One of the characteristics of a self-managed superannuation fund (SMSF) is that it can be common for it to transact with a related party and because of this, the fund must be aware of the relevant rules that apply to arm’s length dealings. The fund needs to comply with the relevant non arm’s length rules found in the Superannuation Industry (Supervision) (SIS) Act, primarily section 109, and avoid being caught by relevant rules in the Tax Act, such as section 295-550.
The Australian Taxation Office (ATO) has issued a draft Law Companion Ruling (LCR) 2019/D3, which clarifies how the 1 July 2018 amendments to the non-arm’s length income (NALI) provisions in the 1997 Tax Act operate where there is a scheme where the parties do not deal with each other at arm’s length and the superannuation fund incurs expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income.
Where income of a superannuation fund is caught by the NALI provisions, the amount of income, less attributable deductible expenses, will be taxed at the top marginal personal tax rate, currently 45%, rather than the concessional rate of 15%. The broadening of the application of the NALI provision to include non-arm’s length expenditure (NALE) has raised a number of issues, particularly in relation to such expenditure that is of a general nature which may cause all of the fund’s ordinary and statutory income to be treated as NALI.
This is close to home for an accountant who has their own SMSF and provides accounting and taxation services free of charge or at less than commercial rates to their SMSF. Such an arrangement could result in all of the fund’s assessable income, including assessable contributions, being taxed at the top marginal personal tax rate. The tax consequences of such an arrangement appear to be punitive when compared to the level of expenditure involved.
For example, 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 $50,000
- 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, based on the draft ruling, 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 $138,000 would be subject to 45% tax rate – fund tax of $62,100.
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 $41,400 [(138,000 x 45%) - (138,000 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%)].
Further, subject to the available concessional contribution cap, the accountant could contribute the $3,000 back to his SMSF and claim a personal tax deduction, resulting in the same tax outcome as not charging his fund the $3,000 fee.
The ATO has issued Practical Compliance Guideline (PCG) 2020/5 which provides a transitional compliance approach for a complying superannuation fund concerning the application of the 1 July 2018 amendments to the NALI provisions where a fund incurs certain non-arm's length expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income.
The PCG states that the ATO will not allocate compliance resources to determine whether the NALI provisions apply to a complying superannuation fund for the 2018-19, 2019-20 and 2020-21 income years where the fund incurred non-arm's length expenditure (as described in paragraphs 9 to 12 of LCR 2019/D3) of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, NALE on accounting services).
However, the transitional compliance approach does not apply where the fund incurred NALE that directly related to the fund deriving particular ordinary or statutory income.
We await the finalisation of LCR 2019/D3 to see what changes to the current draft are made and particularly, what the approach will be in relation to NALE that is of a general nature and whether amendments to current arrangements will be required from 1 July 2021.