Pre-privatisation, the Scheme didn’t pay tax at all, and the members paid tax on their benefits at a higher rate than most super benefits. Now, the Scheme pays tax on contributions and returns, and the members pay less tax on their benefits.
If benefits were unaffected, the members would get higher net benefits (due to less tax on benefits), but the cost of the Scheme would go up (due to the tax that is now paid by the Scheme). The legislation covering privatisation allowed benefits to be reduced to offset the increased cost of the Scheme. This is the Contribution Tax Offset.
A simple example may make this clearer. Suppose your retirement benefi t is a lump sum of $100 and the benefi t tax is 31% (pre-privatisation) or 16% (post-privatisation).
Before privatisation, you would have received $100 on retirement, and paid $31 in tax, leaving you $69 in your pocket.
Now that the Scheme is taxed, the Scheme will have already paid a total of $15 in tax by the time you retire. If your gross benefit was still $100, your tax would be $16, giving you $84 in your pocket, ie $15 better off and giving the Scheme an extra cost of $15.
So the Scheme deducts a Contribution Tax Offset of $15 from your benefit, leaving you with $69. This pays for the $15 of tax that the Scheme has already paid – and you are no worse off, because your net benefit is unchanged.