The arm’s length rule for SMSFs

In this guide

Which SMSF transactions are affected?
The rules around related parties
Assessing an asset’s market value
Non-arm’s length income and expenditure
The bottom line

If you are a trustee of your own self-managed super fund, you’ve probably heard of the ‘arm’s length’ rule.

The concept of ‘arm’s length’ is familiar to businesses the world over. To ensure business transactions are conducted at commercial market values buyers and sellers must act independently, without colluding and without one party influencing the other.

So how does this concept apply to your SMSF?

Broadly speaking, any investments by an SMSF must be made and maintained on an arm’s length basis. That is, all transactions must be conducted at commercial market rates. Buyers and sellers must act independently.

Which SMSF transactions are affected?

SMSFs must ensure that all their investments must be conducted and maintained at arm’s length, including:

Asset acquisitions
Asset sales
Investment returns
Borrowing/loan arrangements at commercial rates of interest.

This is not as straightforward as it might seem, given that many SMSFs are family affairs. They are also popular with small business owners who may own and lease back business property in their fund. The arm’s length rules around transactions involving these ‘related parties’ are strict.

Some of the biggest challenges for SMSF trustees regarding the arm’s length requirements are the rules about related parties. A related party is not just a relative or another member of your SMSF, it includes any of the following associates:

The relatives of each member
The business partners of each member
Any spouse or child of those business partners
Any company that the member or their associates control or influence
Any trust that the member or their associates control
An employer who contributes to the SMSF for the benefit of a member, under an arrangement between the employer and the trustee of the SMSF

Assessing an asset’s market value

Problems arise if related parties sell an asset to an SMSF at below market value. That transaction would be in breach of the arm’s length rule.

An example

John and Elaine own an investment property – a small apartment – through their SMSF. They receive an offer on the apartment from an unrelated party at market value, but they reject the offer. They want to help their daughter Jessica by selling her the apartment at a much lower price, but they are advised this would be in breach of the arm’s length rules.

The ATO provides valuation guidelines for SMSF assets to help you comply with the arm’s length requirements if your fund is buying or selling assets from or to related parties. These guidelines are summarised in the table below.

Asset	Valuation requirement
Collectables and personal use assets when sold or transferred to a related party.	The market value of these assets must be determined by a qualified independent valuer.
Transfers of other assets (excluding collectables and personal use assets) between related or unrelated SMSF parties.	All acquisitions and disposals must be made at market value, based on objective data.

Non-arm’s length income and expenditure

The concept of arm’s length may also apply to some types of income in your fund. Any income earned through your SMSF by activities conducted on a non-arm’s length basis is called non-arm’s length income (NALI) and is taxed at the highest marginal rate (45%) instead of the usual 15% concessional superannuation rate.

NALI originally applied to income or capital gains greater than would be the case in an arms-length transaction. But amendments to the law in 2018 included as NALI income or capital gains where fund expenses incurred in producing the income or gains are less than arm’s length amounts. Just to confuse matters, these expenses are referred to as non-arm’s length expenditure, or NALE.

Need to know

In October 2019 the ATO released a draft companion ruling that explained how these amendments may impact SMSF trustees who conduct services for their funds. In July 2021 the ATO further clarified these changes. The final 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.

Trustees who provide services to their SMSF are now required to charge for those services in certain situations. Get it wrong and all your fund’s income may be deemed NALI and punitive tax rates applied.

The upshot is that non-arm’s length income or expenditure means your SMSF is not allowed to invest or conduct business in a way that favours the SMSF.

Learn more about NALI and NALE.

The following case study from the ATO highlights the dangers of non-arm’s length transactions involving limited recourse borrowing arrangements (LRBAs).

Case study

David and Claire are keen property investors and have been quite successful in buying and selling properties over the years. Through a property investment club in which they are members, they learn that 15% concessional tax rates apply to income earned from investment properties purchased and maintained through an SMSF.

What is the scheme?

Doug, a fellow member of the property investment club, contacts David and Claire and explains he is an expert who has helped many members of the club buy investment properties through an SMSF.

David and Claire establish an SMSF and rollover their retirement benefits into the new fund. However, the money they roll over isn’t enough to purchase the investment property. On the advice of Doug, David and Claire approach their bank for a loan to buy a rental property through their SMSF using a limited recourse borrowing arrangement (LRBA).

Their bank is happy to approve the loan, however David and Claire are unhappy with the terms of the loan. Doug advises that given they have the necessary money held outside of superannuation they could lend this money to their super fund by setting up an LRBA, instead of using a bank.

Under the LRBA, David and Claire loan the SMSF 100% of the principal over a 15-year term; and the trustee of the SMSF is required to make periodic (monthly) repayments of the loan principal with the first repayment made five years after the loan is established. The interest rate applied to the loan was zero.

What happens as a result?

David and Claire’s accountant prepares their individual and SMSF tax returns each year. The accountant informs them he has some concerns with this LRBA under tax and super laws, and that he will consult with the ATO for further clarification.

The ATO advises that the arrangement is a non-arm’s length LRBA. Accordingly, all income from the asset will be considered to be non-arm’s length income and, as a consequence, all the rental income received by the SMSF will be taxed at 45%. The non-arm’s length interest expenditure incurred under the LRBA will also result in any capital gain that might arise from a subsequent capital gains tax (CGT) event happening in relation to the property (such as a disposal of the property) being NALI and taxed at 47%.

David and Claire decide to refinance their rental property investment through a bank and dissolve the non-arm’s length LRBA (avoiding the 47% tax rate) with future rental income taxed at the SMSF concessional rate.

It’s a complex area so to check which factors determine whether income is non-arm’s length, see the ATO website or seek professional advice.

The bottom line

It’s important to ensure that all your SMSF transactions are arm’s length dealings to ensure your compliance with Australian superannuation legislation. The ATO can impose a range of penalties for non-compliance, depending on the seriousness of the breach.

The information contained in this article is general in nature.