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One of the many rules SMSF trustees need to be aware of is the requirement that all their self-managed superannuation fund’s transactions need to be at ‘arm’s length’.
When income accrued to an SMSF is not at arm’s length – for example rent received that is below market rates – this is called non-arm’s length income or NALI and is taxed at 45%.
For a detailed explanation of NALI you can read our article here.
What you may not have been aware of is that your SMSF’s expenses are also considered when determining whether your SMSF’s income is to be taxed as NALI.
Yes, it’s complicated, but the ATO recently clarified its position to clear up some of the confusion.
NALE and NALI rules clarified
The Australian Taxation Office (ATO) has released its final ruling on Non-arm’s length income – expenditure incurred under a non-arm’s length arrangement. It also clarified how amendments to Section 295–550 of the Income Tax Assessment Act 1997 (ITAA 1997) need to be interpreted for the purposes of non-arm’s length expenditure (NALE).
The ruling has implications for professionals such as accountants and real estate agents who perform services for their own SMSF on a non-arm’s length basis. Get it wrong, and all your fund’s income may be deemed NALI and punitive tax rates applied.
What is NALE?
Like NALI, non-arm’s length expenditure (NALE) is expenditure from an SMSF that is not at arm’s length. For example, when an accountant has their own SMSF and does the SMSF’s accounts at a discount, or the SMSF has purchased an investment at less than its market value.
NALE also occurs when there is no expenditure, which would be the case if an accountant engaged their firm to complete their SMSF’s accounts but the SMSF was not charged for the service (i.e. it was a free service).
What has changed?
In October 2019 the ATO released a draft companion ruling that explained how amendments to the Income Tax Assessment Act 1997 – as part of the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 – may impact SMSF trustees who conduct services for their funds. In July 2021 the ATO further clarified these changes with the release of final ruling LCR 2021/2.
Trustees who provide services to their SMSF will now be required to charge for those services in certain situations. These situations will depend on whether or not the SMSF trustee is using their company’s premises and resources.
If they don’t charge for their services, they could have all of their fund’s income declared as NALI and taxed at 45%.
“For example, the non-arm’s length expenditure provisions will apply where a trustee (being an accountant by profession) contracts the bookkeeping or accounting services to their accounting firm, which charges non-arm’s length rates,” Law Companion Ruling LCR 2021/2 states.
Law Companion ruling LCR 2021/2 uses an example in which a trustee of an SMSF is also its sole member. She is a chartered accountant and registered tax agent who is employed in an accounting and tax agent business.
If she prepares the SMSF’s accounts and annual return of the fund in her capacity as a trustee, and does not use the equipment or assets of her employer, nor lodges the annual return using her tax agent registration, she does not need to charge for the work. In this case, the non-arm’s length expenditure provisions do not apply, as the accounts have been prepared in the member’s capacity as trustee, rather than under an arrangement in which parties are dealing with one another on a non-arm’s length basis.
How NALE could impact fund income
However, if the accountant and SMSF trustee in the example above had used her tax agent registration or employment premises at no charge to her SMSF, it could impact the entire income of the SMSF.
LCR 2021/2 uses the following example to illustrate what could happen.
For the 2020–21 income year, Mikasa – as trustee of her SMSF – engages an accounting firm, where she is a partner, to provide accounting services for the SMSF. The accounting services include services other than those relating to, complying with or managing the SMSF’s income tax affairs and obligations. The accounting firm does not charge the SMSF for those services as a result of non-arm’s length dealings between the parties (and not as part of any discount policy referred to in paragraph 51 of this Ruling).
For the purposes of subsection 295–550(1), the scheme involves the SMSF acquiring the accounting services under a non-arm’s length arrangement. The non-arm’s length expenditure (being the nil amount incurred for the services) has a sufficient nexus with all of the ordinary and statutory income derived by the SMSF for the 2020–21 income year. As such, all of the SMSF’s income for the 2020–21 income year is NALI.
This means all the fund’s income would be taxed at the highest marginal rate of 45% instead of the concessional superannuation rate of 15%.
However, LCR 2021/2 provides the following further clarification:
Subsection 295–550(1) would cease to apply if the arrangement changes for the 2021–22 income year so that the SMSF incurs expenditure for the accounting services provided by the accounting firm of an amount that would have been expected to be incurred where the parties were acting at arm’s length. In this situation, none of the SMSF’s income for the 2021–22 income year is NALI.
Service providers that could be impacted
Real estate agents who are also members of SMSFs may like to use their knowledge of the property market to acquire property for their SMSF. But they need to be careful how they do this, or how they provide property management services to their SMSF, if they do not want income from the property asset to be declared NALI.
The LCR uses the example of a trustee and sole member of an SMSF who is also a licensed real estate agent running a real estate business. The trustee’s SMSF assets include a property, which has been purchased by the trustee. The trustee’s business includes property management services for rental properties and the business manages the SMSF’s property. Even if the SMSF charges commercial rates of rent for the property it holds but doesn’t pay a market rate for the property management services, the income from that asset may be NALI for each income year that arrangement is in place.
Whether this occurs hinges on whether the trustee uses the assets of the external business to conduct the service or not. Here is an example from the LCR:
Sharon is a director of the corporate trustee of an SMSF of which she is the sole member. She is a licensed real estate agent and is the director of Ringo Real Estate Pty Ltd, which conducts a real estate business, including property management services for rental properties. The SMSF holds a residential property, which it leases for a commercial rate of rent. Sharon provides property management services to the SMSF as a licenced real estate agent. She utilises the equipment and assets of Ringo Real Estate Pty Ltd (including the business’ website) in performing these services. Her actions are covered by the applicable insurance policies in respect of Ringo Real Estate Pty Ltd. Accordingly, Sharon provides property management services in her individual capacity to the SMSF with respect to the residential property. Ringo Real Estate Pty Ltd does not have a discount policy referred to in paragraph 51 of this Ruling. She charges the SMSF 50% of the price for her services that Ringo Real Estate Pty Ltd would otherwise charge a party.
For the purposes of subsection 295–550(1), the scheme involves the SMSF obtaining the services from Sharon and deriving the rental income. The price charged to the SMSF constitutes a non-arm’s length dealing between the SMSF, Ringo Real Estate Pty Ltd and Sharon, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme.
In this situation the ATO says there is ‘sufficient nexus’ between the NALE and the rental income derived from the residential property. The rental income will therefore be NALI for each income year the non-arm’s length dealing remains in place.
Anyone who provides their services to their SMSF at less than an arm’s length commercial basis could be caught up in these changes.
For example, a tradie who works at no cost to repair a property owned by their SMSF by using the workshop owned by their business could also end up having income from that property declared as NALI.
It could even impact lawyers who use the facilities of their law firm to provide an amended trust deed for no cost to their fund.
The final ruling has provided some important clarifications around what services are deemed non-arm’s length for NALE purposes – for example, a financial planner making investments for their own SMSF using a home computer also used in their business and not charging for their services to the SMSF, would not be considered NALE.
But SMSF trustees providing any kind of service similar to their line of work to their SMSF need to be across these changes or they could be up for a much higher tax rate on any income declared non-arm’s length as a result of the arrangement.