SMSF arm’s-length rules, NALE and NALI explained

Problems arise if related parties transact on terms that are not at market value. That transaction would be in breach of the arm’s-length rule.

The Australian Taxation Office (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.

Non-arm’s-length income (NALI)

The concept of arm’s length may apply to certain income received by 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.

The ATO definition of non-arm’s-length income for SMSFs is as follows:

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“… income is NALI for a complying SMSF if it is derived from a scheme in which the parties weren’t dealing with each other at arm’s length, and more than the SMSF might have been expected to derive if the parties had been dealing with each other at arm’s length.”

There are, therefore, two key requirements that must be present for NALI to apply to SMSF income:

1. The SMSF and the other party to the transaction have not dealt with each other on arm’s-length terms; and
2. The income received by the SMSF is greater than the income that would have been received had the two parties acted on arm’s-length terms.

It is this second point that often causes the most confusion; the NALI rules, for tax purposes, seem to apply only when the SMSF income is more than it would otherwise be.

SISA rules vs tax rules

As mentioned above, tax law applies where a non-arm’s-length transaction takes place that results in a higher amount of SMSF income being earned. That income is then subject to NALI.

The arm’s-length rules under the superannuation legislation (SISA) apply to opposite arrangements and outcomes. They apply to non-arm’s-length transactions or arrangements where the terms are MORE favourable to the other party and not the SMSF. This results in the SMSF receiving less income than it should otherwise receive.

If we continue along with the previous example, but instead the rent received is below the market value rent for the SMSF property, it results in a superannuation compliance issue; a breach of SISA (section 109) that will, in most cases, need to be reported to the regulator by the fund’s auditor in their annual audit report.

Breaches of SISA can lead to financial penalties being imposed on the SMSF trustees personally and, in the case of more serious breaches, can result in the SMSF being deemed non-compliant.

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The specific wording of the super legislation around arm’s-length transactions is provided under SIS section 109:

(1) A trustee or investment manager of a superannuation entity must not invest in that capacity unless:

(a) The trustee or investment manager, as the case may be, and the other party to the relevant transaction are dealing with each other at arm’s length in respect of the transaction; or

(b) Both:

(i) The trustee or investment manager, as the case may be, and the other party to the relevant transaction are not dealing with each other at arm’s length in respect of the transaction; and

(ii) The terms and conditions of the transaction are no more favourable to the other party than those which it is reasonable to expect would apply if the trustee or investment manager, as the case may be, were dealing with the other party at arm’s length in the same circumstances.

It is also important to consider other issues or oversights that could result in non-arm’s-length outcomes, especially around the requirement for transactions and arrangements to not only be entered into on arm’s-length terms, but also be maintained at arm’s length.

If we continue with the previous example of the Jones family SMSF that owns and leases a commercial property to the members’ business. For the lease arrangement to be arm’s length, you would expect there to be an enforceable lease arrangement in place between the two parties.

In cases where no such lease exists or where the terms of the lease are not followed or enforced, it will often result in the arrangement being deemed non-arm’s-length.

The outcomes from this could be:

• If the SMSF is worse off due to the non-arm’s-length nature of the arrangement, then a breach of the SISA results. For example, rent remains unpaid for an extended period and the SMSF trustees fail to enforce the terms of the lease.
• If the SMSF is better off due to the non-arm’s-length nature of the arrangement, then additional NALI tax would be levied on the rental income.

Specific forms of NALI

There are specific examples of non-arm’s-length income for SMSFs set out in the Income Tax Assessment Act.

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These include:

1. Income received under a scheme where the parties to the transaction are not dealing at arm’s length, and the income is greater than it should otherwise be. This would also include income generated from transactions where the new, non-arm’s-length expenditure provisions are enlivened (see below).
2. Dividends received by an SMSF from holding shares in a private company where those dividend payments are not consistent with arm’s-length dealing. However, if the dividends are paid to the SMSF in accordance with the fund’s shareholding in that company and are paid in line with all other shareholders holding the same class of shares and according to the company’s constitution, you would not expect non-arm’s-length income to apply.
3. Trust income or distributions received by an SMSF from a trust where the SMSF does not hold a fixed entitlement in that trust. This would usually relate to distributions received from a discretionary trust or family trust. As the SMSF holds no financial interest in that trust, it should not be in receipt of any income paid from that trust.
4. Trust income or distributions received by an SMSF from a trust where the SMSF does hold a fixed entitlement in the trust, for instance, a unit trust, but where the distributions paid to the SMSF are greater than they would otherwise be in an arm’s-length arrangement.

How to avoid NALI

Most NALI issues, whether they are a tax or SIS issue, arise from dealings or transactions where SMSF trustees seek to gain an advantage either personally or for their fund. By doing so, trustees run the risk of either additional tax being levied or serious compliance action.

In most cases, SMSF trustees can avoid the issues associated with non-arm’s-length income simply by making sure that all fund transactions occur as they otherwise would when dealing with an unrelated person or business and maintaining as much evidence as possible to show how the terms of all their fund’s transactions have been determined.

It is advisable for SMSF trustees to engage with independent, professional service providers where there is any doubt over what an arm’s-length dealing should look like. For instance, obtaining a market-value appraisal for rental income from property owned by the SMSF.

This evidence can go a long way in proving to the fund’s auditor and, in some cases, the ATO as the SMSF regulator, that the trustees’ intentions were in line with both superannuation and taxation law.

Non-arm’s-length expenditure (NALE)

As mentioned above, the requirement to transact on arm’s-length terms applies to both income and expense transactions within a super fund; that is, the non-arm’s-length rules also need to be considered when an SMSF incurs an expense.

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).

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 an 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 resulted in the final legislation being signed off in June 2024 with a 1 July 2024 commencement date.

The explanatory memorandum to these laws states:

“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 after 1 July 2018, then it would be a good idea to raise this with your SMSF administrator or fund accountant.

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.

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.