Non-arm’s length expenditure (NALE) rules for SMSFs

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Background to NALE
What transactions can cause NALE?
General fund expenses
Specific fund expenses
The bottom line

Legislation that was initially introduced into Parliament 5 years ago has only just been finalised and has now become law. These laws relate to the tax treatment of non-arm’s length income and expenses for self-managed super funds and apply retrospectively from 1 July 2018.

SMSF trustees are often reminded of the need to ensure that all their fund’s transactions are entered into and carried out 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.

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.

Important: The non-arm’s length expense rules can apply in two scenarios:

where an SMSF expense is incurred for an amount that is less than might have been expected to be incurred if the parties had been dealing at arm’s length, and
where no SMSF expense is incurred but an expense might have been expected to be incurred had the parties been dealing at arm’s length.

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.)

This ruling proposed that where the related entity didn’t charge for their services or did not charge an arm’s length rate, then all of their SMSF’s income could be 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 sought consultation from the superannuation industry on these NALE rules which, after a lengthy delay, has led to the final legislation being signed off on the 28^thJune 2024 with a 1 July 2024 commencement date.

Important: Although the new non-arm’s length expenses (NALE) legislation commenced on 1 July 2024, these rules have application from 1 July 2018.

As per the explanatory memorandum to these laws:

“These changes apply to the 2018-19 income year and later income years and to expenses incurred or expected to have been incurred on or after 1 July 2018. This retrospectivity ensures that the benefits of the amendments apply from the date the non-arm’s length expenses rules were first introduced.

As these changes are to the benefit of taxpayers compared with the 2018-19 amendments this retrospectivity does not disadvantage any taxpayers.”

If you are concerned with any transaction that your SMSF may have entered into post 1 July 2018, then it would be a good idea to raise this with your SMSF administrator or fund accountant.

Read more about getting ATO advice for your SMSF.

What transactions can cause NALE?

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.

For general expenses, the amount of income that is taxed as non-arm’s length income is limited to twice the difference between the amount of the expense that would have been expected to have been incurred and the amount of the expense actually incurred.

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 director of Purple Co. Purple Co is the corporate trustee of an SMSF of which Al is the sole member. Al, through his accounting firm Al Accountants, provides general accounting services to his SMSF in circumstances such that these services are provided in a capacity other than as a trustee and meet the other requirements of section 17B of the SIS Act. Although Al’s accounting firm charges his clients $3,000 for these types of services, his SMSF acquires the services 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.

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.