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ATO clarifies ‘nexus’ between SMSF non-arm’s length income and expenses

If you are in a qualified profession or trade, it is important that to be aware of the Australian Taxation Office’s Self-Managed Super Fund (SMSF) rules that may impact you.

Under Australian tax law, all Self-Managed Super Fund (SMSF) dealings must be at ‘arm’s length’.

That is, individuals and entities must deal with each other on a commercial, unrelated-party basis.

Arm’s length dealings help ensure the purchase and sale price of SMSF assets, for example, reflect the fair market value of the assets.

SMSF dealings that result in more income than would be expected in an arm’s length transaction or arrangement is deemed to be non-arm’s length income (NALI).

Examples include a trustee loaning money to their SMSF at 0% interest or leasing commercial premises from their SMSF at above market rates.

NALI is used by some individuals to try to increase their superannuation savings in a way that’s not caught by the super contribution caps and to minimise their tax liability.

The federal government penalises it by taxing the non-arm’s length component of a fund’s income, including any capital gains, at the top marginal rate of 45% (rather than the usual concessional rate of 15%).

ATO clarification

Recently, the Australian Taxation Office (ATO) clarified its interpretation of amendments made to the NALI laws on 2 October 2019 (and which were backdated to 1 July 2018).

Those amendments were designed to ensure that where an SMSF incurs non-arm’s length expenses to earn or produce income, that income is considered NALI.

(These expenses include losses, outgoings and expenditure, and can be of a capital or revenue nature.)

Some SMSF trustees, though, remained unsure about whether services they provide to their fund in their individual capacity, for example, are considered arm’s length.

In late-July the ATO clarified that SMSF income (encompassing ordinary or statutory income, private company dividends, and trust distributions) is NALI where:

…the fund incurred expenses in deriving the income that are less than (including nil expenses) those which the SMSF would otherwise have been expected to incur if the parties were dealing on an arm’s length basis.

Depending on the circumstances, these non-arm’s length expenses can end up ‘tainting’ all of an SMSF’s income, including pension income (if applicable).

Examples of NALI

The ATO clarified its position on the ‘nexus’ between non-arm’s length expenditure and income in a law companion ruling (LCR 2021/2).

The ruling provides more than a dozen examples of when SMSF trustees’ dealings are and are not at arm’s length.

Here’s one of them, involving an SMSF trustee carrying out duties in her individual capacity:

Trang is the trustee of her SMSF and a plumber who runs her own business. She undertakes a complete renovation of the bathroom and kitchen of her SMSF’s investment property, which is rented out at a commercial rate. She schedules time in her work calendar to undertake the work and uses the tools of her trade to undertake all the plumbing work. Trang does not charge the SMSF for the work undertaken. Because the fund’s (nil) expenditure on the renovation is not at arm’s length, the rental income from the property is subject to the NALI penalty tax rate. And if Trang disposes of the property, any capital gain will also be taxed at 45%.

Here’s one of them, involving a trustee incurring non-arm’s length expenditure to acquire an asset

Trang is the trustee of her SMSF and a plumber who runs her own business. She undertakes a complete renovation of the bathroom and kitchen of her SMSF’s investment property, which is rented out at a commercial rate. She schedules time in her work calendar to undertake the work and uses the tools of her trade to undertake all the plumbing work. Trang does not charge the SMSF for the work undertaken. Because the fund’s (nil) expenditure on the renovation is not at arm’s length, the rental income from the property is subject to the NALI penalty tax rate. And if Trang disposes of the property, any capital gain will also be taxed at 45%.

See all the ATO’s examples

During the 2019–20 income year, Armin sells commercial property to himself (as trustee of his SMSF) for $200,000 — $600,000 less than its market value. The SMSF leases the property to a third party. Because of the non-arm’s length expenditure the fund incurred in acquiring the property, the rental income from the property is subject to the NALI penalty tax rate. And if Armin disposes of the property, any capital gain will also be taxed at 45%.

Commercial-property leases

If you’re leasing your SMSF’s commercial property to a related party, you need to be careful not to fall foul of the NALI laws.

For example, the rent and/or terms of the lease must be commercially sound, be in writing, and the trustees must ensure the related-party tenant complies with the arrangement.

Overcharging to get around contribution limits and boost your fund’s super balance or — if the tenant is struggling financially — undercharging can land you in trouble with the taxman.

Similarly, trustees need to be wary of bringing forward rent as this may inadvertently create a prohibited borrowing by the fund.

Get expert advice

Clearly, given the financial impact of the non-arm’s length provisions, it is possible that if this issue is not considered by auditors then the financial statements of a super fund could be materially misstated.

SMSF auditors may consider requesting trustees issue a representation letter stating if, and how, they have considered the non-arm’s length tax issues when preparing their fund’s financial accounts.

SMSF auditors might also consider stating in their engagement letter, or other method of reporting to trustees, that they have taken the trustees declaration about this issue into account when auditing the fund.

We’re here to support you. If you have questions, contact us here to book a catch up with an RJ Sanderson professional.

This article is published by R J Sanderson and Associates Pty Ltd ABN 71 060 299 783. This article contains general information only and is not intended to represent specific personal advice (Accounting, taxation, financial or credit). No individual personal circumstances have been taken into consideration for the preparation of this material. It is recommended that you obtain your own personal professional advice before making any financial or business decision.