Head of Education (Tax)
Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Bill 2023 (the Bill), introduced into Parliament on 13 September 2023, sets out long awaited changes to the non-arm’s length income (NALI) provisions. These changes propose a fix to issues that emerged when the NALI rules were extended in 2018 to include non-arm’s length expenses (NALE).
Section 295-550 ITAA 1997 | Meaning of non-arm's length income
(1) An amount of *ordinary income or *statutory income is non-arm’s length income of a *complying superannuation entity if, as a result of a *scheme the parties to which were not dealing with each other at *arm’s length in relation to the scheme, one or more of the following applies:
(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme;
(b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme;
(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.
Specifically, as highlighted by the ATO in LCR 2021/2, the extension to NALI rules requires identifying a nexus between the non-arm’s length expenditure of a superannuation fund and the relevant amount of ordinary or statutory income derived. In analysing this nexus, the ATO noted that ‘in some instances, the non-arm’s length expenditure will have a sufficient nexus to all of the ordinary and/or statutory income derived by the fund’. Clearly this could result in all the income of a superannuation fund being classified as NALI and taxed at 45 percent, even where the expense breach was relatively minor.
The changes proposed in the Bill ameliorate the disproportionate outcome by introducing a cap on the amount of income that is taxed at 45 percent. The Bill does not change the treatment of the NALE rules for expenses incurred in earning income from a particular asset.
The Bill also ensures that the NALE rules will only apply to SMSFs and small APRA funds. Large APRA funds are exempted from the NALI rules to the extent that they relate to NALE. However, they will still be subject to the remaining non-arm’s length income rules for income derived on a non-arm’s length basis.
Key changes from the exposure draft legislation
The changes proposed in the Bill were originally contained in Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s length expense rules for superannuation funds. While mostly the Bill as introduced into parliament aligns with the exposure draft, there are two key differences.
- The exposure draft specifically carved out expenses of a capital nature from the proposed concessional treatment for general expenses. This exclusion has been removed from the Bill, meaning all expenses of a general nature are treated the same.
- The commencement date has been amended to 1 July 2018, rather than from the 2023-24 income year.
Types of expenses
Specific expenses are those that relate to earning income from a particular asset of the fund. Specific expenses include:
- maintenance expenses for a rental property
- investment advice fees for a particular pool of investments
- a limited recourse borrowing arrangement for the purchase of a specific asset.
General expenses are those that do not relate to a particular asset of a superannuation fund. General expenses therefore include:
- actuarial costs
- accountant fees
- fees to an auditor
- administrative costs in managing the fund
- trustee fees
- costs of complying with the regulatory obligations of the fund and
- investment adviser fees, where those fees relate generally to the operation of the fund and not to a specific investment or a particular pool of investments.
Calculation of the non-arm’s length component for SMSFs and small APRA funds
Non-arm’s length component is the lesser of:
1.The sum of:
- For specific expenses: NALI less relevant deductions, and
- For general expenses:
2 X [Amount of expense entity expected to have incurred less amount actually incurred]
2.The amount as a result of the following calculation:
Taxable income of superannuation fund for year
Deductions attributable to concessional contributions
Tip – The above formula can result in a non-arm’s length amount of $0.
Example 7.2 from Explanatory memorandum
Min is a trustee of an SMSF. The members of the SMSF are Min and Min’s spouse Tony. Min is a lawyer and through her law firm, Min Lawyers, provides general legal services, worth $10,000 to their SMSF which the SMSF acquires for $5,000. These services were provided in circumstances such they were provided in a capacity other than as a trustee and meet the other requirements of section 17B of the SIS Act.
Min offers the same services she provides to the SMSF to the general public and the market value of these services is readily apparent from the fee schedule available on Min’s website.
The acquisition of legal services by the SMSF constitutes a scheme between Min and their SMSF in which the parties were not dealing with each other at arm’s length, and the expense was incurred at a value less than what the SMSF would have been expected to have incurred as an expense had the parties been dealing at arm’s length, so the non-arm’s length expense provisions apply. The legal services were general in nature and did not relate to any particular asset or assets so are a general expense that is a non-arm’s length expense captured under subsection 295-550(8).
The total income of the SMSF in 2023-24 is $23,000 in rent from a rental property to which $10,000 in eligible deductions for maintenance apply. No assessable contributions were made in that income year.
The taxable income is calculated as $23,000 in rent income minus $10,000 in deductions minus $5,000 charged for legal services, equalling $8,000.
As a general expense of $5,000 was incurred, which would have been $10,000 if the parties had been dealing at arm’s length, the amount of non-arm’s length income is twice the amount of the difference between what was incurred and what would have been expected to have been incurred had the parties been dealing at arm’s length, which is $10,000.
Applying the cap on the total non-arm’s length component, the cap amount is the total of income other than assessable contributions, minus deductions other than deductions against assessable contributions. In this case, the cap is the $23,000 in rental income minus the $15,000 in deductions, giving $8,000. This cap is lower than the non-arm’s length component arrived at above, so the non-arm’s length component of the SMSF’s taxable income becomes $8,000 instead of $10,000, as previously calculated. This is subject to tax at 45%.
This leaves the low-tax component of the SMSF’s taxable income at $0. The low tax component is any remaining taxable income after calculating the non-arm’s length component.
 Para. 19 of LCR 2021/2
Accurium welcomes the proposed changes to NALE that is general in nature as they provide for a far less severe consequence where there 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 Bill does not address, for example, how having NALE that is general in nature in relation to the acquisition of an asset can forever taint the income from that asset, both ordinary and statutory, as NALI. As a note, the changes also create a different set of rules for SMSFs and SAFs versus large APRA funds.
We await the passage of the Bill and expect the finalisation of other NALE related ATO publications, including:
- draft consolidation contributions ruling (TR 2010/1DC)
- draft Tax Determination (TD) 2023/D1: Non-arm’s length income and capital gains tax provisions.
We also expect changes to be made to the NALE Law Companion Ruling (LCR) 2021/2 to reflect the changes to s. 292.550 ITAA 1997.
The NALI/NALE story, not finished yet………..