One of the benefits of holding investments through a complying superannuation fund is the concessional tax rates of 15% on income and 10% for capital gains (where the asset is held for longer than 12 months) or 0% after the retirement phase pension commences.
However these concessional tax rates are not available where income is deemed to be non-arm’s length income (NALI), such income is taxed at 45%. Specifically, when:
While these measures address the derivation of NALI, they do little to penalise situations where a fund derives a benefit because of reduced or non-charging of expenses.
However, the scope of NALI was broadened on 1 July 2018 with legislation that introduced the concept of non-arm’s length expenditure (NALE), which requires a fund to ensure that not only is all income derived on a commercial basis, but that all expenses associated with fund income are commercial.
The ATO have indicated in Practical Compliance Guideline PCG 2020/5, that they will not allocate compliance resources in relation to general expenses, for the period 1 July 2018 up to 30 June 2021. This is to allow the ATO sufficient time to consider industry submissions before issuing a final ruling and for trustees to make changes where required.
Essentially, when expenditure is less than what would be expected in an arm’s length dealing, NALI can arise. This can have significant tax consequences for a fund, so it’s important to understand what arm’s length means, what NALI and NALE are and examples of expenses that are considered non-arm’s length.
The ATO’s view is, arm’s length is where “a prudent person, acting with due regard to his or her own commercial interests, would have agreed to the terms”. This means investments must be made and dealt with by an SMSF on a commercial basis in all circumstances and when dealing with all parties, related or otherwise.
Under the Income Tax Assessment Act 1997, section 295.550(1), an amount of ordinary or statutory income is NALI if the parties to a scheme are not dealing with each other at arm’s length in relation to the scheme. This can be the case if the amount of income received is more than what would have been received if dealing at arm’s length or it can relate to the expenditure involved, which is what we will focus on here. Where the loss, outgoing or expenditure is less than what would have been incurred OR there was no loss, outgoing or expenditure incurred compared to what you would expect when the parties were dealing at arm’s length, NALI arises.
In summary: Income is more than would be expected on arm's length dealing OR Expenditure is less than (or nil) of what would be expected on arm's length dealing.
To identify NALE we need to identify if there is a scheme. The ATO have provided guidance in LCR 2019/D3, which states, “A scheme is defined as any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise”. There must also be a connection (nexus) between the expenditure and the ordinary or statutory income a fund receives.
The expenditure must have been incurred in gaining or producing the relevant income (or acquiring an entitlement to the income of a trust). The expenditure can be of a revenue or capital nature. Expenditure linked to specific income is more easily identified, such as rental property expense and rental income. Where NALE arises on expenditure to acquire an asset, there is a sufficient nexus to all ordinary and statutory income of that particular asset (while ever it is held by the fund) including any capital gain on disposal of the asset.
The following examples from LCR 2019/D3 indicate how NALI would apply to specific and general expenditure.
Example No. 1 Specific expenditure – Nexus to specific income
Armin holds a commercial property and sells it to his SMSF for less than market value. This is a scheme, clearly, capital expenditure is less than arm’s length; and a sufficient nexus exists between the NALE incurred on acquisition of the property and the property income. Therefore rental income derived will be NALI as will any future capital gain.
Example No. 2 General expenditure – Nexus to all fund income
Mikasa engages an accounting firm where she is a partner to provide accounting services for her fund and they do not charge her for the services. There is a scheme in place and the expenditure (nil) is less than would be expected in an arm’s length dealing.
The NALE has sufficient nexus with all of the ordinary and statutory income derived by the fund for the relevant financial year and therefore all income that year will be NALI.
This is problematic where general expenses, such as accounting and audit fees are less than ‘arm’s length’ since the ATO’s current interpretation is that NALE will have a sufficient connection to ALL of the ordinary and statutory income of a fund. The ATO has been requested to provide greater clarity regarding general expenses.
The NALE provisions are not intended to apply where a trustee provides services to their SMSF in their capacity as trustee. This requires an objective consideration of the individual’s circumstances, their business, profession or employment to assess their skills and knowledge to perform an activity.
The LCR lists the following factors that may assist to determine where an individual is performing their activities in their individual capacity (as opposed to their capacity as trustee):
Where a trustee performs services in their capacity as trustee and they do not charge for the service, this will not be a NALE. This is consistent with the provisions under section 17B of the SIS Act, regarding Trustee remuneration; a trustee can be remunerated for services performed if the services are performed other than in capacity as trustee, and they are appropriately qualified and licenced to do so. They must also perform the services in the ordinary course of business and on arm’s length terms.
Example from LCR 2019/D3 – No.6 – General expenditure - Not NALI/NALE
Leonie is a chartered accountant and registered tax agent and employed in an accounting and tax agent business.
As trustee for her SMSF, she prepares the accounts and annual return for her fund. She uses her own equipment and does not charge the SMSF, nor does she lodge the annual return using her tax agent registration. The NALE provisions do not apply as the services are performed in her capacity as trustee and not under an arrangement where the parties are dealing with each other on a non-arm’s length basis.
It’s important to distinguish this example with example 2 as they have very different outcomes.
Example from LCR 2019/D3 – No.7 - Specific expenditure - Duties in an individual capacity – NALE
Sharon is the trustee of her SMSF and also a licensed real estate agent and runs a real estate business, which includes property management services for rental properties. The SMSF holds a residential property that it leases. Sharon provides property management services to the SMSF, utilises the equipment and assets of her business in performing these services and her actions are covered by the insurance policies of the business. She charges the SMSF 50% of the price for her services.
The price Sharon charges is a non-arm's length dealing which resulted in the SMSF incurring expenditure that was less than would otherwise be expected. There is sufficient nexus between the non-arm's length expenditure and the rental income. The rental income will therefore be NALI for each income year the non-arm's length dealing remains in place.
The capacity in which activities are performed is crucial. Where a trustee performs a service in their individual capacity, the NALI provisions will apply when remuneration is paid by the fund on non-arm’s length terms. This is also the case where no remuneration is provided.
While changes to the legislation have been operative since 1 July 2018, the ATO have not released their final ruling. While they have been generous not to allocate compliance resources to date, they are likely to do so after 30 June 2021.
These changes will have a significant impact on trustees where the fund has not been charged an arm’s length fee for services provided or charged a fee at all.
Great care is required to ensure an arm’s length fee is charged for services provided by members or associates of SMSF trustees, where it is possible to do so.
Individuals across various industries and professions (e.g. lawyers, accountants, brokers, agents, builders, tradespeople) who may have skills and knowledge they can use in managing their SMSF’s investments should carefully consider when to charge their fund for such services. The risk of the fund’s income being treated as NALI will arise where an individual uses the assets, equipment or registrations of the business that they operate or are employed with.
It is critical that all funds consider the changes, especially given that the non-charging of professional fees could potentially result in the application of the NALI rules to all of the income of the fund.
Trustees should review their existing arrangements and also the parameters of the PCG to ensure compliance by 30 June 2021 and subsequent income years.
Superannuation is a complex area and implementing the right actions is vital to maximising superannuation savings. If you require assistance our Superannuation team can help.
Contact Alanah Boylon or your Nexia Edwards Marshall SMSF Specialist for assistance.
The material contained in this publication is for general information purposes only and does not constitute professional advice or recommendation from Nexia Edwards Marshall. Regarding any situation or circumstance, specific professional advice should be sought on any particular matter by contacting your Nexia Edwards Marshall Adviser.