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SMSF trustees should be familiar with, and understand, the requirement that all transactions their self-managed superannuation fund undertakes need to be at ‘arm’s length’. When income accrued to an SMSF is not at arm’s length – for example rent received by an SMSF 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 and recent changes to regulations that SMSFs need to be aware of, you can read our article here.
But as part of those recent changes to the legislation there are some proposed interpretations of non-arm’s length expenditure (NALE) that could have big ramifications for some SMSFs and trustees that perform services for their SMSFs.
What is NALE?
Like NALI, non-arm’s length expenditure 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 completed their SMSFs accounts but the SMSF was not required to pay for them (i.e. it was a free service).
What has changed?
The ATO released a draft companion ruling last October that highlights how recent 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.
Practising accountants who prepare the accounts for their own SMSFs may now be required to charge for their services in certain situations. These situations will depend on whether or not the SMSF trustee is using their company’s premises and resources.
Draft Law Companion Ruling LCR 2019/D3 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, in the above example, our SMSF trustee had used her tax agent registration or employment premises at no charge to her SMSF it could have been a very different story and may impact the entire income of the SMSF.
The draft LCR 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 fund. The accounting firm does not charge the fund for those services.
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 the ordinary and statutory income derived by the SMSF for the 2020–21 income year. As such, all 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%.
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 may 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 if the trustee uses the assets of the external business to conduct the service or not. Here is an example from the LCR:
“[Sharon] utilises the equipment and assets of her business (including the business’ website) in performing these services. Her actions are covered by the applicable insurance policies in respect of the business. Accordingly, Sharon provides property management services in her individual capacity to the SMSF with respect to the residential property. She charges the SMSF 50% of the price for her services that she would otherwise charge a non-related party.
“The price Sharon charges the SMSF constitutes a non-arm’s length dealing between the SMSF 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 the fund by using the workshop owned by his 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.
As it is still a draft ruling, the interpretation of the legislation for NALE may change. However, in its current form, there are big ramifications for SMSFs if any provisions of services are not conducted at arm’s-length and it would be better for SMSF trustees to be safe, rather than sorry.