One of the questions left for SMSF auditors, however, is how the proposed formula impacts whether general expense NALI is material.
The reason is that while materiality does not affect SMSF compliance, it is mission-critical when an SMSF auditor considers whether the financial statements are materially misstated.
Because general expense NALI is not a compliance issue, it is about whether the fund’s tax calculation is correct.
Where general expense NALI materially affects how much tax the fund has to pay, SMSF auditors will qualify Part A of the financial report. It may, however, be dealt with by a comment in the management letter.
And that is it.
Impact of LCR 2021/2
LCR 2021/2 stated that when a fund has non-arm’s length expenditure that does not relate to a specific asset but still has a sufficient nexus – or connection – to the general income of the fund, then all fund income for that financial year is classified as NALI.
And where the SMSF more than benefits, the NALI provisions tax the fund at the highest marginal tax rate of 45 per cent on all income, even if the member is in the pension phase, and any capital gain on disposal.
While the SMSF industry grappled with this, the ATO said they would not allocate compliance resources to general expense NALI on or before June 30, 2023.
Treasury consultation paper on NALI
As the ATO’s general expense NALI clock was ticking, Treasury released a consultation paper in January 2023 and provided a tiny window of opportunity to respond by February 21, 2023.
Firstly, Treasury confirmed there would be no change to specific asset NALI.
Secondly, concerning general expense NALI, SMSFs would be subject to a factor-based approach which sets an upper limit on the amount of tax paid.
While sounding great in principle, Treasury recommended that the upper limit was five (5) times the shortfall between what should have been charged as arm’s length expense and the amount actually charged.
In addition, SMSF trustees were expected to determine an arm’s length price when applying the formula and have the documentation to substantiate the expense.
So, at the highest marginal tax rate of 45 per cent a maximum effective tax rate of 225 per cent (based on five times 45 per cent) would be applied.
Treasury Laws Amendment Bill 2023
Then the May 2023 budget put the SMSF industry out of its misery but created an alternative universe.
Because the government excluded APRA funds from general expense and specific asset NALI, leaving SMSFs and small APRA funds holding the bag.
The Treasury Laws Amendment Bill 2023 included the new formula that calculates general expense NALI at twice the level of a general expense taxed at the highest marginal rate (while excluding contributions and exempting expenditures paid before the 2019 financial year).
Once again, determining what the general expense is worth is the problem.
What is a general expense?
The types of general expenses incurred are found in paragraph 4 of TR 93/17, which include:
- Actuarial costs
- Accountancy fees
- Audit fees
- Costs of complying with ‘regulatory provision’ as defined in s38A SIS (unless the cost is a capital expense)
- Trustee fees and premiums under an indemnity insurance policy
- Costs in connection with the calculation and payment of benefits (not the benefit itself)
- Investment adviser fees
- Other administrative costs incurred in managing the fund
LCR 2021/2 also states that in determining whether there is a connection between the non-arm’s length expenditure and the relevant income, the expenditure does not have to be deductible under section 8-1 for the general expense NALI provisions to apply.
The expenditure may be of a revenue or capital nature or deductible under a specific provision, provided there is sufficient nexus to the relevant income.
As a result, expenditure can also comprise the cost of establishing a trust, executing a new deed, or amending a trust deed.
Materiality
The level of materiality set by SMSF auditors will affect whether general expense NALI is an issue. To this end, non-arm’s length general expenses may not be identified during the audit.
Let us assume that Luke uses his brother’s accounting services which typically cost $3,000 but is charged $0. Under the new formula, what is the accounting fee used to calculate the NALI?
It is not the SMSF auditor’s job to determine the market value of the service, especially when other accounting firms may charge $500 or $5,000.
Documenting arm’s length expenditure
The problem is how will SMSF trustees document that the general expense is at arm’s length.
Given that non-arm’s length transactions primarily involve related parties, the ATO’s compliance approach outlined in LCR 2021/2 is particularly relevant.
Paragraph 92 says that where the ATO applies any compliance resources for general fund expenses, they will only be directed “towards ascertaining whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the fund”.
Where the SMSF has documentation confirming that the parties have made a ‘reasonable’ attempt to determine the expenditure, the ATO will not allocate compliance resources to determine whether those expenses are, in fact, arm’s length expenses.
And it follows that SMSF auditors should not be required to go down this path either.
At the very least, documenting that both parties have made a reasonable attempt to determine that the expense is at arm’s length will be of paramount importance.
Conclusion
There is no doubt that the unintended consequences of the latest Treasury Amendments will continue to plague the industry.
While we await the final ruling to clarify the ATO’s approach, SMSF auditors may struggle to identify the market value of a non-arm’s length general expense where parties do not deal with each other at arm’s length.
Applying a risk management framework will help to identify whether general expense NALI is material.
