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What’s the dividing line between NALI and a contribution?

Daniel Butler and Shaun Backhaus
15 September 2021 — 14 minute read

The ATO issued its comprehensive ruling, TR 2010/1, on what constitutes a contribution to a superannuation fund in February 2010. A revised draft for consultation of TR 2010/1-DC (DC) was issued on 28 July 2021 reflecting changes as a consequence of the ATO’s views provided in Law Companion Ruling (LCR) 2021/2.

LCR 2021/2 confirmed the ATO’s views on non-arm’s length expenditure (NALE). LCR 2021/2 was also issued on 28 July 2021 and focuses on when a fund incurs a loss, outgoing or expense that is lower than arm’s length (or nil) (ie, NALE) that gives rise to non-arm’s length income (NALI). NALI is broadly taxed at 45% rather than the usual 15% tax rate.

The ATO issued the DC to clarify the dividing line between what is a contribution and NALI. Fortunately, the DC is still in draft as there are many unanswered questions arising since the ATO’s views in LCR 2021/2 have been published. In this article we examine one area that requires greater clarification and certainty.

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First, let’s revisit some key aspects of TR 2010/1

The ATO state at [4] in TR 2010/1 that the ordinary meaning of a contribution as follows:

In the superannuation context, a contribution is anything of value that increases the capital of a superannuation fund provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general.

Change in ATO view on what is a contribution is after LCR 2021/2

The ATO state in LCR 2021/2 that where NALE is incurred to acquire an asset all of the income (including both ordinary and statutory income, eg, net capital gain) from that asset will be assessed as NALI at [27] to [30] as:

[27]    Where a complying superannuation fund purchases an asset at less than market value under a scheme where the parties were not dealing at arm’s length, the fund incurs [NALE] for the purposes of applying the [NALE] provisions. …

[28]    In situations where the terms of a contract between the complying superannuation fund and the seller of the asset make it clear that the asset is being purchased by the fund, the difference between the consideration paid (if any) by the fund and the market value of the asset purchased under the contract cannot represent the value of an in specie contribution made by the other party. …

[29]    An in specie contribution can be made in conjunction with a complying superannuation fund purchasing part of an asset where a contract makes it clear the fund is only acquiring part of the asset. In such situations, the fund:

  • purchases the interest in the asset specified under the contract, and
  • receives the in specie contribution of the remaining interest in the asset.

The complying superannuation fund will not have incurred [NALE] for the purposes of subsections 295‑550(1) or (5) where that part of the asset acquired under the contract is purchased at market value. However, if the fund pays less than market value for the part of the asset purchased under the contract, then the [NALE] provisions apply for the reasons outlined in paragraph 27 of this Ruling.

This would be the case even if the in specie contribution relating to the other part of the asset is recorded at market value in the fund’s accounts and is allocated to the member’s superannuation interest.

[30]    A consequence of the [NALE] provisions applying to the purchase of either all, or a part, of the asset is that all of the income derived from that asset will be NALI, including any capital gains from the disposal of the asset.

Example of a part purchase and a part in specie contribution

Let’s now examine and apply this ATO theory to an example to seek to determine how the ATO’s theory stacks up to scrutiny.

Facts –– John’s SMSF –– part purchase and part in specie contribution:

  • John has business real property with a market value of $500,000 that he leases to a third party which uses the property to carry on a business.
  • John enters into a contract of sale to sell a ½ tenant in common (T-i-C) interest for $200,000 to his SMSF (undervalued by $50,000).
  • John also makes an in specie contribution of a ½ T-i-C interest, and his SMSF records this as a $200,000 non-concessional contribution (NCC) to his SMSF (undervalued by $50,000).
  • The ATO subsequently determine the property was undervalued.

Note the above facts are similar to those in example 5 of LCR 2021/2 involving Nadia selling a 50% T-i-C interest of her commercial premises to her SMSF and contributing the remaining 50% as an in specie contribution at market value. However, the transactions in John’s example are not undertaken at market value.

