Fund withdrawal tax

2004 amendment to the Fund Withdrawal Tax rules and their application to superannuation fund members.

Sections CL 4(2) and CL 8 of the Income Tax Act 1994 and sections CS 1 (2),(3),(4) and (4B) and CS 7(2),(3) and (4B) of the Income Tax Act 2004

Introduction

The Fund Withdrawal Tax (FWT) rules have been amended to clarify that they do not apply to those superannuation fund members who have elected that a higher rate (39%) of specified superannuation contribution withholding tax apply, or that the specified superannuation contribution made by their employer be treated as salary or wages.

Amendments also clarify the cessation of employment exemption, which is an exemption for withdrawals made on or after, or shortly before, cessation of employment. They introduce an exclusion from the tax in some situations where specified superannuation contributions have not been made throughout the last two complete income years and during any period subsequent to the last complete income year, "the minimum employment period".

A new annual de minimis of $5,000 applies to withdrawals made upon cessation of employment when the member has completed a minimum employment period.

Background

The rate of specified superannuation contribution withholding tax is generally a flat rate of 33%. When the top personal tax rate was increased to 39% an avoidance opportunity was created.

The FWT rules were introduced to counter this avoidance opportunity. The FWT rules aim to minimise the tax benefit for those earning over $60,000 a year from substituting employer contributions to a superannuation fund for salary and wages and subsequently withdrawing the increased contribution and thus avoiding the 39% rate. The FWT rules provide that, in certain circumstances, withdrawals are subject to tax.

At the recommendation of the select committee considering the bill an annual de minimis of $5,000 was added in relation to withdrawals made on cessation of employment in situations where the member has completed the minimum employment period. The de minimis relates to the amount of the employer contribution to superannuation savings withdrawn and removes the need to assess the consistency in size and frequency of the employer contributions over the minimum employment period.

Key features

The amendments aim to clarify the legislation so that the original policy intent of the legislation is achieved.

The first amendment relates to employees who have elected to have all or part of their employer specified superannuation contribution taxed at either a higher rate of 39% (section NE2AA (1) of the Income Tax Act 1994 and the Income Tax 2004) or treated as salary or wages (section NE 2A(1)). It is not the policy intent that the rules apply to the withdrawal of these amounts from superannuation funds.

FWT is intended to deal with an avoidance concern that is not present when such an election is made. This exclusion was not made clear in the previous rules, and the amendment ensures that employer contributions that are subject to the 39% rate or treated as salary or wages are not subject to FWT.

The remaining amendments concern the exception for withdrawal when a member ceases employment, contained in section CL 8 of the 1994 Act and section CS 7 of the 2004 Act. The FWT does not apply to contributions that are withdrawn on or after, or shortly before, an employee ceases employment, except in limited circumstances. In some circumstances, a literal interpretation of these sections conflicts with its intended application. The practical application is that FWT has applied when it is the policy intent that it should not.

Section CL 8(2) of the 1994 Act and section CS 7(2) and (3) of the 2004 Act have been amended to enable previous employment to be counted for the "two years or more" employment requirement ("minimum employment period") if the employer changes but the member has transferred his or her superannuation entitlement to the new employer's superannuation fund. This scenario may have occurred as part of a business restructuring - for example, a company buy-out where an employee joins the new employer's fund and all of that employee's existing superannuation entitlements are transferred to the new employer's fund.

In some circumstances an employee could meet the "minimum employment period" test but would fail the contribution tests in either of the original sections CL8(2)(b) or CL 8(2)(c) and sections CS 7(3)(b) or CS7 (3)(c) because the employee had been in a scheme for less than three complete years before ceasing employment. New section CL 8(2B) of the 1994 Act and new section CS 7(4B) of the 2004 Act provide the discretion for the Commissioner to relax the contribution tests in circumstances where the employment test is met. In practice, if the amount of the employer's contribution paid on the member's behalf is prescribed by the superannuation fund's documentation and applies generally to members in similar circumstances to the member under consideration, and the reason for joining the fund was not to avoid the top personal tax rate, the withdrawal will not be subject to FWT.

New section CL 8(2)(c)(ii) of the 1994 Act and new section CS 7(2)(d)(iii) of the 2004 Act provide for a de minimis of $5,000 for each income year for withdrawals of contributions if the employer contributions to superannuation savings withdrawn do not exceed $5,000 per year. The de minimis applies if the employee meets the "minimum employment period" and the employer or a previous employer made contributions.

Example

The following example explains how the amendments to section CL 8 of the 1994 Act and section CS 7 of the 2004 Act will apply in practice.

