TR2011/D3 considers when a superannuation income stream commences and when it ceases. According to the draft, a superannuation income stream ceases when there is no longer a member who is entitled to be paid a superannuation income stream benefit from the fund. Where the fund's affairs have been set up correctly and the deceased has a surviving spouse or a minor child under age 18, they could receive a reversionary pension without tax penalty. However what will happen where there is no surviving spouse and the deceased’s children are aged over 18?

The draft ruling states that a pension will cease as soon as the member in receipt of the pension dies, unless a dependent beneficiary of the deceased is automatically entitled under the superannuation fund's deed, or the rules of the pension to receive a pension on the death of the member. As adult children are not considered financial dependants under the tax law, they are ineligible to receive a reversionary pension and must be paid a lump sum.

If the fund is then placed in a position where it has to sell assets in order to pay a lump sum, capital gains tax may be payable on any asset sales at that time. Consider the following example:

David and Sue are the only members and trustees of their SMSF. David is currently in receipt of an account-based pension, and Sue’s benefits are being used to pay her a transition to retirement income stream. The SMSF assets are fully utilised to pay the pensions. As the fund is 100% in pension mode, all income (including capital gains) generated by the SMSF is fully tax exempt.

There is no provision in the governing rules of the SMSF that David’s pension continue to be paid to Sue upon his death. That is, the pension is not auto-reversionary.

On 1 September 2011 David dies. The governing rules of the SMSF allow the trustee to resolve to pay David’s death benefits to Sue as a pension. Due to her grief, it is not until a year later (1 September 2012) that Sue takes advice and arranges for a valid trustee resolution to pay David’s death benefits to herself.

Under the draft ruling, the SMSF must pay tax on income (including capital gains) that relates to Sue's benefits derived between September 2011 and September 2012.

If however Sue had been ‘automatically entitled’ to David’s pension (ie, David’s pension had been auto-reversionary), the SMSF would have retained the tax exemption for the entire time. This also would overcome the need upon David’s death to make new documentation evidencing, for example, a new pension to Sue.

One particularly worrying issue is that the ATO is seeking to have this ruling applied retrospectively from 1 July 2007. Imagine the trauma for those who have lost loved ones in the past 4 years, and now have to revisit financial affairs that have been finalised and potentially have to pay a significant tax bill to the ATO.