Superannuation update: Non-arm’s Length Expenses (August 2021)

The long awaited finalisation of the ATO’s non-arm’s length expense (NALE) ruling, LCR 2021/2  was released on Wednesday, 28th July 2021 and sets out the ATO’s view on how they will apply and enforce the changes to s.295-550 Income Tax Assessment Act 1997 that were enacted back in October 2019.

These changes look to impose upon a superannuation fund (Fund), the top marginal rate of tax of 45% on a portion, or in some instances on all of its income, where the parties (including the Fund) under a scheme, are not dealing with each other at arm’s length and as a result, a loss, outgoing or expenditure is less than it ought to be. In those circumstances, the Fund has derived non-arm’s length income (NALI).

The ATO classifies these expenses into two broad categories:

• Expenses which have a sufficient nexus to a specific asset, for example a property expense; or

• Expenses which have a sufficient nexus to all of the ordinary and/or statutory income of the Fund, for example actuarial costs, accounting fees, audit fees or investment advisor fees.

To illustrate how these will be applied, the ATO have included quite a number of examples in their ruling. It is also important to note that some of their examples can also include those services provided by a Fund’s trustee.

For expenses linked to a specific asset a few of the examples are:

• If an asset, for example a property, is acquired by an SMSF from a related party, for an amount that is less than market value, then even if the property is leased on commercial terms, all of the rental income each year and any eventual capital gain on disposal of the property will be NALI (this is a change to their previous stance where the market value shortfall would likely have been treated as a contribution and so TR 2010/1 has also been updated to match this position);

• If a property, for example, is purchased under a related party Limited Recourse Borrowing Arrangement (LRBA) with non-arm’s length terms, such as a lower interest rate than the approved benchmark rate or the lack of regular monthly repayments, then similar to the above example the annual rental income and any eventual capital gain will NALI and importantly will continue to be NALI even if the LRBA was refinanced to become arm’s length, meaning the asset will be forever tainted.

• The trustee and member of a fund is a plumber by trade. They use their tools of trade to repair a leaky tap in a rental property owned by the SMSF and do not charge for this service. As this is minor, infrequent and irregular in nature, NALI would not apply.

• If instead, the plumber undertakes a full renovation of the bathroom in this rental property, and does the work themselves with no fee charged for this service this will not be considered minor or infrequent. As  a result all of the rental income going forward on this property would be NALI along with any eventual capital gain from the sale of the property.

• The trustee and member is a licenced electrician by trade. Even if the work is minor or infrequent, any work undertaken by them and not charged at a commercial rate in respect to the rental property, would create NALI on both the rental income and eventual capital gain, due to the requirement for that work to be undertaken by someone holding the appropriate license and/or insurance.

For expenses relating to all of the income of the Fund, the ATO’s examples include:

• A partner in an accounting firm engages their firm to prepare the accounts and tax return for the SMSF and the firm doesn’t charge for these services. In this instance, all of the income of the Fund will be NALI, and will continue to be NALI each year until rectified as the expense relates to all of the assets of the fund.

• If instead, the firm charges their services to the SMSF at a discount rate which is offered to all staff, then NALI would no longer apply.

• A partner in an accounting firm prepares the accounts and tax return personally themselves. They do not use the firm's equipment, nor is it lodged by the firm using their tax agent registration. NALI would not apply as the services provided are in the capacity as trustee of the Fund. This would still be the case, even if the use of the firm’s equipment, such as a laptop, was minor and incidental in nature.

For those SMSFs that are part of a family office, it is quite common for families to utilise their family office staff to assist with the running of the Fund, whether it be preparing BAS statements, trial balances, managing properties or investments, and we generally see that where these arrangements exist, there is either no or a below market fee charged to the Fund for these services. As these new rules will now capture these services, it is imperative that all family office arrangements be reviewed.

It is also important to remember that these rules also apply to unit trusts in which a Fund holds a fixed entitlement. So similarly, where that trust has undertaken non-arm’s length dealings resulting in a loss, outgoing or expenditure being lower that it ought to be, the entirety of the distribution paid from that trust to the Fund in that year, will be NALI.

Although these rules apply in relation to income earned by the Fund from 1 July 2018, the ATO have noted that they will only apply compliance resources from 1 July 2022 for those expenses of a general nature (PCG 2020/5) or to ascertain whether parties have made a reasonable attempt to determine an arm’s length amount for services performed by an SMSF trustee or a director of the trustee company, in their personal capacity. Importantly, no similar relief has been offered in respect to expenses relating to a specific asset of the Fund.

So what should you be thinking about and what actions need to be taken:

• Review all expenses that are currently being paid by the Fund or any associated unit trust. Are there any expenses that the Fund or unit trust is not currently paying or is not paying market value for?

• What duties might the trustee be undertaking on behalf of the Fund. Would any of these be minor, infrequent or irregular or involve the use of a license held by them individually?

• Is the trustee using their business or employer to provide services to the Fund or related trust at a lower than market rate, or is this a service offered widely to all employees of the organisation?

• Is the Fund part of a family office, and if so are all of the services provided to the Fund or related unit trust charged at a commercial market rate?

• Ensure all acquisition of assets are undertaken on an arm’s length commercial basis, including any associated LRBA financing arrangements. Remember once broken, it can’t be fixed.