Can we simply pass on the insurance proceeds to the member? Surely the insurer has done a thorough check? An insurer’s decision to pay a claim is an assessment against the terms of its policy — not a determination that the superannuation law has been satisfied. When a payment is made from an SMSF, the trustee must still independently confirm that a condition of release and its cashing restriction are met.
What is temporary incapacity?
Under regulation 6.01(2) of the Superannuation Industry (Supervision) Regulations 1994 (SISR), temporary incapacity applies where ill-health, whether physical or mental, causes a member to cease being gainfully employed, but the circumstances do not amount to permanent incapacity.
The member does not need to terminate their employment.
A member who has stopped attending work but continues to receive paid sick leave, annual leave or other paid leave is still receiving gain or reward from the employment arrangement. In that situation, the temporary incapacity condition will generally not be satisfied until those payments cease.
How can the SMSF pay the benefit?
Temporary incapacity is a condition of release, but it does not provide unrestricted access to the member’s superannuation.
Schedule 1 item 109 of the SISR requires the benefit to be paid as a non-commutable income stream for:
- the purpose of continuing, wholly or partly, the gain or reward the member was receiving before the temporary incapacity; and
- no longer than the period of incapacity from the employment undertaken immediately before the incapacity.
A non-commutable income stream must be paid at least monthly, cannot be converted into a lump sum and does not have a residual capital value.
The amount paid each month must generally remain the same. It can only change where required to comply with the superannuation law or, over a 12-month period, by an annual rate not exceeding 5% or the applicable increase in the Consumer Price Index (All Capital Cities). In other words, the trustee cannot vary the payment amount from month to month at its discretion.
Despite the terminology, this does not mean that the SMSF has to establish an ordinary account-based pension with a commencement balance.
In practice, a temporary incapacity income stream can be processed from the member’s accumulation account. It is not an account-based pension or a transition-to-retirement income stream and does not receive retirement-phase pension treatment.
How much can the SMSF pay?
The SMSF is not required to pay the full amount of the insurance proceeds to the member. Temporary incapacity is a voluntary condition of release, so the trustee may pay all or part of the amount available, subject to the fund’s governing rules. Any insurance proceeds retained in the SMSF remain within the superannuation system and continue to be subject to the preservation rules.
The purpose of the temporary incapacity benefit is to replace, wholly or partly, the member’s pre-incapacity gain or reward.
Accordingly, the payment should not exceed the level of income it is intended to replace.
Where the SMSF owns an income protection policy, the insurer will generally already have established the member’s insured income and calculated the benefit payable under the policy. Income protection insurance commonly replaces only a percentage of the member’s previous earnings.
For example, if:
- the member earned $10,000 per month before becoming incapacitated;
- the insurer approves an income protection benefit of $7,500 per month;
- the SMSF receives $7,500 per month; and
- the SMSF pays $7,500 per month to the member,
there may be relatively little additional calculation required by the trustee.
The insurer’s claim documentation has already done much of the work.
If the insurer’s documentation does not identify the member’s pre-incapacity income, however, supporting evidence of that income should be retained.
The member should also disclose any income protection insurance held outside superannuation.
These amounts may affect the temporary incapacity benefit in two ways. First, an external income protection policy may contain an offset provision that reduces the insurance benefit where the member receives income-replacement payments from another source, including the SMSF.
Even where there is no offset provision, other income-replacement payments should still be considered when determining the amount paid from the SMSF. The purpose of the temporary incapacity benefit is to replace, wholly or partly, the member’s pre-incapacity income. Accordingly, an additional payment from the SMSF may need to be limited where the member is already receiving income-replacement benefits from another source, so that the overall arrangement does not result in the temporary incapacity benefit exceeding the income it is intended to replace.
What can fund the temporary incapacity benefit?
Regulation 5.08(3) provides that an accumulation fund may pay a temporary incapacity benefit only where the amount is not attributable to:
- the member’s member-financed benefits; or
- the member’s mandated employer-financed benefits.
Member-financed benefits include member contributions and earnings attributable to those amounts, while mandated employer-financed benefits include compulsory employer contributions and the earnings attributable to them.
Consequently, a member cannot simply draw on their ordinary accumulated super balance because they are temporarily unable to work.
In most SMSFs, the obvious source of a temporary incapacity benefit will therefore be income protection insurance proceeds received by the fund.
Other amounts may potentially be available, including eligible non-mandated employer-financed benefits — for example, salary-sacrifice contributions — and certain fund reserves, provided the amounts concerned satisfy the attribution requirements in regulation 5.08.
What documents should be retained?
From an SMSF audit perspective, the documentation does not need to be particularly extensive where there is a straightforward income protection claim.
We would generally expect to see:
1. The insurer’s claim approval and payment documentation, showing the amount and period for which the benefit has been approved.
2. A member application or declaration confirming that:
-
- ill-health caused the member to cease gainful employment or temporarily cease receiving any gain or reward under their continuing employment arrangement;
- the member is not receiving paid sick leave, annual leave or other employment remuneration for the relevant period;
- the circumstances do not constitute permanent incapacity;
- any other income protection or income-replacement arrangements have been disclosed; and
- the member will notify the trustee when they return to gainful employment or otherwise cease satisfying the condition.
3. A trustee minute or resolution acknowledging that the temporary incapacity condition has been satisfied and approving the payments.
4. Evidence of payments made to the member, member’s confirmation of payment received
5. Evidence of pre-incapacity income, where this is not already adequately demonstrated by the insurer’s claim documentation.
Is a medical certificate required?
The temporary incapacity provisions do not prescribe a particular medical certificate or require certification from two medical practitioners.
This differs from some other incapacity-related superannuation and tax provisions.
Are the insurance proceeds taxable to the SMSF?
Where a complying SMSF receives income protection insurance proceeds under a policy it holds for a member, the proceeds are generally not assessable income of the fund.
For a complying superannuation fund, a capital gain or loss arising from an insurance policy against an individual suffering an illness or injury is disregarded under section 118-300 of the Income Tax Assessment Act 1997.
In effect, in a straightforward insured temporary incapacity case, the SMSF acts largely as a conduit: the insurance proceeds are received by the fund without being taxed in the fund and are then paid to the member as taxable income-replacement payments.
Don’t forget PAYG withholding
Although superannuation law requires the payment to take the form of a non-commutable income stream, section 307-10(a) of the Income Tax Assessment Act 1997 specifically provides that an amount payable under an income stream because of a person’s temporary inability to engage in gainful employment is not a superannuation benefit for tax purposes.
Because the payment is not a superannuation benefit, the SMSF must not report it as a superannuation income stream. The fund withholds PAYG from each payment and reports it as an individual non-business payment — the category used for compensation, sickness or accident payments and non-superannuation income streams.