Getting NALI - Part 1
It's safe to say that the SMSF industry was never going to sanction LCR 2021/2 ("the LCR") in any form. But as it is now law, we have to make sense of the LCR and start getting NALI.
The latest ruling clarifies the amendments to section 295-550 of the ITAA 1997 ("s295-550") to provide certainty and transparency – or as much as possible - on dealing with non-arm's-length general expenses (NALE).
While the LCR seems to have generated more questions than answers, SMSF practitioners will need to wait and see how it plays out in practice.
Dealing with parties on arm's length terms has always been a part of the superannuation rules under s109 SIS.
But s109 covers investing in assets only and does not deal with the income generated from those non-arms length transactions. Under SIS, there are no repercussions for trustees who partake in non-commercial activities to be penalised for the excessive income from those activities.
In 2007, s295-550 was updated to capture dividends from private companies as special income and to catch certain trust distributions.
It was amended again in 2018 to take into account Treasury's Superannuation Taxation Integrity Measures, which considered the income from non-commercial related party LRBA's and the effect of non-arm's length expenses, losses, or outgoings on the income of the fund.
For the first time, the ATO stepped beyond the concept of linking special income to a specific asset to encompass NALE that taints all of the fund's income.
Soon after, the ATO issued draft ruling LCR 2019/D3, which clarified the amendments to s295-550 by providing specific examples of applying NALE.
One of these examples included a qualified accountant using their professional and business resources to prepare the fund's financials and lodge the tax return but not charge the fund a fee.
Under these circumstances, there is a sufficient nexus with all of the fund's income to become NALI for that income year. Given the negative feedback to the draft ruling, the ATO released PCG 2020/5, which provided the SMSF industry with a transitional compliance period until the 2023 financial year.
However, this does not apply to NALE concerning specific assets, which will still get caught.
While the ATO has categorically stated that it has no plans (at this time anyway) to release any further Explanatory Memorandums to this LCR, it means interpretation of the ruling and understanding how it applies in practice has been left the SMSF industry. So it is critical to get NALI right.
Is NALI a Tax Issue or SIS Issue?
We keep hearing that NALI is a tax issue and not an SIS issue.
The reason is that s109 SIS deals with the ability of the fund to invest in an asset on arm's length terms and conditions – it says nothing about the income from that asset.
There are two (2) limbs to investing at arm's length as required under s109:
- A trustee must not invest in an asset unless both parties are dealing with each other at arm's length; or
- If the parties are not dealing with each other on arm's length terms, the terms and conditions of the transaction are no more favourable to the other party than if they were dealing at arm's length terms
The legislation benefits the fund because it implies the terms cannot be less favourable to the SMSF. However, when the fund receives an advantage, there are no repercussions from s109 SIS (although other breaches may apply) as long as the terms are no less favourable to the fund and no more favourable to the other party.
And this is where the NALI provisions kick in.
The NALI and expenses provisions under s295-550 remove the tax concessions where the SMSF and other parties are not dealing at arm's length concerning a scheme.
The term 'scheme' is very loosely defined and casts an extensive net. While a scheme traditionally has sinister overtones, a 'scheme' can mean any arrangement, agreement understanding, promise or undertaking regardless of whether it's express or implied and whether or not enforceable. It can also include a plan, proposal, action and course of action or conduct.
Where the SMSF more than benefits, the NALI provisions tax the fund at the highest marginal tax rate, which applies to:
- Ordinary or statutory income derived from schemes
- Dividends or amounts attributable to dividends
- Entitlements to trust income (both fixed and non-fixed entitlements)
Where the income is deemed NALI, all income generated from that asset will be taxed at the top marginal tax rate of 45%, even if the member is in the pension phase.
What is NALI?
The ATO will apply three (3) tests to decide if the income is NALI:
1. The fund's ordinary or statutory income is more than expected than if those parties were dealing at arm's length with each other in relation to a scheme.
2. The fund's income will be NALI where the fund has incurred a loss, outgoing or expenditure that is LESS THAN what would have been expected if the parties had been dealing with each other at arm's length
3. The fund's income will be NALI, where the fund DOES NOT incur a loss, outgoing or expenditure that it should have incurred if the parties had been dealing at arm's length.
Typically, when a fund invests in an asset and the income is more than expected under a non-arm's length arrangement, all income from that asset is tainted and taxed at the highest marginal rate.
Remember, too, that NALI does not apply to a proportion of the income; it captures all fund or specific fund asset income for the entire year.
Where non-arm's length arrangements relate to a specific asset, NALI can also apply where there is a capital gain on the disposal of that asset taxed at 45%.
How to Apply NALE
While the NALE tests outlined above continue to trap income as NALI from a specific asset, the LCR goes one step further.
It states that where the fund has NALE 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 the fund's income for that financial year will be classified as NALI.
While NALE applies to all fund income from the 2019 financial year onwards regardless of when the scheme was entered, it is not reportable until the 2023 financial year.
There is no doubt that the new NALE tests place additional pressure on accountants and auditors to identify whether all costs associated with a fund are at arm's length terms.
The first step is to identify the relevant scheme where the parties are not dealing with each other at arm's length and identify the parties involved. The second is to review all facts and circumstances of the arrangement to decide whether it is or is not a scheme.
Precisely what expenses trigger NALI is the question.
The LCR states the type of expenditure does not determine whether the fund has incurred NALE to gain or produce the income. It can be deductible under a specific provision, provided there is a sufficient nexus to the relevant income. But the types of expenses listed in the LCR disputes that point.
The Impact of Expenses
The list of specific expenditures that has a nexus to all fund income that triggers NALI include:
- Actuarial and accounting fees (except those fees incurred in complying with, or, managing, the fund's income tax affairs and obligations which are ordinarily deductible under section 25-5).
- Audit fees
- Trustee fees and indemnity insurance policy premiums
- Costs associated with calculating and paying benefits
- Investment adviser fees and costs
- Other administrative costs
The deductible components of preparing the accounts and tax return are excluded from the actuarial and accounting fee expenditure list. In contrast, the LCR states that the type of expenditure is irrelevant. So what is the answer?
The reality is that the LCR captures all other accounting services such as investment accounting, access to investment platforms, investment analysis and reporting.
As most accountants use SMSF administration software, differentiating between these services will be next to impossible and fee-splitting impractical.
One complex example in the LCR is where Mikasa is a trustee of her SMSF and uses her accounting firm, where she is a partner, to provide accounting services for her fund.
The accounting services include services other than compliance with the fund's income tax affairs and obligations.
Because the accounting firm is not charging Mikasa for those other services, this represents a non-arm's length arrangement that creates sufficient nexus with all of the fund's income for that year, taxed at 45%.
Does it mean that employees, staff, and Partners cannot receive a company discount or pro-bono work?
Paragraph 58 of the ruling states that discounted or pro-bono work can be offered where the trustee cannot influence the service provider's decision to supply the services on that basis.
Documenting a firm's decision to offer a discounted rate or for free is crucial. It is also essential to ensure that the discount policy is consistent with standard commercial practices.
Everyone who qualifies for that pricing should receive it, regardless of whether they are partners, employees, shareholders, or officeholders.
Shelley Banton – Head of Education, ASF Audits
ASF Audits has recently released its NALI factsheet which contains an industry first flowchart that graphically depicts the challenges of navigating your way through the NALI maze to determine whether the NALI provisions apply or not.
The NALI fact sheet, is now available from the website: https://asfaudits.com.au/resources/fact-sheet-smsf-compliance-nali/