Damian Hearn
Technical

Problems with the ‘10% test’ in 2009-10

By Damian Hearn

The start of the 2009-2010 financial year marks the commencement of the new income test definitions for various tax offsets, superannuation concessions and government assistance payments.

In this article we focus on your clients who are both employed and self-employed who will find it harder to pass the ‘10% test’ from 1 July 2009. The inclusion of reportable superannuation contributions within the ‘10% test’ will impact their ability to claim a tax deduction for their personal superannuation contributions.

To recap on the changes to the income test definitions and reportable employer superannuation contributions, please refer to this article in the July edition of @dviser Magazine.

Restructuring investments at retirement remains a viable strategy

With no work test requirement for clients under age 65 to make personal contributions into superannuation, the door remains open for those who are not considered ‘employees’ for superannuation guarantee (SG) purposes to be eligible to claim a tax deduction. This has been a popular strategy for clients who are seeking to reduce their personal income tax due to the sale of investment assets (such as an investment property, shares, managed funds etc).

For more information on this strategy can benefit your client and how the reduction in the contribution caps from 1 July 2009 will impact this strategy, please see this article in the May edition of @dviser Magazine.

Changes from 1 July 2009 will impact the ‘10% test’

On the other hand, if your client is engaged in employment activities (i.e. holding an office or appointment, or engaging in work) which results in them being treated as an employee for SG purposes during the financial year, they must pass the ‘10% test’ to be eligible to claim a deduction for their own personal superannuation contributions.

The basic formula for the ‘10% test’ is based on the employment portion which is ‘attributable to’ those employment activities being less than 10% of the client’s total portion for a financial year. From 1 July 2009, the basic formula for the ‘10% test’ has not changed however reportable employer superannuation contributions will be included within the formula as follows:

  • The employment portion is the total assessable income, reportable employer superannuation contributions (i.e. salary sacrifice contribution) and reportable fringe benefits ‘attributable to’ those employment activities.
  • The client’s total portion which is the total assessable income, reportable employer superannuation contributions and reportable fringe benefits for the financial year.

Importantly, your clients will be unable to use salary sacrifice into super to satisfy the test. Combining this with the reduction in the contribution caps means your client will need to consider whether:

  • the employment activity classifying them as a employee for SG purposes is worthwhile to their overall financial position (taking into consideration the ‘10% test’ and their ability to claim a tax deduction for their personal superannuation contributions);
  • they need to restructure their employment arrangements (and consider whether being an employee through their own company or trust structure is more suitable) whilst taking into consideration the personal services income rules; or
  • to actively plan to satisfy the ‘10% test’ by increasing their assessable income via realising capital gains or private structure distributions (e.g. family trusts).

Working with the ‘10% test’ post 1 July 2009

Prior to 1 July 2009, a client could salary sacrifice all of their employment income (including unexpected bonuses) into super to satisfy the ‘10% test’. In contrast, the ’10% test’ will now (since 1 July 2009) be difficult to plan for and satisfy due to:

  • unexpected employment bonuses in June of the financial year regardless of being salary sacrificed into superannuation.
  • less than expected investment income or capital gains from the sale of investments.
  • the inclusion of any termination and unused leave payments for clients changing employers during a financial year, or being made redundant.
  • unexpected or underestimated reportable fringe benefits for clients who are salary packaging.
  • lower than expected income from their self-employed activity.

To make matters worse, the ‘10% test’ is determined at 30 June of the financial year and clients are unable to retrospectively act to ensure they will satisfy it. You may not be aware that your client has failed to satisfy the test until after the event. This can result in significant negative financial consequences as demonstrated by the following case study of Peter…

Case Study 1: Peter fails the 10% test

Let’s look at the case study of Peter (age 52) who is both employed and self employed. The details of his situation are summarised as follows:

  • His income from his self employed activities is estimated at $90,000p.a. and his employment income is $12,500p.a.
  • Peter has an investment portfolio which is currently valued at $450,000 and has been producing income of $23,223 (including franking credit level of 50%).
  • His tax deductible superannuation contributions have been $10,000p.a.

Peter has been salary sacrificing all of his employment income into super to ensure that he has satisfied the ‘10% test’ (i.e. $0 < 10% of $113,223) for the 2008/2009 financial year (as shown in Table 1). Based on same level of investment income he will satisfy the 10% test (i.e. $12,500 < 10% of $125,723) for the 2009/2010 financial year even though his reportable employer superannuation contribution (i.e. salary sacrifice) of $12,500 is included within the ‘10% test’.

