Approaching NALE and NALI for SMSF clients
While the ATO has extended its compliance relief for non-arm’s length expenditure of a general nature, it's still worth reviewing potential non-arm's length income issues with SMSF clients.
In light of the government’s announcement on 22 March 2022 that it intends to amend the current SMSF law surrounding NALI (non-arm’s length income) and NALE (non-arm’s length expenditure) in relation to the LCR 2021/2 to “ensure it operates as intended”, it’s important to begin to address your SMSF clients’ concerns surrounding the issue.
As you may be aware, tax law has evolved to disincentivise various types of income that would otherwise be taxed at a standard rate — such as the purchase of property from a family member at a discounted price, or a LRBA from a related party at a lower than standard interest rate — from being diverted into SMSFs. This resulted from numerous SMSF holders taking advantage of weaknesses in the legislation in order to lower their expenses and increase their income without tax ramifications.
Currently, NALE and NALI are taxed at a rate of 45%. This is in comparison to arm’s length expenditure and income tax for SMSFs, which is currently taxed at a rate of 15%.
The ATO announced last month that it would again extend its transitional compliance approach set out in PCG 2020/5 in relation to non-arm's length income until 1 July 2023.
However, PCG 2020/5 has a very limited application and only refers to expenditure of a general nature incurred by the fund that has a sufficient nexus to all of the income of the fund. The broader provisions to NALE have been applicable since 1 July 2018.
While it is understood that Labor supports making changes to the operation of the non-arm's length income provisions to ensure they operate as intended, there has been no public announcements on this as yet. Therefore, SMSF professionals may want to review potential NALI issues with their clients.
NALE and NALI explained
NALI refers to income derived from instances where the SMSF receives more than they otherwise would have had they done business with someone in an arm’s length arrangement.
NALE was introduced in 2018 to broaden the scope of NALI. It exists conceptually to ensure that not only should the SMSF income be derived on a commercial basis, but that fund expenditure should also be commercial. In the case of NALE, the SMSF’s expense would be less than if the individual engaged in arm’s length dealing.
What it means for clients
Where an expense is incurred by an SMSF that is less than market value, all of the fund’s income is considered to be NALI, and will therefore be taxed at a rate of 45% after expenses.
This makes instances of NALI and NALE risky for SMSF clients that should generally be avoided, unless the benefit for incurring NALE is proportionate to the taxation.
What counts as NALI/NALE?
Certain instances that might be considered NALE have been discounted by the ATO. For example, doing your own bookkeeping and not charging the fund for the service is not counted as an instance which would make your income 45% taxable under the NALE rules.
Further, financial advisers who use their own skills and knowledge to increase their fund investments will also not be taxable. These are considered instances of acting in your individual capacity. This implies that any use of personal knowledge or skills is acceptable under this legislation as a trustee.
If however a partner at a firm were to get staff to perform accounting work on his SMSF and not charge the SMSF for the service, it would constitute NALE.
Also, when a property is acquired from a related party at less than market value, then all rental income derived from that property becomes “tainted” even if the rental agreement is maintained at arms length.
With a related party LRBA loan that is not maintained at arms length it again “taints” all income derived from the property. Even if the loan were to be subsequently refinanced at arms length the NALI provisions would still apply.
How does this affect SMSF clients?
In order to avoid penalty tax by incurring NALI/NALE, it is worth suggesting that clients:
- Ensure that related parties charge commercial rates. To avoid causing NALI issues, clients should ensure that that they are charged fairly for their services if they do business with a related party.
- Understand the ATO’s expectations. If purchasing assets, such as residential or commercial property, particularly in cases where the asset is purchased in or in part with cash, clients should ensure that they understand what the ATO expects from them.
- If incurring NALE/NALI, ensure that the savings are proportionate to the penalty. Because all income will be taxed at 45% as a result of even a single instance of NALI-tainted income, it is important that clients weigh up their options if considering incurring NALE or NALI.
Reviewing this legislation carefully is imperative to ensuring client security. If in doubt, you can contact the ATO directly for further information.