Session 1A:
The Latest in Reserving Strategies
Robert O’Donohue
Partner, HWL Ebsworth Lawyers
2011 SMSF National Conference
When can an SMSF use a reserve?
 Section 115 of SIS Act - Trustee may maintain reserves
unless governing rules prohibit
 Broad administrative powers in most trust deeds
 Ideally, trust deed specifies power to create reserve
and details what types of reserves may be created
 If unsure trustee should seek legal advice
2011 SMSF National Conference
What must you do in creating and maintaining
reserves?
 Section 52(2)(g) of SIS Act – Trustee agrees to formulate and give
effect to strategy for prudential management consistent with
investment strategy and capacity to discharge liabilities
 Defence to an action for loss (s.55(6))
 Strategy should state:
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purpose of reserve
target level of funds for purpose
how funds invested (refer to fund inv strategy)
policy as to distributions
intervals for review
2011 SMSF National Conference
How are distributions treated for tax purposes?
 General Rule - distributions from reserves are concessional
contributions unless:
1) allocated in a “fair and reasonable” manner to every member (or
class of members) and
2) Together with other distributions for financial year (if any), less than 5%
of member’s account at time of distribution
 If 1 and 2 above satisfied distribution is neither a concessional, nor
a non-concessional contribution
2011 SMSF National Conference
How are distributions treated for tax purposes?
• Rule does not apply to two reserves:
– Distributions from Contributions Reserves
 amount allocated from contributions reserve generally retains character
of contribution made to fund i.e. concessional or non-concessional
contribution
– Distributions from Pension Reserves
 to allow for pension commutations, pension payments and death benefits
greater than 5% of members account
2011 SMSF National Conference
When is a distribution “fair and reasonable”?
 Explanatory Statement to ITAR 1997:
“In determining what is fair and reasonable...it would ordinarily be
expected that the allocation would be in proportion to the existing
interests of the members so that particular members are not favoured
over others”
 ATO in NTLG Superannuation Tech. Subgroup meeting of 8
September 2009
“To be fair and reasonable the Tax Office considers that the
allocation of an amount from a reserve should be allocated to each
member’s interest in proportion to that interest in the superannuation
fund”
2011 SMSF National Conference
When is a distribution “fair and reasonable”?
 APRA agrees with ATO
 Proportionate approach can lead to unfair results:
Example
 Tom has a $1 million account in his family SMSF
 Tom’s wife Katie has a $100,000 account
 Trustee has retained $1,000 p.a. from each of them in an Expense
Reserve to administer the fund
 If the trustee distributes any surplus from the Expense Reserve back to
Tom and Katie in proportion to their accounts Tom must receive 10 x
Katies distribution for it to be considered “fair and reasonable”
 Need clearer regulatory guidance
2011 SMSF National Conference
How are reserves treated for super benefit purposes?
 Accumulation members
 If up to 5% limit and fair and reasonable
o taxable component because not a contribution
 If 5% or above or unfair or unreasonable
o arguably part of tax free component because deemed a
“concessional contribution” and because not assessable in fund
could form part of tax free component
o Critical issue – whether deemed concessional contributions are
“contributions” – not defined in ITAA or ITAR
2011 SMSF National Conference
How are reserves treated for super benefit purposes?
o ATO considers that deemed concessional contributions are not to
be regarded as ‘contributions’ because do not increase the
capital of the fund (NTLG Superannuation Technical Sub-Group
meeting of 8 September 2009)
o Therefore ATO view is that deemed concessional contributions
comprise taxable component of a members interest.
– This means all reserve distributions form taxable component of
accumulation members unless a Court determines otherwise
2011 SMSF National Conference
How are reserves treated for super benefit purposes?
 Pensioners
 ATO confirmed allocations of reserves to pensioners will be
comprised of the same proportions as the components of the
pension when the pension commenced (NTLG Super
Technical Sub-group Meeting of September 2009)
2011 SMSF National Conference
So what is a reserve?
 Seems no-one is entirely sure but crucial definition
 No definition in SIS Act, ITAA or ITAR despite references
 SIS Regulations definition meaningless
 APRA and ASIC
 Acknowledge no definition
 APRA – “reserves in superannuation funds can be regarded as
monies which form part of the net assets of a fund and which have
been set aside for a clearly stated purpose” (Draft Prudential Practice
Guide - SPG 235 – Use of Reserves in Superannuation Funds)
2011 SMSF National Conference
So what is a reserve?
 APRA excludes ‘suspense accounts’ used to record contributions,
provisions for administration expenses, tax, management or service
provider fees
 APRA view nonsensical – if contributions ‘suspense account’ is not a
reserve why does it need to be exempted from the rules relating to
distributions from reserves in ITAR?