What is the outcome when both the sale and contribution are undervalued?

Given that part of the property was purchased for less than market value, this results in all of the income from that property being NALI (ie, both the rental income each financial year and any future net capital gain resulting from disposal will be NALI). Moreover, having regard to LCR 2021/2 at [27] and [30], since part of the asset is NALI, the ATO consider any income from the other part of the same asset held by the SMSF will also be NALI.

In John’s example, both the purchase price and NCC were undervalued. Given that John’s contract of sale specified that his fund was only acquiring 50% of the property, the remaining part can be treated as a contribution. However, John’s SMSF should have reflected this contribution at its correct market value of $250,000. Thus, the ATO would increase John’s NCCs by $50,000 (on top of the $200,000 of NCCs actually reflected in John’s SMSF’s financial statements and statutory annual return). The ATO’s view on this point is outlined in the DC at [25B] as:

25B.   An in specie contribution is required to be reflected at its market value in the fund’s accounts and the member’s superannuation interest. That is, the amount of the member’s contribution is equal to the market value of the in specie contribution. If the relevant asset is recorded at less than market value in the fund’s account and the member’s superannuation interest, the trustee is required to update the fund’s accounts and member’s superannuation interests to reflect the appropriate market value. Further, the amount of the contribution for the purposes of applying the concessional and non-concessional contributions cap rules is the market value of the asset.

Having regard to the above example, the ATO view at [164B] of the DC is that the 50% T-i-C interest in the property purchased at an undervalue gives rise to NALE and the ATO view at [164C] confirms that the other 50% made as a contribution should be adjusted to record the correct market value of the property.

Thus, the ATO view is that the entire property in this example is tainted with NALI even though John’s NCCs were adjusted. It appears the ATO view is based on the theory that John’s SMSF becomes the owner of 100% of the property and since part (in this case 50%) was purchased under market value all of the property remains tainted for NALI purposes.

As noted above, the ATO at [29] state:

… However, if the fund pays less than market value for the part of the asset purchased under the contract, then the [NALE] provisions apply for the reasons outlined in paragraph 27 of this Ruling. This would be the case even if the in specie contribution relating to the other part of the asset is recorded at market value in the fund’s accounts and is allocated to the member’s superannuation interest.

[Emphasis added]

For the reasons outlined below, we query the correctness of the ATO view based on the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and the ATO’s analysis in Tax Determination (TD) 2000/31. Relevantly, s 108-5 provides:

108-5:

(1) A CGT asset is:

(a)    any kind of property; or

(b)    a legal or equitable right that is not property.

(2) To avoid doubt, these are CGT assets:

(a)    part of, or an interest in, an asset referred to in subsection (1); …

[Emphasis added]

Moreover, s 108-65 treats as separate assets if part of land was acquired before 20 September 1985 and adjacent land is acquired on or after that date. Section 108-65 provides:

108-65:

Land that you *acquire on or after 20 September 1985 that is adjacent to land (the original land ) you acquired before that day is taken to be a separate *CGT asset from the original land if it and the original land are amalgamated into one title.

Example: On 1 April 1984 you bought a block of land. On 1 June 1999 you bought another block of land adjacent to the first block. You amalgamate the titles to the 2 blocks into 1 title.

The second block is treated as a separate CGT asset. You can make a capital gain or loss from it if you sell the whole area of land.

The ATO has also provided its view on how separate acquired parts of an asset are to be treated separately for tax purposes in TD 2000/31. The following is an extract from TD 2000/31:

TD 2000/31 Income tax: capital gains: if you own an interest in a CGT asset and you acquire another interest in that asset, do the interests remain separate CGT assets for capital gains purposes or do they become a single asset?

  1. The interests remain separate CGT assets for capital gains purposes.
  2. The interests are separate CGT assets whether the first interest was acquired before 20 September 1985 (a pre-CGT interest) or was acquired on or after 20 September 1985 (a post-CGT interest).
  3. The consequences are that on the occurrence of CGT events affecting the interests (for example CGT event A1 - about disposals of CGT assets - in section 104-10 of the Income Tax Assessment Act 1997):

(a) there is a separate date of acquisition for each interest;

(b) there is a separate cost base for each interest; and

(c) capital proceeds are determined separately for each interest.

