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By Janet Manzanero-Caruana, Senior Technical Manager
Financial advisers of SMSF clients must be alert to how transactions deemed to be non-arm's length can impact the concessional treatment of SMSF income, resulting in a significantly higher tax bill.
Law companion ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement, released by the Australian Taxation Office (ATO) on 28 July 2021 clarifies how incurring non-arm's length expenditure (NALE), can result in a complying super fund's ordinary or statutory income being treated as non-arm's length income (NALI), resulting in a significantly higher tax rate. This can also occur where a loss or no expense is incurred by the super fund.
Incurring NALE can result in a significantly higher tax bill for an SMSF as NALI, less any related deductions, is taxed at 45%, the highest tax rate. Income derived by retirement phase pensions, which are usually tax exempt, can also be included in NALI.
LCR 2021/2 applies to NALE resulting from transactions between a party (or parties) and a super fund from the 2018/19 income year onwards, even if the scheme was entered into prior to 1 July 2018.
In some situations, an expense cannot be easily determined as NALE. This is where it is unclear whether a person delivers the service in their capacity as trustee (or as director of a corporate trustee) of the fund.
A super fund's ordinary or statutory income, including distributions of fixed entitlements to trust income, will be treated as NALI if:
NALE, which may be revenue or capital in nature and may or may not be deductible, that has sufficient connection to certain SMSF income can cause that income to be NALI.
Where NALE is incurred in connection with the acquisition of an asset it can result in both income and any subsequent capital gain relating to the asset to be classified as NALI.
Market substitution rules apply where the super fund acquires an asset at less than market value. While the cost base of the asset will be higher (at market value), non-arm's length rules will still apply to the transaction which can make any income or capital gain realised from that asset NALI.
Tech Tip: A super fund should always acquire an asset at market value, whether it is a purchase, in specie contribution, or a combination of both.
If the super fund cannot fully pay for a permitted asset acquired from a related party, the shortfall amount may be, if eligible, a contribution by the member, if eligible. Records supporting the asset's valuation and details of the transaction must be kept.
Example: An SMSF acquires business real property from a member at $500,000. The SMSF purchases 50% of the property at $250,000 and a $250,000 in specie contribution of the other 50% is made by the member as a non-concessional contribution. The property continues to be rented at commercial rates to a third party. The net rent and any capital gain realised from the property will not be NALI.
In some instances NALE will only impact on the income of the relevant asset, not the whole fund. This can be where acquisition costs (including loans) and income is at arm's length but certain costs which only having a nexus with income related to the asset are not arm's length.
Example: A licensed real estate agent is a partner in a property management business which manages leases for a portfolio of rental properties. One of the properties managed is owned by the agent's SMSF and was acquired and is being leased at market rates.
The business does not have a discount policy for partners, office holders and employees. The SMSF is charged only half the usual rate for the services which relates to the property's rent only. Net rental income for the income years where the SMSF paid discounted management fees will be NALI. In this example, the NALE incurred does not have sufficient nexus to any future capital gain.
In some cases, expenses for services rendered to the fund may not specifically relate to certain fund income, but rather to all fund income in general (such as actuarial, accountancy and audit fees or other administrative costs).
Where these services are provided by the trustee (or director of the corporate trustee) in their individual capacity or by a related party for free or at discounted rates, the expense can be NALE. It is possible that a small amount of NALE can have very large tax consequences for the fund as a whole, with all income in the SMSF taxed at the 45% rate.
On the other hand, where a person delivers services in their capacity as trustee (or director of a corporate trustee) of the fund, the Superannuation Industry (Supervision) Act 1993 prohibits payment for the service. In this case, income will not be NALI.
It is therefore important to consider whether services are delivered in the person's capacity as trustee and whether the amount of expense (including nil or a loss) incurred is non-arm's length.
Indications that services are not performed in a person's capacity as trustee or director of the corporate trustee can include:
Bookkeeping and accounting can be undertaken by a person in their capacity as trustee of the fund and not be paid for it. However, if the person regularly uses their business or employer's equipment or assets in providing services to the SMSF and the use is material, income may still be classified as NALI.
Examples of services provided in the person's individual capacity that can have sufficient connection to all income of the SMSF and can result in NALI for that income year include:
A firm provides audit services to a partner's SMSF for free where the service is not available for free to anyone else in the firm.
A financial adviser frequently uses his employer's computer and software in formulating and executing trades in line with their own SMSF's investment strategy.
'Minor, infrequent or irregular' use of business equipment or other assets by the person in providing a service will not, of itself, indicate the person is not acting in their capacity as trustee.
The relevant facts, situation and factors of each case must be considered to determine whether the person is acting in their capacity as trustee or not. What is unclear though is how to determine whether the use of business or professional assets is 'minor, infrequent, or irregular'.
For an accountant or a financial adviser who works from home, does this mean a separate computer and separate software must be used for their SMSF to avoid NALE? Would a person using their personal computer for work during lockdown for most of the financial year be providing services in their capacity as trustee if the same computer was used to do the SMSF's bookkeeping?
If the trustee has not induced the service provider to provide the service for free, services will be considered to be at arm's length. While a trustee can negotiate for discounted prices, discounts must be consistent with normal commercial practices. For example, a trustee may use a staff discount which is available to all staff, partners, and shareholders of their firm.
Examples where a SMSF does not incur NALE for services delivered are:
Tech Tip: When providing services to the SMSF, it is important to distinguish whether services are delivered by the person in their capacity as a trustee (or a director of the SMSF's corporate trustee). If it is not, the person providing the service must charge professional fees at commercial rates for these services.
An alternative is to engage a third party to perform these services and pay market rates.
Trustees must establish the necessary measures to enable them to show there were reasonable attempts to establish that transactions and payments were at arm's length when acquiring assets and paying for services. Trustees should keep supporting records to show that any decisions, valuations and transactions were at arm's length.
The ATO recognised that there is concern that a small amount of NALE for general fund services, may have a sufficient connection to all of an SMSF's income, resulting in all income being taxed as NALI.
From 1 July 2022, ATO compliance resources relating to general fund expenses will only be directed to services that are provided in the person's individual capacity, not as trustee. If trustees can show that they made reasonable attempts to ensure expenses are incurred at arm's length, the ATO will not allocate compliance resources to further ascertain if those expenses are at arms' length.
Practical Compliance Guideline PCG 2020/5 Applying the non-arm's length income provisions to 'non arm's length expenditure' will continue to apply. This outlines that the ATO will not allocate compliance resources to determine whether NALI provisions apply to a super fund where NALE, that has a sufficient connection to all fund income, is incurred on or before 30 June 2022.
NALE that is of a general nature can have significant tax consequence if it has sufficient connection to all fund income. The line between minor and regular use of business equipment or other assets is not clearly prescribed, and this can also have significant bearing on whether an activity or service is performed in the person's capacity as trustee (or director of the corporate trustee) or in their individual capacity which may result in NALE.
To avoid expense being treated as NALE, SMSF trustees should avoid all non-arm's length transactions. Engaging third parties to provide services can help trustees satisfy the ATO's requirements. Remind your SMSF clients to keep valuations and supporting documents for transactions or services to document that reasonable attempts were made to ensure transactions were at arm's length.
If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.