Think the new $3m super cap won’t affect you? Here’s how it could

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Think the new $3m super cap won’t affect you? Here’s how it could

Opinion piece written by Peter Burgess, CEO, SMSF Association

First published in Financial Review on 23 March 2023. Licensed by Copyright Agency. 

Unintended consequences could include insurance payouts, non recourse property loans and even death benefits.

The government’s decision to introduce a $3 million cap on super balances above which earnings will be taxed at a higher rate has certainly got the hares running. At face value, this seems surprising.

After all, this proposal will not be introduced until 2025 (assuming Senate approval), is estimated to affect only 80,000 superannuation balances and will only add a predicted $2 billion annually to the government’s coffers.

But from our perspective, the intensity of the public debate was to be expected. Three factors, in particular, have come to the fore as the industry contemplates what this proposed change will usher in. They are greater complexity, non-indexation of the $3 million cap, and the likelihood the law of unintended consequences will be triggered.

But before dissecting these three factors, we should put on record our support for a “soft cap” that taxes earnings on balances above the threshold at a reduced concessional rate instead of a “hard cap” that forces money out of the system, potentially causing a raft of unnecessary complexities by disrupting investment markets and individual retirement plans.

That said, if the 30-year history of compulsory superannuation highlights one thing, it’s this – continual change makes for complexity. This comes at a high cost – undermining confidence in the system. Every time the system changes, fund members, especially those nearing or in retirement, ponder what the next change will be. Our feedback with this change is that people are feeling increasingly vulnerable, and not just those directly affected.

The system already has contribution caps and caps on the amount that can be transferred to the pension phase, so adding another cap just makes it more complicated. More than that, it’s addressing a genuine problem – excessively large balances – that’s a legacy issue that contribution caps and the transfer balance cap will address over time.

Exponential growth

The decision not to index the $3 million cap is also raising eyebrows. Although the other caps will mitigate against very large balances in the future, for those entering the workforce today it’s estimated about 500,000 super balances will eventually breach the cap – about one-third of these super fund members are now under 30.

So, today’s 80,000 is set to grow exponentially. The reality for today’s 30-year-old is that a $3 million cap will be worth about $1 million when they leave the workforce.

However, the law of unintended consequences is where our gravest concerns lie.

Members with a total super balance exceeding $3 million with a substantial proportion of their SMSF invested in lumpy or illiquid assets are likely to affected most.

Think small business owners and farmers holding real property (at December 31, 2022, commercial property comprised 10.3 per cent of total net SMSF assets of $846.8 billion). They are often asset-rich and cash-flow-poor. As the proposal stands, a tax levied on unrealised gains may find them lacking the cash flow to pay the tax, potentially forcing the sale of assets.

Contrary to recent commentary, it is not against the rules for an SMSF to invest a significant proportion of the fund in a single asset, such as a property. But the trustees must ensure they have properly considered, among other things, the liquidity needs of the fund. Before the announcement of this change, it would not have been reasonable or fair for the trustees to have envisaged the payment of this new tax, which in some years, and for some SMSFs, could be substantial.

The situation could be further complicated for some SMSFs using debt via a limited recourse borrowing arrangement to fund the acquisition. In some instances, the total value of the loan could be included in the member’s total super balance (TSB), pushing them above the $3 million cap.

Even disability insurance benefits and death benefits could be captured. The payment of a disability insurance benefit could be included in a TSB, potentially pushing the member above the limit and liable to tax on the earnings, despite the significant change in circumstances. A similar situation could apply to life insurance proceeds paid on the death of a member.

Of all these unintended consequences, unrealised capital gains heads the list. Aside from the potential to create cash flow issues for the fund, the inclusion of unrealised capital gains in the calculation of earnings could see these gains subject to double taxation – once as part of the annual taxation of earnings on the proportion of the member’s balance that exceeds $3 million and again when the asset is sold.

To avoid this, a system of tax credits would need to be introduced to recognise the tax paid each year on the unrealised gain, and which could then somehow be used to reduce the capital gains tax payable when the asset is sold. This would require detailed records to be maintained each year of the amount of tax attributable to the portion of earnings represented by unrealised capital gains – not an easy task for any super fund.

The government has indicated it is open to discussion on the minutiae of this proposal. At face value, there are no shortage of issues to discuss.