policy framework strictly limits amounts that can be contributed into super. Consequently, the days of individuals accumulating significant wealth in super are over.

The transfer balance cap operates to strictly limit the amount of capital that can be used to start a retirement income stream or pension. The associated tax concessions on retirement pensions are therefore tightly constrained. And, with the introduction of the fair and sustainable superannuation reforms, member benefits relating to a deceased member must be compulsorily paid out of the retirement savings system. So, over time, these large balances will be expelled from the super system.

The decision not to index the $3 million cap simply compounds the uncertainty. For those entering the workforce today it’s estimated about 500,000 super balances will breach the cap, of which about onethird are now under age 30. So, today’s 80,000 is set to grow exponentially. Remember, too, that a $3 million cap will be worth about $1 million in 30 years. It will inevitably lead to confusion and uncertainty about future retirement planning strategies, with increasing numbers turning to other tax-favoured structures that may be subject to lower levels of regulatory oversight.

The proposed model actively promotes simplicity over equity – a dangerous and concerning precedent. Positioning in this manner is counter to both vertical and horizontal equity taxation principles. And, when the various distortions that will arise and the exceptions that will need to be addressed are factored in, the outcome is far from simple or equitable.

For example, to ensure the proposed calculation of earnings does not overstate the amount of earnings that will be subject to this new tax, numerous adjustments will need to be made to the definition of ‘contributions’ and ‘withdrawals’, and various amounts will need to be excluded from an individual’s total super balance (TSB).

The adjustments that have been identified so far include:

• limited recourse borrowing arrangements (LRBA) – certain amounts included in a member’s TSB will need to be excluded for the purposes of the proposed model,

• disability benefits – insurance proceeds will need to be excluded from the calculation of a member’s TSB,

• death benefits – a deceased member’s interest will need to be excluded,

• excess contribution withdrawals, Division 293 assessments, contribution splitting amounts and family law settlements will need to be excluded from the definition of a ‘withdrawal’, and

• small business capital gains tax concessions and applicable fund earnings associated with an overseas transfer will need to be included in the definition of a ‘contribution’ for the purposes of the proposed model.

What is also disconcerting about this proposal is how it is designed. Put bluntly, it’s a measure that appears to have been designed to benefit large Australian Prudential Regulation Authority (APRA)regulated funds, with about 75 per cent, or 60,000, of the initial 80,000 affected being SMSF members. The lack of equity and resulting unintended consequences arising from the proposal are driven by a desire to placate the large APRA funds.

For example, SMSF members with balances exceeding $3 million should not be required to pay tax on unrealised gains simply because some APRA funds may find it difficult to report the taxable income attributed to fund members. This is a clear case of the tail wagging the dog. Given the significance of the impact on members of SMSFs, and the distortions already arising, any model must be considered in an SMSF context.

Yet the government’s “Better Targeted Superannuation Concessions” consultation paper dismisses the option of calculating this new tax on actual earnings. We believe this issue, in the interests of fairness, can and should be resolved. To this end, our submission in response to the consultation paper proposes an alternative way of calculating earnings based on a member’s actual taxable earnings. Our submission recognises that, in situations where this information is not available or the fund chooses not to report this information, a default notional earning rate would apply. In our view this is the simplest and most equitable way of introducing the proposed $3 million threshold. Importantly, our alternative approach would avoid tax being imposed on unrealised gains.

The impact of taxing unrealised gains should not be underestimated. In our opinion, it has the potential to be the most lethal of the unintended consequences. Under the proposed model, SMSFs with farming or business premises within the fund may encounter significant liquidity pressures.

In this regard, farming is the standout as it is a cyclical industry where bumper seasons are followed by lean years when flooding, bushfires, plagues and drought can exact a heavy toll. It is not just Mother Nature. Global commodity prices and the Australian dollar play a major role in determining farming income.

What this means is a farmer may receive no income in a financial year but still face a higher tax bill due to an increase in the value of their farm. Changes in property values do not automatically correlate to increases in either leasing or farm income. Put simply, the market forces driving rural property prices differ to those driving yield or income. Broadly, yield is driven by the use, size, quality and location of the property asset. Income is determined by commodity prices and the dollar.

Property values can be influenced by increased buying activity (larger operators seeking scale), land treatment, such as soil enrichment for crop or pasture, improved or additional water assets, such as upgrades to irrigation, dams and tanks, new fencing, or land remediation to address salinity, wind, soil and water erosion.

So, there is a real disconnect between income generated and the value of the property. In difficult years where little or no income is derived, this can have an impact on their ability to pay wages and superannuation contributions for themselves. Reduced contributions, or the cessation of contributions, will therefore impact the fund’s liquidity which could be further exacerbated by additional future tax liabilities levied upon the fund’s increase in the paper value of the underlying property.

If trustees are forced to sell the property, the taxation impacts are multiplied as capital gains tax will be triggered. The family may not be able to acquire the property personally, which could result in the loss of the property and/or their family farming business. Furthermore, it may not be an opportune time to sell, which could have a further detrimental impact on the fund. Members should not be forced into a fire sale scenario to fund the payment of this arbitrary tax.

Similar issues arise for small business owners. Typically, the family home and personal assets are at risk due to debt securities, director guarantees and trade or supply agreements. For both farmers and small business owners the key point is this – the level of wealth inside the fund at a point in time is not indicative of the individual’s personal wealth or liquidity outside of the superannuation system.

There are two other points worth pondering. The public consultation phase in response to the objective of superannuation consultation paper has closed and we have still not progressed to an exposure draft. It was a reform that had everyone in the industry in agreement, at least in principle, when it was recommended as part of the Murray review in 2014 (yes, 2014).

We would argue no substantive change to super should occur before we have that objective. Yet the “Better Targeted Superannuation Concessions” consultation paper proposes a significant policy shift and a fundamental change in taxation policy and concepts without considering the broader retirement income system or the impacts on it.

The Retirement Income Review examined the essential pillars and components of the retirement income system of which superannuation is only one part. Other essential components include home ownership and aged care. Significant policy changes must be considered under a legislated objective and consideration of the impacts within the broader retirement income system is paramount. There is no evidence of this happening with the proposed $3 million cap.

The government has announced a 2025 kick-off. Yet despite this lengthy period, there has been limited consultation to allow sufficient time to properly consider the impacts and identify the unintended consequences arising from this model. Indeed, we have seen new concerns arise daily through engagement with our members, stakeholders and other industry groups.

The consultation paper process has the appearance of a tick-the-box exercise that risks detrimental outcomes for the many individuals affected. We urge government to take a careful and considered approach to any policy reform. A rush to legislate could have lasting negative impacts. The superannuation system is one that is already laden with complexity and red tape. What is being proposed will only add to the mire.