 APRA & ASIC distinguish between a reserve and a provision. Reserves are
amounts for contingencies, provisions are for specific obligations from past
events i.e. tax expense
 ATO
 SCR 1999/1 – Commissioner deems any “unallocated amounts” as
reserves being the excess of the net market value of assets over
members accounts
2011 SMSF National Conference
So what is a reserve?
 Much broader than APRA and ASIC
 Divided unallocated surplus amounts into three general
reserves:
o Investment Reserve
o Contribution Reserve
o Miscellaneous Reserve
 Need clear legislative/regulator guidance on what a
reserve is
2011 SMSF National Conference
What is the maximum amount allowed in reserves?
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SIS legislation – no maximum stipulated
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APRA and ASIC – any excess over amount required for purpose of
reserve should be allocated to members
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Competing obligations – requirement to distribute excess reserves v. best
interest of members not to incur excess contributions tax
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Need regulatory guidance
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ATO indicate 15% maximum for investment fluctuation reserve in SCR
1999/1
2011 SMSF National Conference
What reserving strategies are available to SMSFs?
• Contributions Reserve
 Used to hold contributions until allocated to member’s
account
 Must allocate to member within 28 days after month when
contribution received (SIS Regulation 7.08(2))
 Strategy available because of defect in ITAA 97
 S 292-90 of ITAA 97 – non concessional conts = conts made for
a person not included in income of fund PLUS any amount
allocated in accordance with regulations
 This includes amounts distributed from a contributions reserve
2011 SMSF National Conference
Contributions Reserve Cont’d
 Technically counted as non-concessional cont twice:
 Once when contributed to fund; and
 Secondly when allocated from contributions reserve
 ATO have agreed to count only once when distribution made
from the Contributions Reserve if done within SIS Reg timeframe
(ignores 1 month timeframe in s 1017E of Corps Act)
 Means contributions can be made on 1 June of financial year but
not counted for cap until following financial year when allocated
by 28 July
2011 SMSF National Conference
Contributions Reserve Cont’d
 Case Study - Useful for in specie contributions

property
B+H
Super Fund
1.
Bill & Hillary contribute commercial property to their SMSF on 15 June 2011
($1.3 Million M.V.)
2.
2010/11 - Non-concessional caps - $300k counted ($150k each);
- Concessional caps - $100k (50k each)
3.
Remaining portion held in contributions reserve and allocated to member
accounts on 15 July 2011
4.
2011/12 - Non-concessional cap – 900k ($450k each) (bring forward rule)
2011 SMSF National Conference
Contributions Reserve Cont’d
 Case Study - Useful for managing cap overflows
 George’s employer contributes his super under a salary
sacrifice arrangement each year up to the conc. cap
 Agreed with employer that this will be done on 28 September,
28 December, 28 March and 28 June
 At the end of 2010/11, it is realised that George’s employer
paid the June 2010 contribution late in July 2010
 The contributions received by the fund in 2010/11 for George
are therefore $6,250 more than the 25k cap
2011 SMSF National Conference
Contributions Reserve Cont’d
 Utilising the contributions reserve the trustee of Georges SMSF
retains the June 2011 contribution in a contributions reserve and
allocates it to George’s account in July 2011
 This prevents George from breaching the concessional
contributions cap for 2010/11 because the excess is allocated to
2011/12 year
 Faster and easier than getting Commissioner discretion
2011 SMSF National Conference
Self Insurance Reserves
 Used to fund salary continuance, death and TPD benefits
 SMSF essentially self insures members – pay proceeds to member
if event occurs
 Actuary should determine level of reserves required to fund claims
(annual review)
 Is reserve subject to 5% rule? No exception so technically, it
appears so (March 2010 NTLG Super meeting) – watch this space
2011 SMSF National Conference
Self Insurance Reserves Cont’d
 Why self insure?
 Some members can’t be insured externally or terms of insurance too
restrictive
 Fund can claim a tax deduction for either
1. insurance premiums reasonably expected to otherwise pay (actuarial
opinion required); or
2. Amount of benefits paid where event occurs x members future service
days (eg to age 65)/total service period (once chosen this option applies
to all future years)
 Death and TPD insurance not deductible outside of super
2011 SMSF National Conference
Anti-detriment Reserves
 Used to pay out “anti-detriment” benefit
 These are an additional payment made by fund on top of death
benefit to compensate for contributions tax paid by deceased
 Benefit is a lump sum reflecting extra amount that would have
been paid had contributions tax not been payable
 Fund effectively refunded benefit paid due to tax saved from tax
deduction
 Payment must be made first to get deduction so creates cashflow issue and therefore need reserve in an SMSF
2011 SMSF National Conference
Anti-detriment Reserves Cont’d
 Caution needed - September 2009 & March 2010 NTLG Super
Technical Sub-group Meeting - ATO confirm anti-detriment
payment will be a concessional contribution if funded from
reserve b/c generally more than 5% of members account
 ATO approach could mean excess contributions tax payable on
distribution at 31.5% (possibly 78% if non-conc. cap exceeded)
 ATO consulting with APRA on the issue
 Possibly use Pension Reserve to avoid b/c not subject to 5% rule or
possibly use “provision” rather than “reserve”?
