Thankfully, after extensive consultation, the ATO has now confirmed it will not allocate compliance resources to review whether SMSF pensions that ceased due to an underpayment before 30 June 2024 were properly commuted in accordance with the ATO’s view in TR 2013/5, before a new pension was commenced.

This removes the risk that trustees could face retrospective compliance action, including being required to amend prior year tax returns to reverse exempt current pension income (ECPI) claims for pensions that the industry reasonably believed had been reinstated.

However, from 1 July 2024, the ATO’s position is clear: if a pension fails due to an underpayment, the pension will only stop for income tax purposes.

This means that the trustee must be able to evidence that the member has exchanged their rights in relation to the failed pension for income stream benefits from a new pension. Without this additional step, the ATO’s view is that the new income stream will not be entitled to ECPI.

While this outcome is a step in the right direction, significant issues remain, particularly when dealing with death benefit income streams and the unnecessary complexity created by the proportioning rules when there is a pension underpayment.

ATO Compliance Approach: Limited Relief for Account-Based Pensions

The ATO’s compliance approach does not erase the consequences of a failed account-based pension. That is, the loss of ECPI remains and if a pension ceases due to an underpayment, all subsequent withdrawals must be treated as lump sums.

For most retirees over 60, the treatment of withdrawals as lump sums has no tax impact. However, for those receiving a Transition to Retirement Income Stream (TRIS) not in the retirement phase, the consequences can be severe. Although these pensions do not entitle the fund to claim ECPI, such a pension failure will result in a breach of the preservation rules.

Withdrawals originally intended as pension payments are instead treated as lump sums, and if the member has not met a full condition of release, this amounts to early access. These payments are then taxed at marginal rates, and the member cannot return the funds to super without impacting contribution caps.

For TRIS recipients, an inadvertent underpayment can trigger major tax and compliance consequences

Where to Next? Pushing for a Safe Harbour

When an account-based pension fails to pay the minimum pension, the income stream is taken to have ceased from the start of the financial year in which there was an underpayment. This means that the member’s superannuation interest that supported the income stream will merge with any accumulation interest the member had on 1 July of the relevant year. This will impact a member’s tax-free and taxable components when next applying the proportioning rule.

It also means that withdrawals originally intended as pension payments will instead be treated as lump sums from 1 July. Every withdrawal made after the pension ceases will require a new calculation of tax-free and taxable components, based on the newly merged accumulation interest, at the time each lump sum was paid.

This outcome is not aligned with practical fund administration. For instance, to perform this calculation, trustees would be required to calculate fresh earnings allocations, valuations, and financial adjustments before every lump sum payment.

This typically forces trustees to have interim financial statements prepared.
The SMSF industry needs a pragmatic approach to reduce this administrative burden.

We intend to focus our efforts on working with the ATO to find an administrative solution, within the Commissioner’s powers, that maintains the integrity of the proportioning rules and does not materially impact tax outcomes.

For example, assume a member had a $1 million pension with a 30% tax-free and 70% taxable split and an accumulation balance of $500,000 that was fully taxable. Due to a pension underpayment, the member’s interests merge from 1 July in the year of the underpayment.

Instead of forcing trustees to recalculate the tax-free and taxable proportions for every withdrawal from the failed pension, consider a safe harbour that allows the trustee to apply the proportioning rule, as determined on 1 July, for the entire year.

In this scenario, the member’s combined interest would have a new 20% tax-free and 80% taxable split and such a safe harbour would allow the trustee to apply this split to all lump sum withdrawals related to the failed pension, in that financial year. This would not only simplify each calculation, but it would also allow trustees to use existing financials.

Death Benefit Income Streams: A Compliance Nightmare That Must Be Fixed

If the treatment of pension underpayments is problematic, the consequences are much worse when the underpayment relates to a death benefit pension. The rules in this area are outdated, rigid, and impractical, creating unnecessary complexity and additional compliance risks.

As we previously stated, TR 2013/5 confirms that where there is an underpayment the pension is deemed to have ceased at the start of the financial year, meaning all payments made during the year are treated as superannuation lump sums instead of pension payments.

This triggers an unavoidable breach of the compulsory cashing rules under the SIS regulations which limits death benefit lump sum withdrawals to a maximum of two payments, per beneficiary. This is not a breach that can be rectified.
Historically, the ATO has provided informal administrative relief, allowing trustees to treat the benefit as being cashed “as soon as practicable” if they acted swiftly after identifying an underpayment. This has given funds the ability to reset compliance by either commencing a new death benefit pension, cashing out within the two-payment limit, or rolling over to another complying fund.

Given the significant compliance risks for SMSFs, we are pushing for ATO confirmation that this remains their position and calling for clear guidance that provides certainty to the industry.

This is why the development of ATO advice and guidance must be a priority – to provide the SMSF industry with clear, workable solutions. While we accept that some things may need a law change, without a definitive ATO view, we cannot effectively engage with government – leaving the industry stuck without a path forward.

Stay tuned—there’s certainly more to come.