In this guide
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).
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 28th June 2024 with a 1 July 2024 commencement date.
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.
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.
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