Example 1

  1. Sam and Terry jointly purchase land in 1982 to build a holiday house. Terry sells his 50% interest to Sam in 1998. Any capital gain or capital loss Terry makes is disregarded for capital gains purposes because his interest is a pre-CGT interest.
  2. If Sam later sells the land, the sale proceeds are attributed 50% to the pre-CGT interest and 50% to the post-CGT interest. Any capital gain or capital loss Sam makes on his pre-CGT interest in the land is disregarded for capital gains purposes. If Sam makes a capital gain on his post-CGT interest in the land it would be taken into account in calculating his net capital gain or net capital loss for the income year.
  3. If Sam decided to sell only a 50% interest in the land, he could:

(a)     sell either his (50%) pre-CGT interest or his (50%) post-CGT interest; or

(b)     he could sell two 25% interests in the land (being 50% of his pre-CGT interest and 50% of his post-CGT interest).

Applying the ATO’s theory in LCR 2021/2, we query why the entire asset should be tainted with NALE when only part of the asset is acquired at an undervalue.

Indeed, as the fund is required to recognise the market value of the 50% of the property as an NCC, the fund would be considered to have provided arm’s length consideration for this 50% T-i-C interest.

Moreover, the ATO view appears to provide a situation where the fund is adversely impacted in two ways:

  • both 50% T-i-C interests are taxed as NALI including net rental income and any net capital gain; and
  • the fund is required to recognise the additional contribution, in this case an extra $50,000 NCC, which could give rise to excess contributions issues and further issues to deal with.

Thus, we submit that the ATO should provide due recognition to the legislative provisions discussed above and the ATO’s position reflected in TD 2000/31 that treat a part interest in an asset as a separate asset for tax purposes and not seek to apply two different sets of provisions to the same asset (ie, the NALE and contribution provisions resulting in a potential ‘double counting’ outcome).

That is, in this case, we submit that the correct application of the legislation would result in:

  • the 50% T-i-C interest that is purchased at below market value would give rise to NALI in respect of that interest; and
  • the 50% T-i-C interest made as a contribution would give rise to an additional contribution to reflect that part of the asset being acquired at market value. In this case, a $50,000 NCC would be the adjustment to John’s NCCs that may give rise to excess contribution issues.

The view that we submit above overcomes any ‘double counting’ that is associated with the ATO’s current theory.

The CGT market value substitution rule

Note that the market value substitution rule also applies in relation to the above example. This will eventually result in the net capital gain in relation to the 50% T-i-C interest purchased by John’s SMSF being calculated by reference to the correct market value cost base upon a future CGT event occurring, eg, when the asset is disposed of by the fund.

The ATO cover this rule at [81] to [82] of LCR 2021/2 as follows:

  1. Where a superannuation fund acquires a CGT asset at less than its market value, the market value substitution rules in section 112-20 may apply to modify the cost base or reduced cost base of the asset. The superannuation fund, when determining the cost base of its CGT asset, is treated as having acquired the asset at market value. This affects the amount of any capital gain that may arise from a later CGT event, but does not affect the application of the [NALE] provisions in determining whether the asset was acquired by the fund at market value.
  2. Any capital gain that the fund makes from a subsequent CGT event happening in relation to the asset (such as a disposal of the CGT asset) will be NALI.

Thus, John’s SMSF is deemed to have paid the correct market value of $250,000 in respect of its 50% T-i-C interest purchased for $200,000. That is, the cost base of this interest is $250,000 in calculating any future net capital gain.

For completeness, the market value substitution rule would also apply to the in specie contribution of the other 50% T-i-C interest in determining any future net capital gain in respect of that part of the asset.

What if the sale is undervalued but the contribution reflects market value?

