There has been a lot of discussion about how non-arm’s length income (NALI) and non-arm’s length expenditure (NALE) apply to self-managed superannuation funds as a result of the draft ruling issued by the ATO in 2018 (LCR 2018/D10) and the revised version issued in 2019 (LCR 2019/D3).
Now, after three years of uncertainty, the ATO has issued its final ruling (LCR 2021/2) about the NALE rules, which has come as a disappointment to many in the industry.
Why are we concerned?
Any income derived by an SMSF that is NALI or as a result of NALE will be taxed at the top marginal tax rate, rather than the concessional rates that apply to most income in an SMSF.
The NALI rules have been with us for many years, and the NALE rules apply from 1 July 2018. Applying NALE in some situations is straightforward, but the ATO has caused concern about ‘general’ NALE, first in LCR 2018/D10, revised in LCR 2019/D3 and now finalised in LCR 2021/2.
What is NALE?
NALE applies where losses, outgoings or expenditure are either lower than commercial rates or not incurred at all by an SMSF where the parties are not dealing with each other on normal commercial arm’s length terms.
For example, if an SMSF borrows from a related party to buy an asset and no interest is payable, then all the income from that asset will be taxable in the SMSF at the top marginal tax rate.
Expense must be connected to income – most of the time
In LCR 2021/2, the ATO states there must be a ’sufficient nexus’ between the NALE and the relevant income of the SMSF. However, the way this connection is interpreted will have some far-reaching implications, particularly for more general expenses. For example:
- If an SMSF does not incur management fees for services provided by a related party real estate agent for managing a property owned by an SMSF, all the rental income derived by the SMSF for that property will be NALI. This is a fair interpretation of the legislation given the nexus between the expense and the inflated income is clear and distinct.
- If an SMSF purchases real estate from a related party for less than market value, then all income derived by the SMSF from that property will be NALI (unless the documents make it clear the balance is a contribution). This includes the annual rental income from the property (even where the lease is on commercial arm’s length terms with an unrelated party) as well as any capital gain derived by the SMSF upon the eventual sale of the property.
While this may appear to be harsh and possibly disproportionate, particularly if the discount given on the purchase price is only minor, the connection between the expense not incurred by the SMSF and the income derived by the SMSF is clear.
- If real estate is purchased by an SMSF through an LRBA, or by a unit trust in which an SMSF is a unitholder, using a loan that is not on arm’s length terms, then all income derived by the SMSF from that property or unit trust will be NALI. This includes the annual rental income from the property (even where the lease is on commercial arm’s length terms with an unrelated party) as well as any capital gain derived upon the eventual sale of the property.
This will be the case even if the initial loan is refinanced so that the loan is subsequently on arm’s length terms. Although, there is a clear connection between the income received and the non-arm’s length expense, it appears to produce a harsh result where an initial non-arm’s length loan is rectified and put onto arm’s length terms.
- Where this connection gets somewhat blurry is the ATO’s view that a general expense not incurred by an SMSF (or one that is lower than what an arm’s length expense would have been) can result in all the income of the SMSF being NALI. These expenses could include:
a. actuarial costs or accounting fees (except those incurred in complying with, or managing, the SMSF’s income tax affairs and obligations that are ordinarily deductible);
b. audit fees;
c. investment adviser fees; and
d. other administrative costs incurred in managing the SMSF.
However, the application of this principle is not uniform and each situation will need to be considered on its own facts. For example, an SMSF not incurring accounting fees because a trustee is a partner of the accounting firm providing the services will result in NALI. However, if the same trustee is only providing bookkeeping services using the equipment of the accounting practice, this may not result in NALI.
Similarly, employer discounts will not trigger NALI provided the same discount is applied to all employees, partners, shareholder, etc.
While the final view of the ATO provides SMSFs with some certainty regarding how these rules will be applied, the potential penalties for breaching these rules will be substantial. For example, not charging a $550 fee for a general administrative expense could result in a very substantial tax liability – the top tax rate on all the income of the SMSF. This highlights the importance of SMSFs understanding the ATO’s new position and the NALI and NALE rules more broadly.
When does the ATO’s view apply from?
To assist SMSFs with transitioning to these new rules, the ATO has previously advised it will not allocate compliance resources to determine whether the NALE changes will apply to SMSFs for the 2019, 2020 and 2021 financial years where the SMSF incurs expenditure of a general nature.
From 1 July 2022, the ATO has stated that where any compliance resource is applied to investigate expenditure of a general nature it will only be directed toward ascertaining whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the SMSF. Provided this is the case, the ATO will not allocate resources to determine whether those expenses are in fact arm’s length expenses.
SMSFs must be awake to NALI and NALE more than ever, and it is something we see being overlooked frequently – often until it is too late.
Particular traps include:
- making sure contributions of assets are properly and clearly documented
- identifying related party transactions and the evidence required to substantiate the dealings
- services provided by trustees, and differentiating the capacity in which they are provided
- checking the currency of rulings previously obtained about SMSF expenses at less than market value.