Table 1 – a 10% test comparison for pre and post 1 July 2009

  2008/2009 FY –
Old Rules		 2009/2010 FY  –
New Rules		 2009/2010 FY – new rules with reduced investment income
Assessable income from employment $0 $0 $0
Reportable fringe benefits from employment $0 $0 $0
Reportable superannuation contribution $0 $12,500 $12,500
Employment Portion $0 $12,500 $12,500
       
Total assessable income $113,223 $113,223 $101,612
Total reportable fringe benefits $0 $0 $0
Total reportable employer superannuation contributions  $0 $12,500 $12,500
Total Portion $113,223 $125,723 $114,112
‘10% test’ = employment portion which is ‘attributable to’ those employment activities being less than 10% of the client’s total portion.  Yes - 0.00%
Satisfied		 Yes - 9.94%
Satisfied		 No - 10.95%
Failed

Unbeknown to Peter his investment income will reduce by 50% for the 2009/2010 financial year due to market conditions. Peter will not be aware of this until the June quarter distributions are paid by his managed funds (after 30 June 2010). Peter will fail the ‘10% test’ and this means he will be:

  • unable to claim a $10,000 deduction for his personal super contribution; and
  • liable for additional personal income tax as shown in Table 2.

Table 2 – Tax Calculations (pre and post 1 July 2009 rule changes)

  Pre and Post 1 July 2009 Rules
(2009/2010 FY & 2008/2009 FY)		 Post 1 July 2009 Rules – No deduction for personal contribution
(2009/2010 FY)
Self Employed Income $90,000 $90,000
Employment Income $12,500 $12,500
Investment Income $19,125 $9,563
Imputation Credits $4,098 $2,049
Salary Sacrifice – Super -$12,500 -$12,500
Assessable Income $113,223 $101,612
Deductible Super Contribution -$10,000 $0
Deductible Expenses - Self Employed -$5,450 -$5,450
Taxable Income $97,773 $96,162
Gross Income Tax Payable -$26,070 -$25,434
Imputation Credits $4,098 $2,049
Net Tax Payable -$21,972 -$23,385
Take Home Pay $77,153 $76,178

As demonstrated in the table above, Peter’s personal income tax liability has increased for the 2009/2010 financial year however his take home pay has remained relatively unchanged from the 2008/2009 financial year due to:

  • the reduction his investment income; and
  • no deductible superannuation contribution being made.

If Peter was to maintain the same amount of net superannuation contributions he would need to make a further non-tax deductible personal contribution of $8,500 as shown in Table 3 below. This would reduce his take home pay for the 2009/2010 financial year to $67,678 (i.e. $76,178 - $8,500).

Table 3 – Superannuation contribution position

  Pre and Post 1 July 2009 Rules
(2009/2010 FY & 2008/2009 FY)		 Post 1 July 2009 Rules – No deduction for personal contribution
(2009/2010 FY)
Salary Sacrifice $12,500 $12,500
Employer Contribution $1,125 $1,125
Deductible Super Contribution $10,000 $0
Total Taxable Contributions $23,625 $13,625
Contributions Tax -$3,544 -$2,044
Net Contributions $20,081 $11,581
Non-tax deductible contribution
(i.e. after-tax contribution)		 $0 $8,500
Total $20,081 $20,081

Super tax management strategy: making sense of it post 1 July 2009

As mentioned earlier, clients like Peter can actively plan to satisfy the ‘10% test’ by increasing their assessable income via realising capital gains or private structure distributions (e.g. family trusts). This would be beneficial where your client’s:

  • self employed income has reduced during a financial year;
  • employment income has increased due to an unexpected bonus regardless of being salary sacrificed into super; or
  • investment income has reduced due to unfavourable market conditions.

If we revisit the case study of Peter, he could generate a gross capital gain of $50,000 through the sale of his managed fund investment portfolio in order to satisfy the ‘10% test’ (due to his investment income being reduced by 50% for the 2009/2010 financial year).

Case Study 2: how Peter can pass the 10% test

By generating a discounted capital gain of $25,000 Peter will increase his assessable income for taxation purposes to $126,612 and satisfy the ‘10% test’ (i.e. $12,500 < 10% of $139,112) as shown within Table 4 below.

Table 4 – ‘10% test’ comparison for 2009/2010 financial year

  2009/2010 Financial Year – New Rules with reduced investment income
  No discounted capital gain Discounted capital gain of $25,000
Assessable income from employment $0 $0
Reportable fringe benefits from employment $0 $0
Reportable superannuation contribution $12,500 $12,500
Employment Portion $12,500 $12,500
     
Total assessable income $101,612 $101,612 + $25,000
= $126,612
Total Reportable fringe benefits $0 $0
Total Reportable employer superannuation contributions  $12,500 $12,500
Total Portion $114,112 $139,112
‘10% test’ = employment portion which is ‘attributable to’ those employment activities being less than 10% of the client’s total portion.  No - 10.95%
Failed 		Yes – 8.99%
Passed

In Peter’s case, he will be eligible to claim up to an additional $37,500 as a tax deduction for any personal super contributions prior to 30 June 2010. Even though his taxable income has reduced due to the decline in his investment income, he has the option to restrict the rate of tax on the $25,000 discounted capital gain to 15% by claiming a tax deduction for his personal contribution.

