The 1 July 2018 amendments to the non-arm’s length income (NALI) provisions introduced the concept of non-arm’s length expenditure (NALE). A fund with NALE will have NALI that results in an adverse tax outcome.
Nearly two years since the ATO released their draft ruling LCR 2019/D3 to clarify how the 1 July 2018 amendments were to be applied in respect of NALE, we see the release of the final version of the ruling, as LCR 2020/2. The final version of the ruling was expected to address issues raised in many submissions by industry on the draft ruling and whilst it has addressed these issues, not all will be satisfied with the ATO’s responses. In particular, the ATO’s response to the issue of whether there is a nexus between expenditure that is general in nature and all of the fund’s income is not the outcome that industry has welcomed.
The final version of the ruling acknowledges the severity of the tax implications where a fund has NALE that has a low market value:
“….the Commissioner is alive to concerns that a finding that general fund expenses are non-arm’s length is likely to have a very significant tax impact on the complying superannuation fund, even where the relevant expenses are immaterial.”
So where does the final ruling leave us?
We’ve got time to get ready…for general expenditure
In relation to NALE that’s general in nature, the current PCG 2020/5 will continue to apply up until 30 June 2022. This PCG states that the ATO will not allocate compliance resources to determine whether the NALI provisions apply to a fund for the income years 2017-18 through to 2021-22, where the fund has NALE that is general in nature.
From 1 July 2022, where the ATO applies any compliance resources to review whether a self managed superannuation fund (SMSF) has NALE, such resources will only be directed towards ascertaining whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the fund. Provided such a reasonable attempt can be shown, the ATO will not allocate compliance resources to determine whether those expenses are in fact arm’s length expenses.
Consequently, there is time for SMSFs to get ready for the ATO’s compliance approach for reviewing NALE that is general in nature that will be applied from the 2022-23 income year. This will include a review of current and ongoing arrangements to ascertain if such expenditure would come within the scope of the NALI provisions and if so, what evidence is required to demonstrate that a reasonable attempt has been made to determine an arm’s length price.
It’s important to remember that the transitional approach outlined in PCG 2020/5 and the compliance approach outlined in LCR 2020/2 only applies to NALE that is general in nature. It does not apply where the SMSF incurred NALE that directly related to the fund deriving particular ordinary or statutory income. This type of NALE has been under the ATO’s spotlight since the 1 July 2018 when the NALE amendments came into effect.
A small NALE amount can mean significant tax consequences
The most contentious issue of the draft ruling was the assertion that where a fund had NALE that was general in nature that it had a nexus to the whole of the fund’s income. This has the potential to taint all of a fund’s income as NALI, resulting in it being taxed at the top marginal tax rate, currently 45%. Included in assessable income being treated as NALI would be assessable contributions.
Despite the many submissions made in relation to the issue of whether there is such a nexus, the final version of the ruling has not seen any shift in the ATO’s view. Let’s consider the following scenario and potential NALI outcome, based on the final version of the ruling.
An SMSF has the following income and expenses:
- Rental income of $90,000 (lease of business real property (BRP) to related party tenant at market rate + property acquired at market value from related party).
- Assessable contributions of $55,000.
- Other assessable investment income of $20,000.
- Rental property expenses of $20,000.
- General expenses of $2,000.
- Additionally, the trustee of the fund is an accountant and provided free accounting and taxation services valued at $3,000, using the resources of his accounting business.
As the SMSF has NALE of a general nature, all of the SMSF’s ordinary and statutory income would be treated as NALI, including assessable contributions. That is, the SMSF’s taxable income of $143,000 would be subject to 45% tax rate – fund tax of $64,350.
The failure to pay an arm’s length fee of just $3,000 for services provided by the trustee in their individual capacity as an accountant has resulted in additional tax of $42,900 [(143,000 x 45%) – (143,000 x 15%)]. Had the $3,000 fee been charged and assuming the accountant was subject to tax at the top marginal rate of 45%, the tax differential (including the 2% Medicare levy), in favour of the ATO, would be $960 [($3,000 x ((45% + 2%) – 15%)].
By not charging the SMSF an arm’s length fee for the accounting services, the individual has effectively had $3,000 taxed at the SMSF’s concessional 15% tax rate. However, subject to available space in their concessional contribution cap, the same outcome can be achieved where the individual charges the fund $3,000 for the accounting services and contributes it back to his SMSF and claims a personal tax deduction – the same tax outcome as not charging his fund the $3,000 fee.
Consider a slight change to the previous scenario – the whole of the SMSF consisted of retirement phase account- based pensions and there were no assessable contributions, that is, assessable income of $110,000. Generally, the fund would claim all of this assessable income as exempt current pension income (ECPI). There would be no deductions, leaving taxable income of nil. However, income that is treated as NALI cannot be claimed as ECPI and consequently, this produces an outcome similar to the previous scenario – the fund having taxable income of $88,000 and a tax bill of $39,600!
The final ruling also includes at paragraph 19, a list of expenses that are deductible under the general deduction provision, section 8-1 ITAA 1997, that the ATO considers would have a sufficient nexus to all the income of the fund.
