ATO releases final ruling on NALI
The ATO has released its final ruling confirming the application on non-arm’s length income in the expenditure incurred under a non-arm’s length arrangement.
The ATO has released LCR 2021/2 clarifying how the amendments to section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) operate in a scheme where the parties do not deal with each other at arm’s length and the trustee of a complying superannuation entity incurs non-arm’s length expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income.
SMSF Association deputy CEO Peter Burgess said that the ATO ruling confirms that the general expense cannot have a direct link to the income of the fund and that non-arm’s length expenditure (NALE) can have a sufficient nexus to all the ordinary and/or statutory income derived by the fund.
“I think it’s fair to say that the industry seems to have lost its battle to convince the ATO and others that a general expense cannot have a direct link to the income of the fund,” Mr Burgess said at the SMSF Association Technical Summit 2021.
“The ATO has confirmed in this ruling that non-arm’s length expenditure can have a significant nexus to all of the ordinary or statutory income derived by the fund.
"This means situations could arise where an SMSF, which does not incur a general expense on arm’s length terms, would have all its income taxed as non-arm’s length income (NALI) – regardless, it would seem, of the monetary value of the service provided."
“Whether we agree or disagree with the ATO’s position, I think what really matters here is the consequences of having all the income taxed as non-arm’s length income just because the fund did not receive a general expense on arm’s length terms which are very severe and disproportionate.
Even though the ruling makes it clear the ATO does not consider the general expenditure issue to be a significant compliance risk that would warrant a particular focus, Mr Burgess said the SMSFA urges the Government to review these provisions to avoid any undue concern or confusion.
Mr Burgess acknowledged the underlying policy rationale of the NALE rules is to ensure all SMSF transactions occur on arm’s length terms.
“Although we accept the underlying policy intent, the penalty imposed on SMSF trustees who may not see the harm in entering arrangements with related parties on favourable terms to their SMSF, can be very significant and grossly disproportionate.”
“I should say the only way that I think we’re going to be able to get this issue addressed now is to push for a law change.”
Confirmations on non-arm’s length applications
In the final ruling, the ATO has made it very clear that as long as the SMSF incurs an expense on arm’s length terms for all the services it receives, then these new arm’s length expenditure rules will have no application.
However, there are important exceptions to that, such as when it is the trustee themselves that are providing services to the fund and that they’re doing that in their capacity as a trustee.
Mr Burgess said where this ruling is particularly useful is that it does provide some additional examples of what constitutes acting in the trustee capacity versus the individual capacity.
This is important for clients who are providing services to their own fund to know whether they’re performing that service in their capacity for a trustee or in their capacity as an individual.
“We know that providing bookkeeping services to your own fund is not a non-arm’s length expense, so you don’t need to charge your fund for providing those types of bookkeeping services. But what we do know now as a result of this ruling is that the use of business knowledge and skills to perform duties of itself does not indicate that the individual is not acting in the capacity of the trustee,” Mr Burgess explained.
“A good example is financial advisers who may have their own SMSF. If they use their own skills and knowledge to formulate an investment strategy for their fund, that does not give rise to non-arm’s length expenditure if they don’t charge their funds.
“Stated in example six in the ruling, there is no requirement for financial advisers to charge their fund for the service they provide there; it’s not considered to be NALE, it’s considered to be something they’ve done in their capacity as a trustee.”
The ruling also explains that the application for the minor infrequent or irregular use of equipment or assets will not, of itself, indicate the individual is acting in their individual capacity, meaning that the individual is acting in an individual capacity.
“What they’re saying here is that we can use business assets in a minor infrequent or in a regular way and that won’t mean that you’re acting in the capacity of an individual,” Mr Burgess noted.
“There are some useful examples of this in the final ruling. What it seems to suggest is minor instalments are okay, but something like the complete renovation of the bathroom, for example, is not accepted.”
Where the ruling really does draw the line, however, is services that are provided by the trustee where they are required to hold a licence or a qualification in order to provide that service or the service that’s being provided is covered by insurance policy, according to Mr Burgess.
“In those situations, the individual of the trustee will be considered to have provided that service in their individual capacity, and it will be important in those situations for the trustee to charge a fee for the service provided or run the risk that the income from that asset will be treated as NALI,” he explained.
“On this point, it does appear to be the case that if you are a registered tax agent and have an SMSF and lodge the tax return for the fund using your tax agent number, then you will be required to charge your fund a fee for that service, but if you don’t use the tax agent number, then it isn’t required.
“The ruling also seems to draw a distinction between accounting expenses and it seems to be saying that if the accounting service that’s being provided relates to the production of the tax returns or the production or the lodging of the fund’s tax return, then that won’t give rise to NALI if no fee is charged.
“But if it relates to other things such as the preparation of financial statements, then it may give rise to NALI. The distinction seems to be items that are ordinarily deductible under section 8.1, then if the fee is not charged on arm’s length terms, then that could be a problem; otherwise, it’s not a problem.
“There’s a distinction there when it comes to accounting services and accounting fees which you’ll see in the examples of the ruling.”
In the ruling, Mr Burgess said there is also confirmation now that there is a significant, sufficient nexus between the initial NALI incurred to acquire the asset in any future capital gains.
This means if an SMSF acquires an asset on non-commercial terms, then that asset is forever tainted. When that asset is eventually sold by the SMSF, the capital gain will be subject to be taxed as NALI.
Based on the SMSFA’s discussions with the ATO, Mr Burgess confirmed it also appears that where the asset is sold in that final year if the fund had originally bought the asset on arm’s length terms, in that year they sell the asset and incurred NALE in that year, then all the capital gain in that final year will be taxed as NALI.
“It does depend on in some cases as to what the non-arm’s length expenditure actually is and whether there is a direct nexus to the capital gain,” Mr Burgess explained.
“If the expenses is in relation to improving the value of the property, that does have a direct nexus to the capital gain and, therefore, will be taxed as NALI, but if it’s a recurring expense, then it doesn’t have a direct nexus to the capital gain, in which case it won’t be NALI.”