Superannuation and NALE: Non-Arm’s Length Expenditure (October 2023)

The long awaited and anticipated exposure draft law relating to Non-Arm’s Length Expenditure (NALE) were introduced to Parliament on 13 September 2023. We detail below a comparison between the current legislation and proposed amendments as well as areas of Australian Taxation Office (ATO) concern and key guidelines they will look for when determining if an arrangement is arm’s length.

Current legislative position

The non-arm’s length income (NALI) rules impose the top marginal rate of tax (45%) on a portion, or in some instances, all of the income of a superannuation fund where parties have not dealt with each other on arm’s length terms.

As an extension to these laws, in July 2018 legislation came into force to include non-arm’s length expenses (NALE), meaning that we no longer just look at the income earned by a superannuation fund but also the expenses.

So, if a loss or outgoing is less than what would ordinarily have been derived if the parties had dealt with each other at arm’s length – this will now be caught!

The ATO’s interpretation of these NALE rules is there are two types of expenses, being either a ‘specific’ expense or a ‘general’ expense.

• A general expense is defined as anything that is not related to gaining or producing income from a particular asset of a fund.
• A specific expense is therefore any other expense that is not considered to be general in nature. 

Proposed changes

In January 2023, The Treasury proposed a change to the general expense NALE rules whereby rather than potentially tainting ‘all’ of the income of the fund as NALI, the amount of income that will be taxed as NALI will be limited to five (5) times the difference in the non-arm’s length expense amount incurred. 

After initial consultation on these proposed changes, on 9 May 2023 the Government announced further changes in the Federal Budget stating that large APRA-regulated funds would no longer be subject to these provisions and for Self-Managed Superannuation Funds (SMSF) and small APRA-regulated funds, the key multiplier would be reduced to a rate of two (2) times the difference in the general expense incurred. Draft legislation was then released on 19 June 2023 for consultation, with a Bill introduced into Parliament on 13 September 2023.

This multiple essentially sets an ‘upper’ cap on general expenses to ensure that the total amount taxed at the highest marginal tax rate does not exceed the SMSFs total taxable income. 

As a basic example as to how this would work, if there was general NALE of $1,000, this would give rise to $2,000 of NALI (provided there is sufficient taxable income) which would be taxed at 45%, resulting in $900 of tax to the fund. This represents an effective tax rate of 90% in respect to the NALE.

Note: For specific expenses, the new lower rate multiplier of 2 will not apply and the entire amount of income derived from the scheme will continue to be taxed as NALI.

Importantly, also introduced within this draft legislation was a limitation on the time period from which NALE can be applied, effectively restricting it’s application to dealings which were entered into until after 1 July 2018.

ATO interpretations

Law Companion Ruling LCR 2021/2

The ATO’s discusses allocating potential non-arm’s length expenses into the two categories:

1. Specific expenses, which may result in all current and future income (including capital gains) to be tainted as NALI; and
2. General expenses, where only the income derived in the year in which the NALE expense occurs is subject to the NALI provisions.

This ruling also details the distinction between when the Trustee or Director of a corporate trustee performs work for their own SMSF. This type of work will be in either:

• In their individual capacity where generally an arm’s length charge for services would need to be paid, for example: 

- using the staff, assets or equipment or under an insurance policy of their business or profession; 

- activities pursuant to a licence and/or qualification relating to their own business, profession or employment) for example a plumber or electrician who performs work on an investment property owned by their SMSF that can only be completed by a licenced tradesperson.

• In their capacity as the Trustee or Director, where generally there will be no requirement to charge for there services, for example: 

- performing bookkeeping or accounting services; 

- management of investment portfolios. 

Draft Taxation Determination TD 2023/D1

The ATO released TD 2023/D1 on 28 June 2023 outlining their views as to how the NALI and capital gains tax (CGT) provisions interact where a capital gain arises as a result of a non-arm’s length arrangement.

We summarise below the key takeaways from TD 2023/D1 below:

• At a high level, the net capital gain included in a Fund’s statutory income for the purposes of calculating the amount of NALI is calculated in the ordinary course per section 102-5 of the Income Tax Assessment Act 1997 (ITAA 1997); 
• Where a superannuation fund’s net capital gain in an income year is nil due to the application of current year and carried forward capital losses, the fund will have no amount of NALI;
• A capital gain caught under the NALI provisions will be caught where one or both of the following occur:

- The amount of the capital gain is more than the amount the Fund might have been expected to derive if the parties had been acting on arm’s length terms in relation to the scheme; or

- In gaining/producing the capital gain, NALE is incurred (including nil expenditure) in respect of the CGT asset that is less than the amount of a loss, outgoing or expense that the fund might have been expected to incur if the parties were dealing with each other on arm’s length terms, in relation to the scheme.

• The amount of NALI is determined by reference to the amount of the non-arm’s length capital gain, being the capital proceeds less the cost base arising from ‘the scheme’. The amount of NALI cannot exceed the Fund’s net capital gain calculated under ordinary provisions. Accordingly, the amount considered to be NALI is the lesser of:

- the ‘non-arm’s length capital gain’ (no discount or losses applied); or

- the net capital gain. 

Taxpayer Alert TA 2023/2 - Property Development

The ATO has highlighted in their recent Taxpayer Alert 2023/2 on 15 June 2023, some areas of concern they have identified in a number of arrangements, particularly relating to non-arm’s length arrangements where:

• One or more SMSFs have, or acquire, direct or indirect ownership of a special purpose vehicle (SPV), such as an unlisted company or unit trust, that undertakes a property development project, and
• Because of the non-arm’s length arrangements between the SPV and other entities, the SPV derives a profit that ultimately benefits the SMSF/s which is more than what it would have been if all the parties had dealt with each other at arm’s length.

The ATO’s primary concern in relation to these types of arrangements is the lack of commerciality which results in diverting profits attributable to a property development project to an SMSF at a concessionally taxed rate.

Other considerations

It is important to not only consider services provided by an individual trustee or director, but also those services provided by a related entity of an SMSF. In our experience, where no fee has been charged, based on the ATO’s guidelines within LCR 2021/2, the following expenses (though not a limited list) are likely to be classified as NALE:

• General bookkeeping and maintenance of management accounts;
• Collecting rental income from assets leased to related parties;
• Maintaining and managing the relationship with external advisors;
  
• Providing general administration and support services. 

It is therefore important to charge a fee and document the methodology used when related entities of an SMSF are providing these types of services.

How we can help

Health Check

• Free review of arrangements within an SMSF or SPV to determine if there is exposure risk to the NALI/NALE provisions. 
• Review of charges by a related entity of an SMSF providing general expense services. 
• This can be done via an initial consultation to discuss your personal circumstances, how the rules apply and potential strategies to mitigate unexpected adverse outcomes and can be held in person or via video conference. 

Planning and Advice

Following a review of arrangements where there is exposure risk to the NALI/NALE provisions, where it is determined that arrangements are not on arm’s length terms, we can provide an action plan to mitigate or reduce any exposure and bring arrangements onto arm’s length terms. 

Where there is a history of non-arm’s length dealings, we can work with you and the ATO to solve the problem.