Non-arm’s length income rules and SMSFs – where are we at now? How NALE impacts SMSFs

The 2017 Budget saw the announcement of the ‘NALE’ changes to the non-arm’s length income (NALI) rules effective from 1 July 2018. These changes have been passed and, combined with the ATO’s interpretation, these new NALE rules could have significant impacts for some SMSFs.

We have written on the NALE proposals before.

The Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 was passed in September 2019 and received royal assent in October 2019. It contains a number of important changes, including the NALE rules, which apply from 1 July 2018.

NALI and the NALE changes

SMSFs pay tax on NALI at the top marginal tax rate, rather than the concessional rates that usually apply to income earned in SMSFs.

The changes extend NALI and the top tax rate to include where the SMSF has entered into an arrangement where the parties are not dealing at arm’s length and either:

• the SMSF’s expenses are less than would have been incurred had the parties been dealing at arm’s length; or
• there is no loss, outgoing or expense incurred by the SMSF where one would have been expected if the parties had been dealing at arm’s length.

An example of where this could apply is a related party lending to their SMSF at an interest rate lower than that which would be charged by a bank. That low rate loan is likely to make all the income (including capital gains) from the LRBA NALI and assessable to the SMSF at the top marginal rate. Some advisers obtained private binding rulings on these arrangements when entering into them originally, and they should check those PBRs for the years to which they apply. The ATO will usually limit the time period that PBRs are effective and, once that time is up, the result may be very different to that outlined in the PBR.

ATO interpretation

The ATO has released LCR 2019/D3 for comment. In that, the ATO discuss the necessary connection between the loss, outgoing or expense to identify the income that will be NALI as a result of these rules.

Some points about how the ATO will apply the new NALE rules:

• Expenses such as accounting expenses have a sufficient connection to all the income of the SMSF. This means that, if an accounting firm does not charge a partner’s SMSF for accounting work, or charges less than the market rate, all the income of the SMSF is NALI. The result may be different if the trustee provides the services outside work hours and without using the resources of the accounting firm.

This could also apply to businesses offering discounts to employees and related entities where that includes SMSFs. For example, if a stockbroking firm offers discounts on brokerage to employees, their family trusts and SMSFs could result in income earned by the employees’ SMSFs to be NALI if an SMSF takes advantage of the discount.

• If an asset is purchased for less than market value, or using a loan with a lower than market interest rate, all the income including capital gains from that asset will be NALI.

The LCR is yet to be finalised. If the final version issues in the same terms as the draft, even a small amount of expenses not charged to the SMSF could result in a very substantial tax bill as all the income of the SMSF could become NALI.

Advisers and trustees must be vigilant in substantiating expenses, particularly those paid to related entities, to avoid what could be a draconian outcome.

Summary

The new rules provide another layer of complication to SMSF dealings in an often misunderstood and overlooked area. Advisers must be alert to the potential for these rules to apply to SMSFs, particularly in light of the ATO’s view in LCR 2019/D3.

To discuss how you or your clients may be affected by this proposed change, contact a member of our superannuation team.