Non-arm’s length expenditure: NALE

On this page

Background to NALE
What transactions can cause NALE?
General fund expenses
Specific fund expenses
Application of the NALE rules
The bottom line

SMSF trustees are often reminded of the need to ensure that all their fund’s transactions are done at ‘arm’s length’.

Trustees are also often told that failure to comply with this requirement can lead to some unwanted outcomes, including tax being applied to the fund’s income at the top 45% rate of tax.

This income is referred to as non-arm’s length income or NALI.

It can also result in breaches of the SIS Act that can result in the SMSF becoming non-compliant.

However, many SMSF trustees are not aware that their SMSF’s expenses are also considered when determining whether their SMSF’s income is to be taxed as non-arm’s length income. That is, the requirement to transact on arm’s length terms applies to both income and expense transactions within the super fund.

So where an expense transaction is entered into on terms that are not at arm’s length (NALE), it can result in any income that is generated as a result of that transaction being caught as non-arm’s length income (NALI).

Learn more about the non-arm’s length income (NALI) rules for SMSFs.

Background to NALE

In October 2019, the ATO released a draft ruling on how certain changes to the tax rules could impact SMSF trustees who provide certain services to their own SMSF.

In particular, the ruling looked at arrangements where the SMSF was charged below market rates for these services or not charged at all.

Then in July 2021 the ATO further clarified these changes with the release of a law companion ruling, LCR 2021/2. The upshot of these changes is that SMSF trustees who provide non-trustee services to their SMSF will now be required to charge for those services.

“For example, the non-arm’s length expenditure provisions will apply where a trustee (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.)

If they don’t charge for their services, they could have all their fund’s income declared as NALI and taxed at 45%.

The SMSF industry lobby has raised concerns that by not charging for a service that would have cost minimal fees anyway (for example, in the case of accounting services), a fund could be penalised thousands of dollars if the income of its entire fund is taxed at the higher rate.

It therefore became apparent that there was a clear need for the government to provide more detailed information on:

When a non-arm’s length expense of an SMSF would be seen to be a general expense and result in all income being deemed NALI
When a non-arm’s length expense of a SMSF would be seen to be a specific expense and result in only income from that event being deemed NALI.

In response, the former federal government promised in March 2022 that it would “make legislative changes to ensure the non-arm’s length expense provisions operate as envisaged.”

To achieve this outcome, the Albanese Government has sought consultation from the superannuation industry on these NALE rules. This consultation period began on 19 June 2023 and closes on the 7 July.

What transactions can cause NALE?

Further details were provided on the proposed application of the NALE rules by the government in a recent exposure draft release in June 2023.

The following information clarifies the way in which the NALE rules are intended to apply and differentiates between a general fund expense and a specific fund expense.

General fund expenses

A general expense will be an expense that is not related to gaining or producing income from a particular asset of the fund.

Examples of general fund expenses would include:

Actuarial fees, accounting fees and auditor fees
Administration costs in managing the SMSF
Investment adviser fees where those fees relate generally to the operation of the fund and not to a specific investment or a particular pool of investments.

The amount of income that will be taxed as NALI will be twice the difference between the amount of the expense that should have been incurred had the parties been dealing at arm’s length, and the amount the entity did incur.

Where the entity did not incur any expense, the amount of income that will be taxed as non-arm’s length income will be twice the amount that might have been expected to be incurred had the parties been dealing at arm’s length.

The following example is provided in the Explanatory Memorandum.

Example 1

Al is the sole trustee of their SMSF of which they are the sole member.

Al is an accountant and provides general accounting services worth $3,000 to their SMSF, which the SMSF acquires free of charge.

The acquisition of accounting services by the SMSF constitutes a scheme between Al and their SMSF in which the parties were not dealing with each other at arm’s length, and no expense was incurred when the SMSF would have been expected to have incurred an expense in respect of its acquisition had the parties been at arm’s length, so the non-arm’s length expenditure provisions apply.

The accounting services were general in nature and did not relate to any particular asset or assets so are a general non-arm’s length expense captured under subsection 295-550(9).

The total income of the SMSF in 2023–24 is $20,000 in rent from a rental property to which $5,000 in eligible deductions for maintenance apply, resulting in a taxable income in 2023–24 of $15,000. No assessable contributions were made in that income year.

As no expense was incurred towards the general accounting services, the amount of non-arm’s length income will be twice the amount that might have been expected to have been incurred, or twice the $3,000 value of the services which is $6,000.

Applying the cap on the total non-arm’s length component, the cap amount is the total of income other than assessable contributions, minus deductions other than deductions against assessable contributions. In this case, the cap is the $20,000 in rental income minus the $5,000 in deductions against that rental income, giving $15,000.

As the cap on the total non-arm’s length component is higher than the non-arm’s length component arrived at above, the non-arm’s length component remains at $6,000 to be taxed at the highest marginal rate. This leaves a low-tax component of $9,000. The low tax component is any remaining taxable income after calculating the non-arm’s length component.

Specific fund expenses

A specific expense will be any other expense that is incurred as part of a scheme where entities are not dealing with each other at arm’s length, where the expense is less than it should have been, and that expense is in relation to a particular asset or assets.

Examples of specific fund expenses would include:

Maintenance expenses for a rental property
Investment advice fees for a particular pool of investments
A limited recourse borrowing arrangement for the purchase of a specific asset
The purchase of an asset such as a rental property or shares.

For specific expenses, the existing treatment will continue to apply, and the amount of income that will be taxed as non-arm’s length income will be the amount of income derived.

That is, where a specific expense is incurred because of a scheme in which the parties are not dealing with each other at arm’s length, the amount of NALI will include all of the ordinary or statutory income that results from the scheme.

Take the example of an SMSF that acquires shares in a listed entity from a related party but does not pay the market price for those shares; the amount paid is not at arm’s length.

All income, such as dividends from those shares would be caught as NALI as the expense to acquire those assets was not entered into on arm’s length terms.

Any capital gain realised on the sale of those shares would also be treated as non-arm’s length income.

Application of the NALE rules

At this stage, these changes will apply to income derived by SMSFs in the 2023–24 income year or a later income year, and expenses incurred or expected to have been incurred on or after 1 July 2023.

There may be some changes to this after the industry consultation.

The bottom line

The easiest way to avoid the NALE and NALI issues is to ensure that you transact with your SMSF as you would with any other unrelated party.

Trying to gain an unfair advantage when dealing with your SMSF will almost always result in a nasty tax outcome and can often lead to other severe compliance outcomes.