SMSFs: Can all income be NALI?
One key criticism of the draft Law Companion Ruling 2019/D3 (Draft LCR) is the breadth of the ATO’s view in relation to the “nexus” required between the scheme and the loss, outgoing or expense that can constitute non-arm’s length income (NALI) under s 295-550 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).
The ATO’s view is that where an expense is incurred by a fund that is less than an arm’s length amount, all of a fund’s ordinary income and statutory income is NALI, which (after relevant expenses) is taxed at 45 per cent.
Extrapolating this to a “general expense” incurred by an SMSF, the ATO takes the view that where a direct nexus to a particular source/asset is missing, there is instead a nexus to all income of the fund, regardless of the source of that income or whether any asset produces that income or gain.
While the Draft LCR confirms that a non-arm’s length expense (NALE) causes the income from that particular year to be NALI, this ATO view also leads to the conclusion that all future income (including net capital gains) on all assets held by the fund at that particular time would also be NALI.
For example, a $100 reduction in an accounting cost for a widely diversified mum and dad SMSF with an average fund balance of $1.3 million would expose all future income and all future capital gains on all assets then held by that fund to NALI.
The Tax Institute lodged a detailed submission on “Non-arm’s length income and expenses – LCR 2019/D3 and PCG 2019/D6” to the ATO dated 4 December 2019 adopting a different construction of the wording in s 295-550(1). The Tax Institute’s view is examined below and contrasted to the ATO’s view. (Note that PCG 2019/D6 was finalised as PCG 2020/5 which is discussed below.)
In preparing this article, we wish to acknowledge The Tax Institute’s NALI submission for raising this “nexus” issue.
All references are to the ITAA 1997 unless otherwise stated. Emphasis is added by bolding throughout.
Section 295-550(1) contains a nexus requirement in paragraphs (b) and (c) –– that if, as a result of the scheme … the parties to which were not dealing with each other at arm’s length in relation to the scheme, one or more of the following applies:
(b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme;
(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.
Clause 2.38 of the Explanatory Memorandum (2019 EM) that introduced Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 (Cth) (NALE Act) states:
[w]here there is a scheme that produced non-arm’s length income by applying non-arm’s length expenses, there must also be a sufficient nexus between the expense/s and the income; that is, the expenditure must have been incurred “in” gaining or producing the relevant income. This reflects the analysis that must be undertaken in determining whether an expense is deductible under section 8-1, or can be included in the entity’s cost base for the transaction if the expense is of a capital nature (see below).
This nexus point is not critically examined in the Draft LCR. Rather, the ATO readily accepts that a nexus is easily established. For example, paragraph 17 of the Draft LCR states:
Non-arm’s length expenditure incurred to acquire an asset (including associated financing costs) will have a sufficient nexus to all ordinary or statutory income derived by the complying superannuation fund in respect of that asset. This includes any capital gain derived on the disposal of the asset (see Example 1 of this Ruling).
Broadly, the Draft LCR suggests that NALI will arise if there is a nexus between the acquisition of an asset and any eventual capital gain derived, when the fund incurs an expense less than the arm’s length amount.
Background to NALE being introduced
The introduction of the NALE Act was largely due to the growth of low-interest loans in relation to limited recourse borrowing arrangements (LRBAs).
The Superannuation Taxation Integrity Measures Consultation Paper was issued on 11 January 2018 (2018 Consultation Paper) together with exposure draft legislation and an exposure draft EM. It stated:
- The current NALI rules ensure that income derived from related party transactions does not receive concessional tax treatment if it is higher than could be derived on commercial terms. However, the rules do not currently take into account fund expenditure incurred that would normally apply in a commercial transaction, which reduce non-arm’s length income, e.g. where interest is not paid on the loan from a related party, meaning the fund’s net income is higher than it would have been in a commercial transaction.
- The proposed amendment would include these expenses, meaning that these arrangements with higher net income will not receive concessional tax treatment.
There are two examples (i.e. examples 2 and 3) in the 2018 Consultation Paper that involve low-interest LRBAs. There is no reference to or example of a general expense or lower professional fee giving rise to NALI.
The following paragraphs are extracted from the exposure draft EM of January 2018:
1.16. The legislation requires the identification of a specific amount of ordinary or statutory income that is NALI. That is, the existence of an amount of NALI does not necessarily “taint” all of a superannuation entity’s income; it is necessary to specify the scheme in relation to which the NALI was derived.
1.23. The framework or the ordinary and statutory NALI rules remain the same:
• There must be a scheme;
• The party or parties must not be dealing with each other at arm’s length by incurring less or nil expenditure than would otherwise be expected if the parties were dealing with each other on an arm’s length basis in relation to the scheme; and
• the expense must be identifiable as a specific amount (including a nil amount), as must the income gained or produced.
