As part of the calculations required by Section 305-70 of the ITAA 1997 for QROPS transfer tax liability, one needs to know the amount vested on the day before Australian tax residency. This is not always available from the UK scheme. There is no prescribed basis to calculate this amount. In a low inflation environment, the basis used by the ATO will often result in a lower “applicable fund earnings” that is assessable as compared to the more detailed basis used by NetActuary. To highlight this, we stopped processing the calculation of date of residency amounts as it may be in the client’s best interest to request a value from the ATO. However, at times the ATO basis produces a higher taxable amount as compared to the comprehensive calculation. Consequently, we have been asked by a number of practitioners to detail this issue in some depth to assist them manage particular cases.
We understand that the ATO estimate of date of tax residency amount is to discount the amount received back to date of residency by the annual inflation rates. I have no argument with a discounting actual received amount approach. The way the scheme would reserve for the accrued benefits would have the assumed economic condition changes from time to time. So – to be consistent with how the ATO deals with exchange rates – actual rather than nominal rates is logical. This is especially true if the transfer amount has a funding deficit reduction. I also have no objection to items such as death in deferment being omitted – their financial significance is small.
An example will show the issues. Let’s say the anticipated returns on scheme assets is 5% p.a. So, for $100 in a year’s time you would reserve roughly $95. The balance would be
funded by investment earnings. If 2% inflation increases were granted over that year, then $97 needs to be put aside. This is sometimes expressed as a 3% “real” rate of anticipated return/discount. The ATO approach is to discount by the inflation rate i.e. 2% making their estimate value $98 - a lower taxable impost for the client. In essence, the ATO is using the inflation rates as a proxy for the real rate of return. Back in 3% inflation environments this was not unreasonable, but it is no longer the case.
The problems really start to occur when there is a GMP pension element. Many of the QROPS transfers could have a fixed rate GMP revaluation of up to 7.5% p.a. It would be totally inappropriate for the ATO to have a 7.5% real rate of discount – 2% to 5% range would be acceptable. I doubt whether the ATO is splitting the calculation into different pension elements with different revaluation in deferment increases. So, where a GMP component is involved, the ATO basis may not be a reasonable estimate.
What I would suggest as a basis to check with the ATO as to whether it is acceptable is:
- Precise modelling of in deferment revaluations for each of the pension elements.
- An assumed rate of earnings for the relevant period of the UK Lipper median pension scheme return less 1.5% administration cost allowance.
- The above used to discount the actual received amount in GBP at the date of receipt.
There are a few other items which would be good to clarify with the ATO at the same time. The assessable amount (in essence) is the growth in value during Australian tax residency. With a defined contribution design, one would deduct employer and member contributions. These are capital items not investment earnings growth. With a defined benefit design that accrued benefits after Australian tax residency (not common – but possible) contributions are made in aggregate to cover all benefits. We need to check with the ATO that they will accept an actuarial estimate of what these “notional contributions” will be and any constraints they may impose. This is very similar to how defined benefit accruals are treated for Australian contribution cap purposes.
Since ATO Interpretative Decision ATO ID 2015/17 the Commissioner’s view about foreign currency translation rules in relation to lump sum transfers from foreign superannuation funds is fairly clear. Where the benefits are transferred to an Australian QROPS fund but kept in GBP, one needs to use the ATO published daily exchange rates. If the monies are transferred to Australian dollars, can one choose between the actual commercial rate received and the ATO published daily rates?
A fairly common transfer strategy is a UK defined benefit entitlement being transferred to a UK SIPP. Some monies are then sent to a second UK scheme. This resets the “start date” and requires various “previously exempt fund earnings” amounts to be calculated. The Commissioner’s views in ATO ID 2012/48 and ATO ID 2012/49 provides some guidance on the first out or proportionate treatment of applicable fund earnings/previously exempt fund earnings. This staggered approach for clearing large amounts is inefficient. The alternative approach is a refund of excess contribution strategy. This may be feasible as the fund cap amount was abolished and being older than 55, HMRC would permit a QROPS withdrawal. However, the component that doesn’t count against the NCC cap remains in the fund after 15% tax. This means millions of dollars could be transferred into the SMSF. That is against the spirit of the $1.6m TBC provisions. Some definitive guidance from the ATO is desirable on this issue.
Often fees are deducted from the SIPP after the transfer from a defined benefit transfer. After that, the monies are forwarded to Australia. Clarification here revolves around confirmation that the growth component is net of these fees. This is akin to the deductibility of financial planning fees. The argument would be that these transfer fees and fund establishment fees are deductible i.e. the nexus between expense and generation of assessable income is met.
Since April 2015, UK schemes that are defined contribution in design can offer more freedom with drawdowns. This can be a Flexi-Access Drawdown (FAD) i.e. the UK 25% tax free component taken at outset, or an Uncrystallised Fund Pension Lump Sum (UFPLS). This latter spreads the UK 25% tax free component to each withdrawal. In the UK, the excess is taxed at marginal tax rates. Under the old rules where only the tax free component was removed, the UK Scheme would not have a withholding tax. The 25% UK tax free component was taxed in Australia. Now amounts are in excess of that, the UK scheme will want to withhold tax. The UK – Australia Double Taxation Agreement has Article 17 which provides “Pensions (including government pensions) and annuities paid to a resident of a Contracting State shall be taxable only in that State”. The DTA provision takes precedence. Do the withdrawals have to have a regularity to fall under this provision? If the withdrawal does not, then which article of the DTA applies and what should be the withholding rate? The implementation of these provisions is a mess at the moment and lacks consistency in implementation between UK schemes.
If clarification can be obtained with the above issues, practitioners will have far more clarity on how to deal with financial planning issues for UK QROPS transfers. I strongly recommend until that standard practice and precedent is available, that private rulings are obtained for individual cases.