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Pension sharing on divorce

To the vast majority of people, their retirement savings represent a major share of their wealth. If statistics are to be believed, up to 2/3rds of marriages end in divorce. There can be no doubt then that the recent amendments to the Pension Funds Act and the Income Tax Act will have a significant impact on a great many people. These amendments have been made in order to effect a clean break on divorce. Closer scrutiny of these provisions reveals that they hold serious financial implications for both parties.  The division of pension interests in a  settlement agreement should not be entered into without due consideration of the consequences for both parties and pro-forma settlement agreements dealing with the division of  fund benefits should be avoided at all costs.  Both parties will require advice prior to and after their divorce.

The Divorce Act

Section 7(8) of the Divorce Act (70/1979) allows a court granting an order or divorce to award part of a member's interest in a retirement fund to the non-member spouse.  This applies to:

• marriages in community of property
• out of community of property marriages entered into before 1 November 1984, and
• out of community of property marriages subject to the accrual system.

For pension and provident funds, pension interest is defined as "the benefits to which that party as such a member would have been entitled in terms of the rules of the fund if his membership of the fund would have been terminated on the date of divorce on account of his resignation from office."

Here we encounter our first problem….

The problem with preservation funds

On resignation from office a member of a pension or provident preservation fund will not become entitled to any benefit from the preservation fund. This means the member's interest as described above will be nil and no award can be made to the non-member.

Non-member spouses approach preservation funds only to face the disappointment of being told that the order is incorrect and that they will have to enter into costly negotiations with the member spouse in order to acquire some other asset, if any, in lieu of a pension interest.

The Pension Funds Act refers to "the member's benefit or individual reserve". This phrase is also referred to throughout in the Income Tax Act. This simple amendment to the Divorce Act could easily rectify the current situation.

Clean break

From the outset the major complaint with regard to the division of pension fund interests on divorce, under the old dispensation, was that the non-member spouse only became entitled to payment of the benefits from the fund when the benefits accrued to the member.  No growth accrued to the portion set aside for the non-member.  All the while the growth on the non-member's share accrued for the member's benefit.  This meant that the member was incentivised to frustrate the non-member spouse's claim by not exiting the fund.

The changes

The Pension Funds Act and the Income Tax Act have been amended by the Revenue Laws Amendment Act, 35 of 2007, in order to remedy these complaints as well as give effect to the clean break principle.

In summary, all the amendments taken together set out to achieve the following:

• The Divorce Act:  On divorce the court may grant an order as explained earlier.  No changes have been made to the Divorce Act – this means that a non-member will not be entitled to any interest in a preservation fund.

       

• The Pension Funds Act:  Section 37D has been amended with effect from 17 September 2007 to allow a fund to deduct from a member's individual reserve:

• The amount awarded to the non-member spouse, and
• Any employee's tax to be deducted, or withheld on the amount as required by the 4th Schedule

• The Income Tax Act:  Several provisions of the Income Tax Act have been amended to give effect to the above.

       

• The amount to be included in the member's gross income under paragraph (e) of the definition will be the aggregate of the amounts deducted from the member's minimum individual reserve, i.e. the award, plus the attributable tax.

• Paragraph 2 of the 2nd Schedule: The member spouse may recover the tax from the non-member spouse.

Note:The member is not granted any relief as contemplated in paragraph 6 of the 2nd Schedule (R1 800) on the award as would be the case with a normal withdrawal benefit.

• The definition of E in formula B and sub-paragraph (i) (bb)(A) of Paragraph 6 of the 2nd Schedule: It is clear from these provisions that the benefits to which the non-member spouse becomes entitled will be taxed, irrespective of whether the amount is taken in cash or transferred to another fund.  The after tax amount transferred to another fund will be treated as a "disallowed contribution" and, may be used to enhance the tax free benefits received by her from the fund on retirement, death or withdrawal.

How much tax is to be deducted?

In terms of paragraph (e) of gross income, the amount to be included in gross income is the retirement fund lump sum withdrawal benefit, which, for the purpose of this article, is in turn described in the 2nd Schedule as the award to the spouse plus the tax calculated on that amount.

Assume Mr & Mrs Ex's fund value is R1m and is split 50:50.

R500 000 plus tax at 30% plus the tax on the tax.
i.e. R500 000 - (R500 000 )
  1 - .30
= R214 285
Amount to be withdrawn from the fund :  R714 285

The Right of Recovery

It is important to note that the income tax act states that the member may recover the tax from the non-member.  It does not create a right of recovery.  The right to recover the tax must be created in the settlement agreement.

If the agreement is silent, the member will not be able to recover the tax.

Cash or Transfer

The non-member spouse is given the option of taking the benefit in cash, or transferring the benefit to another fund – both amounts being after tax amounts. It appears from the wording in the Pension Funds Act that this is an all or nothing provision. There is no option of taking a part in cash and transferring a part. Where the member elects to recover the tax from the non-member and the non-member has elected to transfer the entire benefit to another retirement fund she will have to pay the member's claim from "other resources", provided that such other resources are available.

If the non-member spouse really wants to keep the award in a fund environment, it would probably be advisable to select the cash option. The member's claim can then be settled, and the balance can be used as a contribution to a retirement annuity fund as a current contribution – with the benefit of an upfront tax deduction.

Conclusion

The amendments are obviously a step in the right direction but as stated earlier, need to be dealt with carefully by both parties to the divorce as well as their advisers.

Parties will have to consider the following:

• Is the fund a preservation fund or not?
• Should a right of recovery be inserted in the settlement agreement or not?
• Should the non-member take her award in cash or transfer?
• If taken in cash, how will it be invested?
• What steps need to be taken in order to supplement the member's retirement funding?