Example 1.1 of the exposure draft EM of January 2018 also relates to an LRBA. The circumstances in this example involve an LRBA with no interest, no repayments, 100 per cent gearing and repayment of principal required at the end of the 25-year loan term.
Broadly, the SMSF industry had not contemplated that the proposed NALI changes would result in a general expense tainting all (of an SMSF’s) ordinary and statutory income. As noted, for a considerable period, it was envisaged that an expense such as a lower interest rate in respect of rental income related to an LRBA could give rise to NALI. This was on the basis that a superannuation fund is permitted under s 67A of the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA) to borrow to acquire a single acquirable asset. Thus, with LRBAs, there is a sufficient nexus with the lower expense and the specific asset producing that income.
The ATO’s Practical Compliance Guideline (PCG) 2020/5 dated 1 June 2020 confirmed the ATO’s position that a general expense would taint all ordinary and statutory income. The following paragraphs best explain the background to the ATO’s revised view:
- As a result of consultation feedback received on LCR 2018/D10, the ATO has provided clarification on particular issues in LCR 2019/D3. One of these issues concerned when non-arm’s length expenditure will have a sufficient nexus with income derived by the complying superannuation fund for the NALI provisions to apply. In particular, the commissioner has set out the preliminary view that certain non-arm’s length expenditure incurred by a complying superannuation fund may have a sufficient nexus to all ordinary and/or statutory income derived by the fund for that income to be NALI (for example, fees for accounting services).  This can be contrasted to non-arm’s length expenditure that has a more direct nexus to particular ordinary or statutory income derived by the fund (for example, expenditure relating to the acquisition of an income-producing asset).
- The ATO recognises that trustees of complying superannuation funds may not have realised that the amendments will apply to non-arm’s length expenditure of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in an income year, noting that it was not explicitly stated in LCR 2018/D10. It is also recognised that the amendments apply in relation to the 2018–19 and later income years which may result in all income derived by a fund during the 2018–19 and 2019–20 income years being classified as NALI where it has incurred non-arm’s length expenditure of a general nature.
- A number of comments were received in respect of LCR 2019/D3 and all these comments are being considered in the finalisation of that draft Ruling.
- Pending the finalisation of LCR 2019/D3, the ATO considers it is appropriate to apply the transitional compliance approach outlined in paragraphs 10 and 11 of this Guideline.
Thus, the SMSF industry was not expecting NALE to taint all ordinary and statutory income when the 2018 Consultation Paper was issued in January 2018 with exposure draft legislation and exposure draft EM. The SMSF industry was put on notice of this broad view when the Draft LCR was issued on 2 October 2019.
As noted above in paragraphs 6 to 9 of PCG 2020/5, the ATO’s broader view resulted in considerable controversy from certain sectors of the SMSF industry. The ATO confirmed in the PCG 2020/5 that the ATO decided that no compliance resources would be applied for the period of 1 July 2018 to 30 June 2021. However, as noted below, this period was extended on 24 March 2021 to cover the 2021–22 financial year.
The NALI/NALE legislative changes in late 2019
The NALE Act was, upon receiving royal assent, finalised as law on 2 October 2019 with retroactive powers from 1 July 2018. Moreover, the changes are expressed to apply to schemes regardless of when they were entered into. For example, an SMSF that acquired an asset for less than market value in 2000 could be exposed today to NALI.
We will now examine the impact of NALE where an asset is acquired below market value and, secondly, where an asset is acquired at market value.
Assets acquired below market value — is there a nexus?
Example 1 of the Draft LCR involves Armin selling commercial property with a market value of $800,000 for $200,000 to his SMSF. According to the Draft LCR, all the income and capital gain from that property is NALI.
However, what is not taken into consideration in this example is the application of the CGT market substitution rule and the ATO’s long-established practice of treating a transfer of an asset below market value as a contribution in accordance with TR 2010/1; the ATO’s tax ruling on superannuation contributions.
Where the CGT market value substitution rule in s 112-20 applies, the member transferring the asset to the fund below market value is deemed to have received the market value of the asset that exceeds any consideration received as capital proceeds in accordance with s 116-30. Therefore, Armin would typically be treated by the ATO as having made a non-concessional contribution (NCC) equal to the difference between the sale price ($200,000) and the asset’s market value ($800,000); i.e. a $600,000 contribution. This approach is consistent with the ATO view reflected in TR 2010/1.
Note that if a member exceeds their NCC cap, then they will be subject to the excess contribution system which may potentially expose them to tax at a rate of 47 per cent unless they elect to release the excess amount of NCCs, plus 85 per cent of the associated earnings on the excess NCC amount, in which case the member will then pay tax on 100 per cent of their associated earnings.
