Taxation of Income of Superannuation Funds
21.37. There are a number of provisions in the Act governing the total or partial exemption from tax of the income of superannuation funds.
21.38. Section 23 (jaa) exempts from tax the income of a superannuation fund established by:
‘(i) an Act, a State Act or an Ordinance of a Territory of the Commonwealth; or
(ii) a municipal corporation, other local governing body or public authority constituted by or under an Act, a State Act, or an Ordinance of a Territory of the Commonwealth’.
No conditions are prescribed for the exemption of the income of such a fund.
21.39. Section 23 (ja), which was inserted in the Act in 1952, exempts from tax the income of a superannuation fund established for the benefit of self-employed persons where:
- (a) the number of members of the fund is not less than twenty; and
-
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(b) ‘the terms and conditions applicable to the fund … have been approved by the Commissioner, having regard to the classes of persons who are eligible for membership, the reasonableness of the benefits provided for, the amount of the fund in relation to those benefits and such other matters as the Commissioner thinks fit’.
The Commissioner has set out guidelines for the approval of funds under section 23 (ja) and these include a restriction on the maximum permissible benefit to $100,000 and a limitation on the maximum contribution which a member may make in any one year, ranging from $1,200 where the member is under forty years of age up to $2,800 where the member is over fifty-five. In addition, such a fund must comply with the provisions of section 121C in regard to the maintenance of a minimum proportion of its assets in public sector securities in order to qualify for exemption. At least 30 per cent of the increase in the assets of the fund since 1 March 1961 (at cost price) must be invested in public sector securities, with at least 20 per cent being invested in Australian Government securities—the so-called ‘30/20 ratio’.
21.40. Section 23 (jb) exempts the interest and dividend income derived in Australia by a foreign superannuation fund. No conditions are prescribed for this exemption.
21.41. Section 23F governs the exemption of the income of ‘conventional’ private sector superannuation funds set up by employers for the benefit of their employees. This section was inserted in the Act in 1964 and amended in 1965 and was largely the result of recommendations contained in the Report of the Ligertwood Committee. That Committee had found that the earlier provision—section 23 (j) (the predecessor of which dates back to 1915)—which simply exempted the income of such funds, was being seriously abused. In particular such funds were being used as recipients for private company dividends that would otherwise have borne tax in the hands of shareholders (who were of course members of the superannuation fund as well). The present section 23F closely parallels sections 82AAA-82AAR in many respects, including the complexity of its provisions.
21.42. The main requirements for approval of a superannuation fund under section 23F and the exemption from tax of its income under section 121C are:
- (a) The fund must be established and maintained solely for the provision of superannuation benefits for employees in the event of their retirement or in other circumstances of a kind approved by the Commissioner, or the provision of benefits for the dependants of employees in the event of death.
- (b) The employer(s) must contribute to the fund and, broadly speaking, only employees and employers may contribute.
- (c) Benefits forgone by an employee who leaves the service of the employer before retirement must be either applied towards providing benefits for the members (or their dependants) or dealt with in some other manner approved by the Commissioner.
- (d) The benefits to be provided by the fund for an employee or his dependants must not be excessive
having regard to his remuneration and length of service, to benefits which he or his dependants have
received or may receive from another fund to which section 23F applies, and to such other matters as the
Commissioner considers relevant. This is commonly referred to as the
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‘reasonable benefits’ test. The criteria that have been adopted for determining reasonable benefits are discussed below. - (e) The amount of the fund must not be substantially in excess of the amount required to provide the benefits, having regard to the future contributions that will be made to the fund and its earning rate.
- (f) Rights of members to benefits must be fully secured and members must be notified of the existence of a right to receive benefits.
- (g) That part of the income of the fund comprising private company dividends will not be exempt, and will be currently liable to tax at a rate of 50 per cent, unless the Commissioner is satisfied that it would be reasonable to exempt such dividend. Broadly speaking, the dividend must have the character of an arm's length transaction to qualify for exemption.
- (h) The fund must also satisfy the 30/20 ratio, outlined in paragraph 21.39, in relation to its investments.