Member A and Member B both joined the superannuation scheme offered by their employer, First Co Limited, on 1 April 2001. In January 2003 First Co Limited was acquired by New Co Limited, and employees of First Co Limited became employees of New Co Limited. As part of the deal, New Co Limited agreed to continue to offer superannuation benefits on the same terms as those offered by the First Co Limited. The members' earnings were not altered by the deal.

Member A chose to transfer his entitlement from the First Co Limited superannuation fund to the New Co Limited superannuation fund. Member B joined the New Co Limited superannuation fund but elected to receive his First Co superannuation fund benefit.

Member A and Member B both resign from the employment of New Co Limited in December 2004.

Member A satisfies the "minimum employment period" specified in amended sections CL 8(2)(a) of the 1994 Act and CS 7(2)(a) and CS 7(3)(a) of the 2004 Act and the requirements of CL 8(2)(b) and CS 7(2)(b) and (c) as the member has been employed by either First Co Limited or New Co Limited for all of the period from 1 April 2002 to December 2004.

Whether or not Member A's benefit is subject to FWT will depend on which (if any) of the conditions set out in amended sections CL 8(2)(c) and CS 7(2)(d) apply.

Sections CL 8(2)(c) and CS 7(2)(d) provide an FWT exemption if the specified employer contributions that are part of the withdrawal do not exceed $5,000 for each income year for which contributions have been made. For Member A this amounts to $18,750 for the three years and nine months during which contributions have been made by either of the two employers.

Assuming that Member A is eligible for 60% of his employer account, employer contributions of $31,250 could have been made over the three-year nine-month period and the benefit would be exempt.

If this exemption does not apply, the conditions of amended sections CL 8(2B) (a) or (b) and CS 7(3) and (4) or (4B) will need to be satisfied. Under sections CL 8(2B)(a) and CS 7(3) and (4) the conditions are specific and provide for an exemption if contributions in each of the income years during the minimum employment period have not increased by 50% or more over the previous complete income year (including the annualised contributions for any period since the last 31 March).

In the case of Member A this will necessitate a comparison of the employer contributions in the income year 1 April 2002 to 31 March 2003 with those in the year 1 April 2001 to 31 March 2002, as well as for the subsequent financial and part financial years. As Member A was a member of First Co Limited's fund for all of the 2002 financial year, and as his superannuation terms and pay conditions were not altered by the sale of First Co Limited to New Co Limited, it is expected that Member A's benefit would be exempt from FWT.

Member B satisfies the conditions of sections CL 8(2)(a) and (b) and CS 7(2)(a) and (3)(a) and (b). However, in relation to section CL 8(2)(c) and section CS 7(3)(c), it is necessary to consider only the period and contributions relating to his membership of the New Co Limited fund. Hence the de minimis threshold is $10,000 for the two years during which specified superannuation contributions have been made by New Co Limited. If the amount withdrawn is $10,000 or less the de minimis will treat the withdrawal as not being subject to FWT.

If the de minimis rule does not apply it is necessary to consider the application of section CL 8(2B) and CS7(3) and (4) or (4B). With only two years of employer contributions, Member B will fail the requirements of sections CL 8(2B)(a) and CS 7(3)(c).

The next step is to consider whether sections CL8(2B)(b) and CS 7(4B) apply, which is at the discretion of the Commissioner of Inland Revenue.

The factors taken into account in applying this discretion are as follows:

  • Consistency of employer contribution: In a situation where employer contributions to superannuation savings on behalf of a member have been maintained at a consistent level (either in absolute dollar terms or as a percentage of earnings) throughout the part of the minimum employment period that the employee was a member (such as is the case for Member B) this factor will be met.
  • Short membership period but minimum of three years' employment: If the employer contributions to superannuation savings made on a member's behalf were made at a rate specified by rules that apply to other employee members of the fund in a comparable position this factor will be met.

Other factors that may be necessary to take into account in determining whether the discretion in sections CL 8(2B) (b) and CS 7(4B) apply:

  • In relation to provisions in defined benefit arrangements, the Commissioner will consider the employer contributions have been set so as to provide benefits that are consistent with value of those defined benefits. If so the factors will be met.
  • In relation to factors in subparagraphs (i) and (ii) of section CL 8 (2B)(b) and CS 7(4B)(b) and (c) the Commissioner will also consider whether the employee member had a controlling interest in the employer over the period of the contributions. If so, the factors may not be met.

Application date

The amendment clarifying that the FWT rules contained in section CL 4 of the Income Tax Act 1994 do not apply to those fund members who have made an election under section NE 2AA(1) or section NE 2A(1) will apply retrospectively from 14 September 2000, when the FWT rules came into effect.

The amendments clarifying the cessation of employment exemption in section CL 8(2) of the 1994 Act and section CS 7(2) and (3) of the 2004 Act will apply from the date of enactment, 21 December 2004. The amendments to the 2004 Act apply from the 2005-06 income year.