The amendments made to the non-arm’s length income rules to include the concept of non-arm’s length expenditure took effect from 1 July 2018. However, despite nearly four years passing, an ATO draft ruling, consultation period, finalisation of the ATO’s ruling, there still remains significant concerns on the wide reaching effect of these 2018 amendments and particularly the potential dire tax outcome for a superannuation fund that has non-arm’s length expenditure.
The small nut and the giant hammer
The original policy intent of the amendments was to ensure that a fund could not circumvent the contribution caps by using non-arm’s length expenditure to inflate their overall income. For example, by borrowing money from a member at a reduced interest rate1.
The amendments could also be seen to address the perceived mischief of effectively moving assessable income from a higher tax rate to the concessionally taxed superannuation rate by charging a fund less than a market rate for expenditure. For example, a member performs a service for their SMSF which has a value of $1,000, the member does not charge their fund for that service. By not charging the fund for the service, that $1,000 of income is retained in the fund and taxed at 15%, rather than being included as income of the member and subject to tax at their marginal tax rate, which could be as high as 45%. Using the top personal tax rate of 45%, there’s a tax advantage of $300.
Rather than having legislation that would simply include that $1,000 as income of the service provider, the amendment penalises the fund by treating the amount as non-arm’s length expenditure and taxing the related net income at the top marginal rate, 45%. For example, if the service related to a rental property owned by the fund, then the net income from that rental property, for example say it was $45,000 ($55,000 rental income, less $10,000 rental property deductions), would be taxed at the top marginal rate, being $20,250 – a bit more than the $300 tax advantage.
However, the outcome for the fund can be even worse. If the NALE is regarded as “general in nature”, that is, it does not have a connection to specific fund income, it’s regarded as having a connection, known as a “nexus”, to all of the fund’s ordinary and statutory income. This is where the large hammer and small nut analogy comes in.
Statutory income includes capital gains and assessable contributions. Consequently, it’s not just the assessable investment income of the fund, the ordinary income, that will be treated as non-arm’s length and taxed at 45%, but also any capital gains and assessable income, statutory income.
Let’s revisit our example of the $1,000 service provided by the member, but it’s no longer connected to specific fund income, it’s a general expense, deductible under the general deduction provision, section 8-1, in the Tax Act2. The ATO’s ruling states that the non-arm’s length expenditure will have a nexus to all of the fund’s ordinary and statutory income. Effectively, the taxable income of the fund will be taxed at 45%. Where the fund had $50,000 of assessable contributions, together with a $10,000 assessable capital gain, the rental property net income of $45,000 and other net income of $5,000, the taxable income of $110,000, would give rise to tax of $49,500, rather than $16,500 – effectively a tax penalty of $33,000, again a bit more than the $300 tax advantage.
And even further, certain non-arm’s length expenditure could forever taint a fund asset such that all future ordinary and statutory income from that asset will be treated as non-arm’s length and taxed at 45%. Take example 9 from the ruling where a plumber undertakes a complete renovation of the SMSF property’s bathroom and kitchen and does not charge the fund for the renovations. This gives rise to all future rental income from the property and any capital gain on its future disposal being treated as non-arm’s length income and subject to 45% tax.
ECPI won’t save the fund
Some may think that where the fund is paying retirement phase pensions that non-arm’s length income and expenditure will not be an issue, as the income can be excluded as exempt current pension income (ECPI). Not so!
The relevant ECPI provisions exclude any income that is caught by the non-arm’s length provisions. There is also a similar outcome for any capital gain derived from the disposal of a fund asset, whether a segregated current pension asset or not.
So, in our previous example, had the fund consist wholly of retirement phase pensions, it would not be able to claim any of its income as ECPI, as all the income would be non-arm’s length. The tax outcome would be the same, albeit a greater penalty – 45% tax on income, rather than 0%.
Legislative fix a must
The ATO’s ruling, LCR 2021/2, outlines how the regulator will apply the 1 July 2018 amendments. The ruling even acknowledges the significant adverse tax outcome for a fund with a small amount of non-arm’s length expenditure, particularly where that expenditure is general in nature, “…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”.
Further,the Minister for Superannuation, Senator Jane Hume, has previously acknowledged the concerns of industry about the 1 July 2018 amendments relating to general expenditure and how the ATO will apply them “We know the concerns about the Commissioner’s ruling, and I can assure you … [that] we are looking into your question”3.
There has also been a joint submission from the accounting,tax, actuarial and superannuation bodies, sent to the Treasury and the Minister which outlines these concerns and states that “…it has become evident that the administration of the provision is broader than the original policy intent”.It is noted in the submission that the professional associations “…are supportive of the original policy intent of the provision…We do not disagree with its purpose”.
The submission sets out two suggested approaches to potentially reform the non-arm’s length income provisions, in line with guiding principles that have been listed in the submission:
- A re-write of the existing legislation with new principles, which still achieves the original policy intent (the preferred approach)
- Amendments to the existing legislation, using existing principles (not the preferred approach, given the inherent complexity of the drafting).
We await the Federal Government’s response to the joint submission. However, given the looming Federal Election, it may be sometime before we see any legislation to address the issues and concerns raised, which may be further exacerbated in the event of a change in government. Given the Minister’s comments and the submission, consideration should also be given by the ATO to providing further administrative relief, for example, an extension to the application of PCG2020/5 to beyond 30 June 2022.
1.Second reading speech to the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2019
2.Per example 2 in LCR 2021/2
3.2021 Tax Institute National Super Conference