2011 SMSF National Conference
Investment Fluctuation Reserves
 Used by funds to “smooth” investment returns on a year-to-year
basis
 Example
 Investment objective = earnings of CPI + 2% pa
 To meet objective trustee retains 2% in IFR in years when fund earns
CPI + 4%
 Extra 2% distributed to accounts from IFR in years when only CPI
earned by fund
 Superannuation Contributions Ruling SCR 1999/1 – should be
limited to 15% of fund
2011 SMSF National Conference
Investment Fluctuation Reserves Cont’d
 In distributing need to have regard to equity between
members i.e. exited members may be paid further
amount if reserve wound-up to compensate for time in
fund
 Should be careful if distribute 5% or more
2011 SMSF National Conference
Pension Reserves
 Holds “segregated current pension assets” to support pension
liabilities
 Actuarial certificate required to determine assets required
 Tax exempt (unless non arms-length) and allocations not
concessional contributions if used to pay pension, rollover to
another pension or fund a death benefit (reg 292-25.01(4)(b) of
ITAR)
 Very useful for funds with assets with large uncrystallised CGT
liabilities
2011 SMSF National Conference
Pension Reserves Cont’d
Case Study – managing CGT liabilities
• John and Janette SMSF - $4 million ($2 million equities,
$2 million commercial property)
• Equities - $1.5 million capital gain, Property – no gain
• John 65 – wants to start an account based pension
• Trustee decides to segregate equities to support
John’s pension – no CGT payable when shares sold
2011 SMSF National Conference
Pension Reserves Cont’d
 ATO indicated that pension accounts may be
“topped up” from distributions from reserves (NTLG
Superannuation Sub-Committee Meeting - Sept 2009)
 Reserve distributions added to pension account are in
same tax free/taxable proportions as pension itself
 Creates planning opportunities
2011 SMSF National Conference
Pension Accounts and Reserves
Case Study – managing tax components
 Brad and his partner Angelina are 55 and have their own SMSF
 Fund = $2.3 million in assets
 Brad’s Account = Tax free - $900,000
Taxable - $100,000
 Ang’s Account = Tax free - $950,000
Taxable - $50,000
 IFR = $300,000
2011 SMSF National Conference
Pension Accounts and Reserves Cont’d
 Both Brad and Ang decide to commence TRIS’s
 After commencing pensions trustee decides to wind-up the 300k
Investment Fluctuation Reserve and distribute it over a 3.5 year
period (to prevent breaching 5% limit)
Result
 Brad - $135,000 is added to his pension account as tax free
component, 15k added as taxable component
 Ang - $142,500 added as tax free component, $7,500 as taxable
component
2011 SMSF National Conference
Pension Accounts and Reserves Cont’d
 If the trustee had decided to wind-up the IFR in the
accumulation phase (or distribute earnings directly)
the whole $300,000 would have been taxable
component (compared to just $22,500 whilst in
pension phase)
 ROT – always better to distribute from reserves when
members in pension phase
2011 SMSF National Conference
Other Reserves
 Expense Reserve – for administration expenses including
accounting and legal fees, investment management fees,
insurance and other expenses
 In-house Assets Reserve – allows trustee to observe total in-house
assets at a glance
 Forfeiture reserve – generally only utilised by SMSFs with defined
benefit pensions such as lifetime pensions where no RCV after
member dies. Capital supporting pension re-allocated within the
fund.
2011 SMSF National Conference
Asset Protection
 Amounts in reserves (apart from a Contributions
Reserve or Pension Reserve) more likely to be
protected from family law claims as such amounts do
not comprise a member’s superannuation “interest”
for family law purposes
 Investment fluctuation reserve, expense reserve, antidetriment reserve and self-insurance reserve may assist
in this respect
2011 SMSF National Conference
Conclusion
 Reserves may be utilised for:
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Managing excess contributions
Smoothing investment returns
Eliminating potential CGT liabilities
Managing tax components
Insuring members who may not otherwise be insurable
Accessing anti-detriment payments
Asset protection
 Residual issues - What is a reserve? What is a fair and reasonable
distribution? Requirement to distribute surplus reserves v. potential
conc. contributions if 5% or more? 5% rule and certain reserves?
2011 SMSF National Conference