First, to address the obvious query that may arise here –– it could be said that a mismatch in value (between a part sale and part contribution) is unlikely to happen as most people would apply the same value to both parts of a 50-50 sale/contribution (or a proportionate value split if the interests sold and contributed in specie was otherwise than on a 50-50 basis).

However, in practice, often a part sale may occur at one time and some other time down the track, the other part is contributed, or vice versa, and therefore a mismatch in value can easily occur. So a mismatch in value is likely to arise as invariably the sale and contribution do not occur at the same time.

Now reverting back to the facts in John’s example above and assuming that John’s SMSF recorded the correct market value for the contribution of $250,000 but the fund only paid $200,000 for the 50% T-i-C interest under the contract of sale, then the ATO view is that all income remains tainted as NALI given its comments at [30] of LCR 2021/2 as:

[30]    A consequence of the [NALE] provisions applying to the purchase of either all, or a part, of the asset is that all of the income derived from that asset will be NALI, including any capital gains from the disposal of the asset.

The ATO view results in 100% of the rental and 100% of any net capital gain on a future CGT event being NALI.

As noted above, we do not agree with the ATO’s view on this point as each T-i-C interest should be accorded its separate and distinct treatment for CGT purposes. The current ATO view appears to be based on the idea that once the SMSF acquires both interests, the ‘merger’ of those interests results in the whole asset being acquired for less than market value.

In this current example, the purchase cost was $200,000 and the contribution in specie of $250,000 has resulted in the property being acquired for $450,000 overall when its market value is $500,000. However, the application of the market value substitution rule results in the property having a cost base of $500,000. Thus, we query why the entire property should be tainted when the contribution is recorded at market value.

What if the sale is at market value but the contribution is undervalued?

If we now assume that John’s SMSF paid the correct market value for the 50% T-i-C interest purchased and undervalued the 50% T-i-C in specie contribution, then it would appear that NALI would not apply as the ATO would merely treat John as having an additional $50,000 contribution as an NCC (which may give rise to excess contribution issues).

However, given the ATO has only issued the DC in draft for consultation and given that LCR 2021/2 has only recently been finalised, SMSF trustees should seek advice before making any decision based on these ATO materials as numerous superannuation and industry bodies are still seeking to clarify a number of important ramifications arising from the ATO’s recent views. 

For example, an expense payment on behalf of a superannuation fund has been treated as a contribution since TR 2010/1 was originally issued. However, since a fund would not be paying such an expense (either in full or part) an expense payment on behalf of a fund would also appear to be NALE. However, there is no ATO guidance on this point and there is no tie breaker to prevent double counting.

Also, when a superannuation fund is set up, often the costs of the SMSF deed and corporate trustee are not paid by the fund. Similarly, there appears to be a NALE risk with this practice and clarification from the ATO is needed.

Make sure sale contracts specifies what part(s) are being purchased

Until we get further clarification (hopefully in the form of legislative clarification), the practical take away from the above is to ensure that where part of an interest in an asset is being purchased, the sale contract should specify the part that is being acquired. This allows the remaining part of the asset to be treated as a contribution.

Note that where assets such as shares in a company or units in a unit trust are being purchased by an SMSF to the extent this is permitted under s 66 of the Superannuation Industry (Supervision) Act 1993 (Cth), the specific number of shares or units or the specific identification number or serial number to these shares or units should be specified so that there is a clear division between what is covered by the contract of sale and what might be covered as an in specie contribution.

Conclusions

The changes above represent a significant change to the traditional approach to contributions. As can be seen from looking at the above examples, the ATO’s views about the division and interaction between NALE and contributions leaves a number of important issues to be determined and clarified although we note that the revised the DC is yet to be finalised.

Advisers need to be alert to the current uncertainty and seek advice wherever there is any doubt.

By Shaun Backhaus, Senior Associate (This email address is being protected from spambots. You need JavaScript enabled to view it. and Daniel Butler, Director (This email address is being protected from spambots. You need JavaScript enabled to view it.), DBA Lawyers

What’s the dividing line between NALI and a contribution?
daniel butler shaun backhaus smsf
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