There is no guidance in the LCR about what takes precedence — the contributions regime or NALI — to avoid any potential “double jeopardy”. Indeed, the recognition of an NCC reflects market value consideration for the asset. This is the view of the High Court in Cook v Benson  HCA 36 per Gleeson CJ, Gummow, Hayne and Heydon JJ in relation to contributions made by a member who was made bankrupt, at :
… the first respondent made contributions in return for the undertaking by the trustees of the funds of obligations to pay death, retirement or other related benefits, to him or his nominees, in accordance with the rules of the respective funds. He obtained consideration in money’s worth in return for the payments.
If the ATO seeks to change its long-established practice of treating an asset acquired below market value other than as a contribution, then the ATO should revise TR 2010/1 and communicate its revised position to the tax industry.
Further, while the 2019 EM is not law and should only be referred to where there is ambiguity in the law, the commentary in the 2019 EM and the examples referred to (e.g. paragraphs 2.17, 2.19, 2.20, 2.21, 2.35, 2.39, 2.41, 2.44, 2.45, 2.46, 2.47, 2.48, 2.49 and 2.50 and examples 2.1 and 2.2) all relate to a specific asset or category of income. There does not appear to be any commentary or example in the 2019 EM that refers to a general expense tainting all of a fund’s income.
In summary, the current ATO view results in a potential “double jeopardy” by applying the NALI provisions and also treating the same amount as a contribution under TR 2010/1. If the ATO construction of the NALE Act is correct, then we would hope the ATO’s contribution ruling is revised accordingly.
Assets acquired for market value — is there a nexus to all income?
The Tax Institute’s submission dated 4 December 2019 submits that, if a lower revenue expense is incurred by an SMSF in relation to the acquisition of an asset at market value, only the ordinary income should be assessed as NALI. Consequently, NALI should only apply to any net capital gain (statutory income) when that asset is eventually sold if there is a relevant nexus. The Tax Institute’s submission queries whether there is any relevant nexus when an arm’s length price is paid and the capital gain is solely from capital appreciation of that asset.
In other words, a capital gain generally arises from capital appreciation over time and not “as a result” of the lower revenue expense, i.e. the lower revenue expense was not incurred in relation to “gaining or producing the [statutory] income” under s 295-550(1)(b) or (c).
Example 4 of the Draft LCR provides the example of Kellie’s SMSF. This example highlights a situation where both the net rental income and any net capital gain from the eventual disposal of a commercial property funded by a non-arm’s length LRBA is NALE (where the SMSF borrows 100 per cent of the purchase price, an interest rate of 1.5 per cent p.a. applies and repayments made annually over a 25-year term). However, Kellie’s SMSF paid the market value of $2 million for this property.
It is important to note here that many SMSFs are passive investors and benefit from long-term capital appreciation of assets. In this type of case, why should Kellie’s SMSF have its capital gain exposed to NALI if it incurred a lower revenue expense?
The capital gain in this situation generally remains the same regardless of lower expenses such as discounted service fees or interest rates on a related party LRBA. Thus, The Tax Institute’s submission argues that there is not a sufficient and relevant nexus between the lower revenue expense and the subsequent capital gain that may eventually be realised on disposal.
Indeed, the capital gain in relation to many SMSF investments including property, shares and many other investments arises from the original contract price and any capital appreciation subsequently received.
For example, consider an SMSF that holds an investment property for 20 years and experiences a 400 per cent increase in value over that time. In the final year prior to sale, the SMSF trustee, who is a builder, does some free services to better position the property for sale, enabling the fund to realise the best sale price. On the ATO’s reasoning, the total capital gain achieved over the past 20 years would be NALI, despite there being no connection between the capital appreciation from the prior 19 or so years accrued before the builder provided free services. As discussed below, the ATO argues that there is no flexibility to pro-rata or apportion this gain for NALI purposes.
The Tax Institute submission also argues that there is also need to ensure that an appropriate nexus between an expense and the income that is tainted. In particular, a lower revenue expense can taint ordinary income and a lower capital expense can taint a capital gain (i.e. statutory income). The Tax Institute’s submission, for instance, readily accepts that in a case such as Kellie’s SMSF (Example 4 of the Draft LCR), there is a relevant nexus between NALE and the future capital gain on the eventual sale of the property, if the fund would not have been able to acquire that property but for the non-arm’s length loan being provided. This approach is in line with the ATO’s analysis in TD 2016/16 (which is a public ruling that predates the NALE Act) on how the ATO applies NALI to a non-arm’s length LRBA. Paragraphs 4 and 5 of TD 2016/16 provide:
- Having identified a hypothetical borrowing arrangement between the SMSF and the lender the terms of which are on an arm’s length basis, it is then necessary to establish whether it is reasonable to conclude that the SMSF could have and would have entered into the hypothetical borrowing arrangement.
