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One of the key requirements for self-managed super fund (SMSF) trustees is to ensure all their fund transactions are entered into and maintained on an arm’s-length basis.
Failing to meet this requirement can result in your SMSF losing its concessional tax treatment and relevant income being taxed at the highest marginal rate of 45%. It can also lead to serious compliance breaches.
Non-arm’s-length income (NALI) has become a hot topic for SMSFs in recent times, and a major focus area for the ATO, with the release of updated compliance guides and rulings.
This article will focus on the receipt of income aspect of the NALI rules and the key issues for SMSF trustees to consider, rather than issues relating to non-arm’s-length expenditure (NALE) within an SMSF.
Background to non-arm’s-length income
The ATO definition of non-arm’s-length income for SMSFs is as follows:
“… income is NALI for a complying SMSF if it is derived from a scheme in which the parties weren’t dealing with each other at arm’s length, and more than the SMSF might have been expected to derive if the parties had been dealing with each other at arm’s length.”
There are, therefore, two key requirements that must be present for NALI to apply to SMSF income:
- The SMSF and the other party to the transaction have not dealt with each other on arm’s-length terms; and
- The income received by the SMSF is greater than the income that would have been received had the two parties acted on arm’s-length terms.
It is this second point that often causes the most confusion; that the NALI rules, for tax purposes, seem to apply only when the SMSF income is MORE than it would otherwise be.
But what happens when the income received by an SMSF is less than it should receive in an arm’s-length dealing? For instance, what if the rent received by the SMSF from a related party tenant is below the market value rent for the SMSF property?
To get a better understanding of this issue, we need to look at the difference between the application of taxation law and superannuation law (the Superannuation Industry Supervision Act, or SISA).
Super (SISA) vs tax
As mentioned above, taxation law applies where a non-arm’s-length transaction takes place that results in a higher amount of SMSF income being earned. That income is then subject to NALI.
The arm’s-length rules under the superannuation legislation (SISA) apply to opposite arrangements and outcomes. They apply to non-arm’s-length transactions or arrangements where the terms are MORE favourable to the other party and not the SMSF. This results in the SMSF receiving less income than it should otherwise receive.
If we continue along with the previous example, but instead the rent received is below the market value rent for the SMSF property, it results in a superannuation compliance issue; a breach of SISA (section 109) that will in most cases need to be reported to the regulator by the funds auditor in their annual audit report.
Breaches of SISA can lead to financial penalties being imposed on the SMSF trustees personally and, in the case of more serious breaches, can result in the SMSF being deemed non-complying.
The specific wording of the superannuation legislation around arm’s-length transactions is provided under SIS section 109:
(ii) The terms and conditions of the transaction are no more favourable to the other party than those which it is reasonable to expect would apply if the trustee or investment manager, as the case may be, were dealing with the other party at arm’s length in the same circumstances.
It is also important to consider other issues or oversights that could result in non-arm’-length outcomes, especially around the requirement for transactions and arrangements to not only be entered into on arm’s-length terms, but also be maintained on arm’s-length terms.
If we continue with the previous example of the Jones family SMSF that owns and leases a commercial property to the members’ business. For the lease arrangement to be arm’s length, you would expect there to be an enforceable lease arrangement in place between the two parties.
In cases where no such lease exists or where the terms of the lease are not followed or enforced, it will often result in the arrangement being deemed non-arm’s length.
The outcomes from this could be:
- If the SMSF is worse off due to the non-arm’s-length nature of the arrangement, then a breach of the SISA results. For example, rent remains unpaid for an extended period and the SMSF trustees fail to enforce the terms of the lease.
- If the SMSF is better off due to the non-arm’s-length nature of the arrangement, then additional NALI tax would be levied on the rental income.
Specific forms of NALI
There are specific examples of non-arm’s-length income for SMSFs set out in the Income Tax Assessment Act.
- Income received under a scheme where the parties to the transaction are not dealing at arm’s length and the income is greater than it should otherwise be. This would also include income generated from transactions where the new, non-arm’s-length expenditure provisions are enlivened.
- Dividends received by an SMSF from holding shares in a private company where those dividend payments are not consistent with an arm’s-length dealing. However, if the dividends are paid to the SMSF in accordance with the fund’s shareholding in that company and are paid in line with all other shareholders holding the same class of shares and according to the company’s constitution, you would not expect non-arm’s-length income to apply.
- Trust income or distributions received by an SMSF from a trust where the SMSF does not hold a fixed entitlement in that trust. This would usually relate to distributions received from a discretionary trust or family trust. As the SMSF holds no financial interest in that trust, it should not be in receipt of any income paid from that trust.
- Trust income or distributions received by an SMSF from a trust where the SMSF does hold a fixed entitlement in the trust, for instance a unit trust, but where the distributions paid to the SMSF are greater than they would otherwise be in an arm’s-length arrangement.
How to avoid NALI
Most NALI issues, whether they are a tax or SIS issue, arise from dealings or transactions where SMSF trustees seek to gain an advantage either personally or for their fund. By doing so, trustees run the risk of either additional tax being levied or serious compliance action.
In most cases, SMSF trustees can avoid the issues associated with non-arm’s-length income. Simply by making sure that all fund transactions occur as they otherwise would when dealing with an unrelated person or business and maintaining as much evidence as possible to show how the terms of all their fund’s transactions have been determined.
It is advisable for SMSF trustees to engage with independent, professional service providers where there is any doubt over what an arm’s-length dealing should look like. For instance, obtaining a market value appraisal for rental income for property owned by the SMSF.
This evidence can go a long way in proving to the fund’s auditor and, in some cases, the ATO as the SMSF regulator, that the trustees’ intentions were in line with both superannuation and taxation law.
The application of the non-arm’s-length rules will continue to be a key focus area for those tasked with SMSF compliance.
This means SMSF trustees need to be careful that all dealings, especially with related parties of the fund, clearly show an arm’s-length arrangement and that evidence is obtained and maintained to prove this, should it ever be needed.