Greater clarity needed from ATO on nature of recurrent expense in NALE and NALI

However, the ATO’s view is that a lower general expense (or a nil general expense) incurred by an SMSF can result in all the income of the SMSF being non-arm’s length income (NALI).

Where a complying superannuation fund incurs NALE of a recurrent nature fund, deriving ordinary or statutory income during a particular income year that does not relate to the acquisition of an asset, and subsequently ceases to incur that NALE in a later income year, income derived by the fund in that later income year is not NALI.

In contrast, where an SMSF incurs NALE relating to the acquisition of the asset, the income from that asset including any future net capital gain on disposal, will be NALI as set out in the ATO ruling. This is the case even if a non-arm’s length limited recourse borrowing arrangement (LRBA) is subsequently refinanced and put on arm’s-length terms.

DBA Lawyers director Daniel Butler said there was an urgent need to flesh out what a recurrent expense is, how expansive is it and whether it includes capital as well as revenue items. He notes paragraphs (1)(b) and (c) and (5)(b) and (c) of section 295-550(7) of the Income Tax Assessment Act 1997 (Cth) apply to a loss, outgoing or expenditure whether or not it is of capital or of a capital nature.

“The industry is not sure whether the ATO will accept that a recurrent expense will cover capital costs, for example, a recurrent improvement that occurs, say, annually to a property that is not deductible in contrast to a revenue outgoing such as a regular recurrent repair,” he said.  

“For example, an LRBA starts off on non-arm’s length, the ATO in LCR 2021/2 does not accept this can be refinanced and fixed. However, an LRBA that starts as arm’s length, and then is non-arm’s length for several financial years, should only taint those particular financial years.”

Mr Butler said there is no certainty the ATO will accept this analysis even though it appears the ruling accepts interest is a recurrent expense. This is because the NALE provisions were initially aimed at non-arm’s length LRBAs and, therefore, it is best to apply for a private ruling.

“Also, it would be appreciated if the ATO established a practice to allow those with temporary aberrations to get back on track, to ‘err’ is to be human; that is, humans are bound to make errors, such as having an arm’s-length LRBAs going off the rails for a short or temporary time,” Mr Butler noted.

“Particularly given the extreme economic conditions we are now in with the COVID pandemic, there appears to be no empathy or sympathy reflected in the ATO’s ruling to people who are struggling to survive in this harsh climate.

“NALI or NALE may arise due to financial difficulties due to COVID-related forced lockdowns where people and businesses cease to derive income and at times due to oversight or human error, mental, financial or a range of other pressures, and SMSFs should be given a reasonable opportunity to rectify in line with arm’s length terms as soon as practicable after they detect an issue.”

This is also particularly important to consider during the transitioning period of the new legislation and the ATO’s views reflected in the NALE ruling LCR 2021/2. The ATO has recently indicated that it is examining reviewing its COVID relief relating to rent concessions, loan deferrals and certain other measures.

Mr Butler continued: “While we recognise there are some concessions made by the ATO as reflected in PCG 2020/5 to mid-2022 and from mid-2022, if there is reasonable benchmark evidence for general fund expenses not giving rise to NALI (in respect of the ATO’s theory that a general expense taints all income including net capital gains and concessional contributions as there is a sufficient nexus to all income), the super industry including large APRA funds and SMSFs and the advisers and others working in this industry do need a reasonable time to adjust to this substantive change in ATO view on the general expense nexus tainting all income which the ATO considers is the better view of the legislation.

“However, there are numerous professional bodies that take a contrary view of the law and consider the legislation should not give rise to absurd outcomes such as an immaterial general expense of $100 tainting a fund’s entire income.”

Mr Butler pointed out that the ATO in paragraph 90 and 91 of its own ruling states it is particularly important for trustees of large APRA‑regulated superannuation funds to have appropriate internal controls and processes in place to enable trustees to demonstrate that they have made reasonable attempts to determine arm’s length expenditure amounts when making acquisitions from related parties. 

It also states that “appropriate internal controls and processes will be dependent on several factors including the size and nature of the arrangement. Having appropriate controls and processes should form part of the fund’s tax risk management and governance framework.”

“Nevertheless, the commissioner is alive to concerns that a finding that general fund expenses are non‑arm’s length is likely to have a very significant tax impact on the complying superannuation fund, even where the relevant expenses are immaterial,” he said.

But while the ATO does have some practical concessions for general fund expenses, there are still aspects of the legislation that relate to specific expenses relating to particular assets that need further work, according to Mr Butler.

“For example, in example 9 in LCR 2021/2, the plumber improving property where Trang renovates the kitchen and bathroom to the rental property owned by his SMSF. What if, instead of Trang doing an improvement, he only carried out a repair that was more than using his tools on a minor, irregular or infrequent basis?” he said.

“The LCR does not give a clear answer on this issue and we are not certain whether the ATO will accept that a repair is in the nature of a recurrent expense. Indeed, the industry now needs to determine what is a recurrent expense. Perhaps, a private ruling is required to flesh this query out too, but it would be good to clarify what a recurrent expense will and will not cover.

“Indeed, why did the ATO come up with a new theory of ‘recurrent expense’ when there is well-established tax law established over many decades on what is a repair versus an improvement? By not taking the well-trodden path of established case law gives rise to considerable uncertainty for advisers and may take many years before any case law is available for us to glean what a recurrent expense actually is, as compared to being guided by what the ATO says one is.”

Mr Butler said the ATO should at least give some recognition to the key professional bodies that represent the industry that the general expense nexus is not the preferred view of what is the better construction of the legislation; ideally, the ATO should not action this view until this matter is tested before the courts.

“What is clear here now is that some form of urgent legislative fix is needed so there is a general overriding principle of proportionality and fairness, including some opportunity to rectify and make good is reflected in the law,” he said.

“This is especially so during these testing and trying COVID times where SMSFs in particular are seeking to cope with rent relief, LRBA loan deferrals and many other issues relating to complying with applicable superannuation legislation and acting in the best financial interests of their members. Hopefully, further clarification issues soon on the ATO’s extension to its COVID-related relief.”