- Where it is reasonable to conclude that the SMSF could not have, or would not have, entered into the hypothetical borrowing arrangement, the SMSF will have derived more ordinary or statutory income under the scheme than it might have been expected to derive under the scheme with the hypothetical borrowing arrangement. In this instance, the ordinary or statutory income derived under the scheme is NALI.
As mentioned above, assuming Kellie’s SMSF could have acquired the property that is the subject of the LRBA without the non-arm’s length LRBA, then The Tax Institute’s view is that the capital gain on disposal of that asset lacks the relevant nexus to the expense.
Should ordinary income or statutory income be apportioned?
The question of apportionment of value caused by different acts/events also needs to be considered for such situations. Referring again to the above example, where capital appreciation of a residential property by 400 per cent may be tainted in the final (20th) year of disposal by free services provided by the builder who is an SMSF trustee/member, appears most unfair and brutal. Assume further that planning approval via an external consultant was also obtained which also resulted in considerable capital appreciation. This increase in the value of the property due to the planning approval should not be tainted by NALI. The overall increase in value should at least be apportioned between the free services provided by the builder (which is also treated as a contribution by the ATO under TR 2010/1) and the increase in value that relates to the planning approval.
As noted above, the ATO has for many years treated free services that added value to an asset as a contribution (e.g. an NCC if provided by the member reflective of the value of those services; see TR 2010/1 and ATO NTLG Superannuation Committee minutes of March 2013). If an NCC was recognised for these free services, this should neutralise any need for the ATO to apply NALI.
It is recommended that the ATO review and revise TR 2010/1 in view of its construction of NALI.
PCG 2020/5 – general expenses
In recognising the controversy arising from the substantial broadening of the NALE provisions to include that a lower general expense (i.e. NALE) taints all ordinary and statutory income of a fund, the ATO sought to provide a practical concession to industry to adjust to this much wider tax net.
The following are the key paragraphs from PCG 2020/5:
- The ATO will not allocate compliance resources to determine whether the NALI provisions apply to a complying superannuation fund for the 2018–19, 2019–20 and 2020–21 income years where the fund incurred non-arm’s length expenditure (as described in paragraphs 9 to 12 of LCR 2019/D3) of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, non-arm’s length expenditure on accounting services).
- This transitional compliance approach does not apply where the fund incurred non-arm’s length expenditure that directly related to the fund deriving particular ordinary or statutory income.
On 24 March 2021, the ATO Assistant Commissioner, Mr Justin Micale, announced a 12-month extension to the period covered by PCG 2020/5 so that it also covers the 2021–22 financial year; thus, PCG 2020/5 now covers the 2018–19, 2019–20, 2020–21 and 2021–22 financial years. Mr Micale said that given the complexity and level of interest in this issue, the ATO will be seeking independent, specialist advice from the public advice and guidance panel before finalising the Draft LCR.
Thus, the ATO will not be applying compliance resources for the period of 1 July 2018 to 30 June 2022 where the NALI provisions apply to all the ordinary and statutory income of a fund simply because it incurs NALE of a general nature.
Mr Micale confirmed that it is important to recognise the ATO’s transitional compliance approach does not apply in other circumstances where the fund incurs NALE that relates directly to particular income.
The NALE changes have proved very controversial. The legislation was enacted on 2 October 2019 and the Draft LCR is still to be finalised (ETA at a guess could possibly be six to nine months, say, late 2021 or early 2022). It appears the initial intent of the exposure draft legislation has taken on a far broader application, given the ATO’s views in relation to how a general expense can taint all income (ordinary and statutory). Specifically, the interpretation that a sufficient nexus is very easily established even if that nexus is remote and tenuous, as illustrated above by the examples of the property held for 20 years and the $100 accounting fee discount tainting all the fund’s income.
Bearing in mind that the evidential burden falls on the taxpayer and the current expansive and pro-revenue construction of the NALI provisions being espoused by the ATO, SMSF trustees need to take great care to ensure they have sufficient and appropriate evidence to defend themselves against NALI claims. Broadly, SMSF trustees may assume that in any related party dealing NALI will apply unless they prove otherwise, given the ATO may issue an assessment and place the burden on the SMSF trustee to prove it is excessive.
Naturally, this is not at all a fair system and urgent action and reform is needed. Considerable uncertainty exists with the application of NALE and NALI until the ruling is finalised.