21.43. The concept of ‘reasonable benefits’ is quite central to the operation of section 23F and, as pointed out in paragraph 21.35, the Commissioner now, as a matter of practice, applies the standards of reasonableness determined for the purposes of section 23F in stipulating the maximum deduction allowed for contributions to a fund by an employer under section 82AAE, and also, where this is possible, to retiring allowances paid by an employer and claimed as a deduction under section 78 (1) (c). The standards of reasonableness have been increased at various times since they were first introduced in 1965 and the present position, in very general terms, is that a benefit will be considered ‘reasonable’ in the following circumstances:
- (a) In the case of a lump sum, if it does not exceed the lesser of $100,000 or seven times the average annual remuneration of the employee in the three years preceding retirement. In cases where seven times the average annual remuneration at retirement exceeds $100,000, the Commissioner is normally prepared to approve a higher figure—up to approximately $300,000 in the case of very highly-paid executives—but the multiple of average annual remuneration that will be approved will decline progressively from seven as the amount increases. Thus a benefit of $250,000 may be approved in a particular case but this may represent only three or four times the average annual remuneration of the executive over the three years preceding his retirement.
- (b) In the case of a fund providing pension benefits on retirement, the pension must not exceed 70 per cent of the employee's average remuneration over the three years preceding his retirement. No dollar limit is set on the pension, providing the same method of calculating pension entitlement is applicable to substantially all the members of the fund.
- (c) In the case of a fund providing benefits in part pension, part lump-sum form, a combination of methods (a) and (b) is used.
The above criteria apply, without any further limitations, to employees of private companies. In the case of non-arm's length employees of private companies (directors, shareholders and their relatives), the same tests apply with the two following exceptions:
- (a) Where section 109 of the Act has been applied to reduce the amount of the employee's remuneration
which may be claimed as a deduction, the
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remuneration so reduced will be used as the basis for calculating the maximum benefit permitted. - (b) Where the employee concerned will have had less than twenty years’ service with the company at retirement, the maximum benefit permitted will be the benefit calculated as above but reduced by the ratio that the service which will be completed at retirement bears to twenty years.
21.44. If a superannuation fund fails to qualify for exemption from tax under any of the foregoing provisions, it may nonetheless qualify for approval under section 79 which was inserted in the Act in 1965. Funds to which section 79 applies do not receive exemption from tax but instead are granted a deduction from assessable income of an amount equal to 5 per cent of the cost price of the assets of the fund. The balance of the income of the fund is liable to tax at a rate currently fixed at 50 per cent. However, by investing in assets such as shares that have a dividend yield of 5 per cent or less but high capital growth prospects, it is possible to avoid tax altogether and indeed this is the policy followed by most funds approved under this section. The main tests a fund must satisfy for approval under section 79 are:
- (a) its membership must be restricted to persons following a gainful occupation either as employees or self-employed persons;
- (b) it must impose restrictions on benefits and contributions which are broadly similar to those applicable to a fund approved under section 23 (ja); and
- (c) no benefits may be paid out of the fund prior to a member's sixtieth birthday or his prior death or disablement.
It is to be noted that funds of this type do not have to comply with the 30/20 ratio nor must they have a minimum number of members, as is the case with a fund approved under section 23 (ja). Several large funds approved under section 79 have been set up by banks and similar institutions to cater for self-employed people or employees whose employers may not have a staff superannuation fund of their own.
21.45. A superannuation fund that fails to qualify for concessional treatment under any of the foregoing provisions will be taxed on its income under section 121DA. The rate of tax currently applicable in such cases is a flat 50 per cent.
21.46. Many superannuation funds are managed by life insurance companies and the assets of the funds comprise life policies of one type or another. Changes to the Act made in 1961 have the effect of exempting life insurance companies from tax on that part of their investment income attributable to policies issued for the purposes of tax-exempt superannuation funds. This exemption is subject to certain conditions, including compliance by the life insurance company with the 30/20 ratio in respect of all its assets. The exemption from tax on superannuation policies results in the life insurance company being able to issue these policies on more favourable terms than non-superannuation policies. One minor anomaly of these provisions is that where a policy is issued in respect of a fund approved under section 79 of the Act, the whole of the investment income attributable to that policy is exempt rather than simply the first 5 per cent of the cost price of the assets concerned. On the other hand, as the life insurance company has to comply with the 30/20 ratio in respect of such a policy, the two aspects probably balance out fairly evenly.