The government has released a consultation paper (24 January 2023), ‘Non-arm’s length expense rules for superannuation fund‘ which outlines options to amend the non-arm’s length income (NALI) provisions which apply to superannuation funds. The intention of these potential changes is to ensure the rules continue to operate in line with their original policy intent and provide a greater level of certainty to trustees ahead of the expiry of the transitional compliance approach (PCG 2020/5) on 30 June 2023.
The proposed changes only relate to expenditure that is general in nature, that is, expenditure which has a sufficient nexus (connection) to all ordinary and statutory income derived by the fund. The proposed amendments that the paper outlines are:
- SMSFs and Small APRA funds (SAFs) would be subject to a factor-based approach which would set an upper limit on the amount of fund income taxable as NALI due to a general expenses breach. The maximum amount of fund income taxable at the highest marginal rate would be 5 times the level of the general expenditure breach, calculated as the difference between the amount that would have been charged as an arm’s length expense and the amount that was actually charged to the fund. Where the product of 5 times the breach is greater than all fund income, all fund income will be taxed at the highest marginal rate.
- Large APRA-regulated funds would be exempted from the NALI provisions for general expenses.
The consultation paper notes that this methodology applies a maximum effective tax rate of 225% (5 x top marginal rate of 45%) in respect of the general expenditure breach. However, as per the proposal, this would not apply to large APRA funds, only to SMSFs and SAFs.
A question that has been raised is what was the basis for using a factor of 5 and whether this still gives rise to a disproportionate penalty? Would simply taxing the amount of non-arm’s length expenditure (NALE) at 45% be a more fair and reasonable approach, but also still act as a disincentive?
An SMSF asset can still be tainted for life.
The potential changes only address NALE that is general in nature. Where NALE is related to a specific asset, the current NALI rules would continue to apply, such that all the income of that asset will be NALI and subject to the highest marginal tax rate. Such income would include any assessable capital gains derived upon the sale of the asset.
Further, there is no opportunity to rectify. Regardless of how it arose, where an SMSF has NALE that is in connection to the acquisition of the asset, it taints the asset forever and cannot be fixed. Consider ‘Example 2: SMSF acquires an asset at non-arm’s length price’ from the consultation paper, all future net rental income will be taxed at the top marginal rate – nothing can be done to rectify. Same goes for any capital gain on the sale of the property. Even if the trustees wait until the members retire and commence retirement phase pensions before selling the property, none of the capital gain can be claimed as ECPI1.
Further, this may not only apply where the SMSF acquires the whole asset. Example 9 in Law Companion Ruling (LCR) 2021/2 includes a scenario where an SMSF has an existing rental property and for this purpose I assume that it was acquired from an unrelated party on commercial terms as it appears to be a residential property. The member/trustee of the SMSF, with the use of their tools of trade and an employee (from their business) undertake a complete renovation of the bathroom and kitchen. The member/trustee does not charge their SMSF for the work undertaken. Consequently, the SMSF has NALE.
However, whilst the renovation represents only a portion of the whole property, all of the future rents will be treated as NALI. Further, the ruling states that ‘The non-arm’s length expenditure will also result in any capital gain that might arise from the subsequent disposal of the second SMSF rental property being NALI‘. Not a portion of the rental income, or a portion of the capital gain – all of it! And once again, there is no way to rectify.
Proposed potential changes welcomed, but more is required
My initial reaction upon first read of the summary of the proposed changes was ‘after all this time to consider all the submissions from industry, that’s the best option?’ Remember these NALE amendments took effect from 1 July 2018, nearly five years ago.
The proposed changes to NALE that’s general in nature are welcomed as it provides for a far less severe consequence where this is a small amount of NALE that has a nexus to all of the fund’s income, both ordinary and statutory. However, the penalty does still appear to be disproportionate to the alleged mischief. Further, there remain a number of issues, that industry has raised on many occasions that the consultation paper does not address. The proposed changes also create a different set of rules for SMSFs and SAFs versus large APRA funds.
I get the impression from the language of the consultation paper that there are unlikely to be any further changes being proposed, despite a consultation period that was open until 21 February 2023. So where to from here? Should we just call it time on NALE and move forward or is there still hope that we can get the government to see sense on these issues?
If you’d like to read more on this topic, refer to Mark’s extended version of this blog article in here.