Table 5 – Tax Calculations – satisfying the ‘10% test’ makes a difference

  Pre 1 July 2009 Rules
(2008/2009 FY)		 Post 1 July 2009 Rules – No deduction for personal contribution
(2009/2010 FY)		 Post 1 July 2009 Rules – Deduction for personal contribution
(2009/2010 FY)
Self Employed Income $90,000 $90,000 $90,000
Employment Income $12,500 $12,500 $12,500
Investment Income $19,125 $9,563 $9,563
Imputation Credits $4,098 $2,049 $2,049
Salary Sacrifice - Super -$12,500 -$12,500 -$12,500
Discounted Capital Gain $0 $0 $25,000
Assessable Income $113,223 $101,612 $126,612
Deductible Super Contribution -$10,000 $0 -$10,000
Deductible Super Contribution – Capital Gains Tax $0 $0 -$25,000
Deductible Expenses - Self Employed -$5,450 -$5,450 -$5,450
Taxable Income $97,773 $96,162 $86,162
Gross Income Tax Payable -$26,070 -$25,434 -$21,484
Imputation Credits $4,098 $2,049 $2,049
Net Tax Payable -$21,972 -$23,385 -$19,435
Take Home Pay $77,153 $76,178 $70,128
Non-tax deductible contribution $0 $8,500 $0
Adjusted Take Home Pay $77,153 $67,678 $70,128

Importantly, Peter’s net superannuation contributions for the 2009/2010 financial year will increase to $41,331 whilst the reduction in his take home pay can be attributed to the reduced investment income.

Failing the ‘10% test’ and exceeding the contribution caps

Failing the ‘10% test’ could be costly for Peter if he intended to maximise the non-concessional contribution caps using his share portfolio and available cash held by his wife. The non-concessional contributions being planned by Peter are outlined as follows:

  • $150,000 prior to 30 June 2010; and
  • ‘3 year bring forward’ of $450,000 in July 2010.

Once Peter determines he had failed the ‘10% test’ for the 2009/2010 financial year this could mean the following:

  • his tax deductible personal contribution of $10,000 would be counted against the non-concessional contribution cap; and
  • the ‘3 year bring forward’ would be triggered (i.e. $160,000 > $150,000) within the 2009/2010 financial year instead of July 2010.

The total amount of his personal contributions would exceed the non-concessional contribution cap in the 2010/2011 financial year resulting in an excessive tax liability of $50,400 as calculated in the following table.

Table 6 – Excessive Tax Assessment 2010/2011 financial year

  Financial Year Personal Contribution Made  Amount $
Personal contribution denied as tax deduction 2009/2010 $10,000
Personal contribution 2009/2010 $150,000
Personal contribution 2010/2011 $450,000
Total   $610,000
Contribution Cap   ($450,000)
Excess Contribution   $160,000
Excess Contributions Tax   $50,400

Important: if Peter satisfies the ‘10% test’ for the 2010/2011 he could claim a tax deduction for his personal contribution using the remaining concessional contribution cap. This could reduce the personal contributions counted against the non-concessional contribution cap and the excessive contributions tax.

So what do you now need to consider?

The landscape has changed when recommending clients to use the ‘10% test’ as part of their tax and retirement planning strategy. There are several areas that you should consider and factor into this strategy as follows:

  • As a rule of thumb, your client’s employment income (i.e. total employment portion of the ‘10% test’) must be close to 10% of their total portion before starting the strategy.
  • Generating a capital gain from the sale of an investment to satisfy the ‘10% test’ will not be worthwhile unless your client can claim a tax deduction for their personal contributions to restrict the rate of tax capital gain to 15%. Otherwise, your client will be paying marginal rates of tax on the capital gain which could be deferred until eventual retirement when their income is substantially less (i.e. no employment income and tax-free pension over age 60).
  • Collaborating with the client’s accountant will be important to ensure the clients taxation position can be estimated in June of a financial year before increasing their assessable income (i.e. triggering a capital gain).
  • Access to accurate unrealised capital gains tax reporting for managed fund investments will be essential to ensure required capital gain will be generated prior to the event
  • The opportunity exists to use the ‘10% test’ for clients over age 50 before the transitional concessional contribution cap reduces to $25,000 p.a. by 30 June 2012.
  • Consider other alternative tax management and wealth accumulation strategies such as gearing.

Summary

Planning with clients who use the ‘10% test’ from 1 July 2009 will become more problematic. Advisers should review clients who are using this strategy and proactively plan to satisfy the test for the current financial year should the need arise.

In the next edition of @dviser Magazine we will focus on another case study showing how the change in the Income Test Definitions will impact the popular strategy of salary packaging.