In-specie contributions still permitted, but be careful
An SMSF will still be permitted to acquire an excepted asset via an in-specie contribution. However, it will be crucial to ensure that the value on the purchase contract for the asset or part thereof, is market value. Any difference between the contract purchase price and market value cannot represent the value of an in-specie contribution and will most likely result in the fund having NALE of a capital nature. Consequently, this will taint that asset forever, treating all future net ordinary income and any capital gain on disposal as NALI – it cannot be fixed! Refer to examples 3 of LCR 2021/2 for where the acquisition will result in the fund having NALE and example 5 for where an in-specie contribution is made and there is no NALE.
LRBA on non-arm’s length terms results in NALI outcome
Similarly, where an SMSF acquires a permissible asset under a limited recourse borrowing arrangement (LRBA) that’s not on arm’s length terms, the net ordinary income will be treated as NALI, despite the asset under the LRBA being acquired on arm’s length terms. Further, the net ordinary income derived will be treated as NALI for all future income years, regardless of whether the LRBA is subsequently refinanced on arm’s length terms. Further, the NALE incurred under the LRBA will also result in any capital gain that might arise from a subsequent disposal of the asset being NALI. This will also be the case regardless of whether the LRBA is subsequently refinanced on arm’s length terms. Refer to example 4 of LCR 2021/2.
Capacity in which individual acts is crucial
It will be necessary for an individual to ascertain whether they are performing an activity as a trustee of the superannuation fund or whether they are acting in a different capacity. Where it is determined that they are acting in their capacity as trustee, the NALE provisions will not apply. For example, the NALE provision will not apply where a trustee, acting in that capacity, performs bookkeeping or accounting services for the fund for no remuneration. This also ensures that there is not a conflict with sections 17A and 17B SIS Act, which only permits a trustee to be remunerated for non-trustee services where the trustee meets certain requirements.
Where a person is performing their activities in an individual capacity, potentially the NALE provisions apply where an arm’s length price is not paid. Factors that indicate that the individual is performing their activities in their individual capacity and not in their capacity as a trustee, or a director of a corporate trustee are listed in paragraph 47 of LCR 2021/2. There is, however, some relief provided under the final version from the draft, including:
- Where the use of equipment and other assets of the individual’s business or of their employer is minor, infrequent or irregular. For example, minor, infrequent or irregular use of a business computer at the office by an individual would not, of itself, indicate the individual is acting in their individual capacity.
- Staff discounts will not result in an SMSF having NALE, provided they are consistent with normal commercial practices and the SMSF trustee is entitled to a discount under a discount policy where the same discounts are provided to all employees, partners, shareholders or office holders.
- Services provided to an SMSF on a pro bono basis will also not be considered NALE where the SMSF trustee is not able to influence the service provider’s decision to supply the services on a pro bono basis.
Refer to examples 6, 7, 8, & 9 of LCR 2021/2.
However, there is an interesting take- away from comparing examples 9 and 10. It appears that where the performance of the activity requires a license, such an activity will be considered to be performed in an individual capacity and consequently potential for the NALE provisions to apply. This could be likened to an individual who provides tax agent services to their SMSF for less than an arm’s length price.
Application of the market value substitution rules
When an SMSF trustee acquires a CGT asset as less than market value, the market value substitution rules may apply to modify the cost base of the asset (there would also be a problem with section 66 SIS Act and a potential 12 months free room and board at Her Majesty’s hotel!). Under this rule, the SMSF, as purchaser, is treated as having acquired the asset at market value.
Whilst the market value substitution rule may adjust the quantum of any capital gains that the SMSF makes on a disposal, it does not affect the application of the NALE provisions. Any such capital gains will be treated as NALI. Refer to example 13 of LCR 2021/2.
Changes to Contribution ruling
The ATO’s superannuation contribution taxation ruling, TR 2010/1, has also had a draft consolidation released to explain the interactions between the NALI provisions and the rules concerning contributions. The draft consolidation also updates for the removal of the maximum earnings test, commonly referred to as the 10% rule, for claiming an income tax deduction for a personal superannuation contribution. This 10% rule was removed with effect from 1 July 2017.
In relation to the interactions with the NALI provisions, it states (paragraphs 25A to 25C) that:
- The acquisition of an asset by a superannuation fund is not an in-specie contribution where the asset is purchased from an entity under a purchase/sale contract.
- However, an in specie contribution may be made in conjunction with the purchase of an asset. This may occur, for example, where 50% of the asset is purchased with the remaining 50% of the asset being subject to an in-specie contribution.
- Where a superannuation fund purchases an asset under a contract at less than market value, the fund has incurred NALE. However, the difference between the consideration paid (if any) and the market value will not represent an in-specie contribution being made as the asset has been acquired under the terms of the contractual agreement and not through an in-specie contribution.
There is obviously a considerable amount to understand and consider with the release of the final ruling and how the NALE rules may apply across SMSF clients. Practitioners and advisers will have the task to assist their SMSF clients to navigate these complex rules that can have significant tax implications for such minor infringements. Given the final version of the ruling has been met with considerable disdain, it may be time for the industry to lobby for a legislative fix.