Author: Emma Partenza, Manager, TAG Financial Services
Law Companion Ruling (LCR) 2021/2 was recently issued by the ATO clarifying their interpretation of amendments to Non-Arm’s Length Income (NALI) provisions where expenditure is incurred under a non-arm’s length arrangement. The ruling applies from 1 July 2018, even if the “scheme” that results in the NALI was entered into before this date.
s295-550 ITAA1997 has been amended and applies to a scheme where the parties do not deal with each other on arm’s length and the trustee incurs non-arm’s length expenditure in gaining and producing ordinary or statutory income.
NALI attracts tax at 45% and ECPI does not apply to any income classified as NALI.
What is NALI?
To revisit, the NALI provisions apply to a SMSF where ordinary or statutory income was derived under a scheme where the parties were not dealing with each other at arm’s length and that income is more than what might have been expected to be if those parties had been dealing with each other on an arm’s length basis.
A simple example of this would be rent paid from a related tenant which is over and above market rate.
What is NALE?
The ruling also deals with NALE, which is an extension of the non arm’s length income provisions, but relates to expenditure.
NALE is a scheme in which the parties are not dealing with each other at arm’s length and the fund incurs a loss, outgoing or expenditure of an amount in gaining income, and the amount of the loss, outgoing or expenditure is less than the amount that would have been expected where those parties had been dealing with each other on an arm’s length basis.
As with the NALI provisions, if there is NALE, the top marginal tax rate will be applied.
Furthermore, NALI will apply where the fund does not incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties had been dealing with each other on arm’s length.
When the draft law ruling was originally released, the inclusion of NALE was initially included to overcome the issue of nil/low interest related party LRBA’s. However, as is often the case when legislation is drafted, the wording of the law included a lot more circumstances than perhaps was originally intended.
Now of concern (particularly in the accounting fraternity), is where trustees are providing services to their own SMSF at little or no cost. In the worst of these cases, some relatively minor fund expenses would not be considered arm’s length, and therefore could result in some or all of the fund’s income being classified as NALI and having the top marginal tax rate applied.
Expenditure incurred – Trustee capacity vs Individual capacity
For individuals undertaking work in respect to their SMSF in their capacity as trustee (as part of their ongoing trustee duties and responsibilities), s17A SIS Act provides trustees cannot receive any remuneration for any duties or services performed by the trustee.
However, where the individual performs work for the fund in their individual capacity (i.e. as an accountant, real estate agent, plumber, etc – for non-trustee duties) a fee can be charged to the fund. Generally, this type of work is undertaken by the individual for which they are appropriate qualified. Arm’s length expenditure must be incurred by the fund for such services to avoid the application of NALI provisions.
Many of us (accountants / advisers) have our own SMSF’s and we undertake the accounting and taxation for our own funds (one of the perks of working in the industry!!). If we process the fund using our business’s assets or equipment (i.e. the licensed software we prepare the accounts and tax returns on), we lodge the return through our tax agent’s licence and the services are covered by our PI policies, then it is likely we are operating in our individual capacity, and NALE will apply. This may result in NALI being applied on the entirety of the fund’s income (not attributed to a specific investment of the fund).
Recurring costs of a general nature not being incurred on an arm’s length basis will only cause NALI to apply in financial years in which they are not charged on an arm’s length basis. So, the income of the fund will not be tainted forever.
Where a trustee incurs a reduced fee from their employer (or own business) due to a discount policy provided to all employees, officeholders, shareholders etc – NALE will not apply.
How to avoid NALI and NALE?
To avoid any application of NALE, and therefore the NALI provisions, all parties must ensure they are acting with each other on an arm’s length basis in relation to their SMSF and ensure arm’s length expenditure is incurred by the fund. This may involve a review of the fund’s arrangements and obtaining evidence of dealing on an arm’s length basis.
For accountants that are processing their own SMSF’s using their business’s software, make sure a fee is being charged for this service, and if it is a discounted fee, that this discounted fee applies to all team members.
Transitional rules
PPCG 2020/5 applying NALI to NALE has provided guidance whilst this ruling has been in its draft form in respect to non-arm’s length expenditure incurred by a fund. It applies to funds for financial years 2019 – 2022. It is expected the ATO will only apply compliance resources to this new LCR from 1 July 2022. In the meantime, SMSF trustees will be directed to ascertain whether parties have made a reasonable attempt to deal on an arm’s length basis and apply expenditure for services provided to the fund on this basis.
If you have any questions please contact us on 03 9886 0800 or via email.
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Disclaimer: The information contained is general in nature. Professional advice should be sought before acting on any aspect on this page. Financial planning services provided by TAG Financial Advisors Pty Ltd (ABN 77 154 205 017 AFSL 415632), a wholly owned subsidiary of TAG Financial Services Pty Ltd (ABN 67 075 374 686). Copyright 2021. Please do not reproduce without the expressed written consent of the author.