Trustees trapped in nightmare of new expense rules

They were introduced in October 2019 (and backdated to July 1, 2018) to address perceived deficiencies in the non-arm’s-length income (NALI) provisions.

The angst around NALE was only somewhat diminished by the January 2023 Treasury announcement that proposed the shortfall between an arm’s-length and non-arm’s-length general expense (that is, an expense that does not relate to a specific fund investment) be multiplied by a factor of five. It was certainly better than the Australian Taxation Office’s view where a lower general fund expense had the potential to taint all an SMSF’s income as NALI and be taxed accordingly.

Industry breathed a little easier when the May 9 federal budget announced that the five times multiple would be cut to two. This meant a general expense shortfall amount of $2000 would result in $4000 (2 x $2000) being classified as NALI and taxed at 45 per cent.

This budget announcement has since been confirmed with the release of draft legislation. As announced on budget night, and confirmed by the draft legislation, it appears the NALE provisions are entirely aimed at SMSFs, with large APRA funds having been carved out of the provisions for both general and specific expenses. The long-held principle that any tax must be underpinned by a level playing field has been abandoned.

Good, bad and ugly

That said, and to be fair to Treasury, this draft legislation is not all bad. Indeed, on reading it, that famous Clint Eastwood/Sergio Leone movie, The Good, the Bad and the Ugly, comes to mind.

The “good” is that the proposed multiple of two change for general expenses is a much improved position compared with current law whereby all the fund’s income could be tainted as non-arm’s-length.

Under the proposed draft legislation, the total amount taxed at the highest marginal tax rate will also be subject to an “upper cap” to ensure it does not exceed the SMSF’s total taxable income.

The draft legislation will also ensure that assessable contributions and related deductions are not subject to the higher rate of tax under the NALI provisions. Under current legislation, assessable contributions – such as SG, salary sacrifice and personal deductible contributions – could be captured and taxed as NALI.

Finally, it confirms that expenditure incurred before July 1, 2018 will be exempt from NALI. Again, under the current legislation, NALE applies retrospectively and can apply to income derived after the changes were introduced.

But that’s where the good news ends. The rest is “bad” or just plain “ugly”.

Tax penalty of 45 per cent

June 30 this year saw the end of the ATO’s transitional compliance approach to determining whether the NALI provisions apply to a fund that incurred NALE. This transitional compliance approach meant, in effect, that the ATO took a “relaxed view” regarding NALE compliance as it related to general expenses. So, it means that with the ending of the ATO’s benign approach to NALE, the importance of the proposed legislation becoming law as soon as possible becomes imperative if SMSFs are to avoid being penalised with a 45 per cent tax rate.

It also means the SMSF sector is left with a heavy compliance burden to demonstrate that expenses incurred are on par with what would be expected to be incurred had parties been dealing at arm’s length. To add to the administrative headache, the proposed law now also requires capital and revenue expenses to be taxed differently if not on arm’s length terms.

Other “bad” features of the draft legislation include the fact that SMSF auditors may be left exposed as NALE and NALI is not a superannuation law compliance breach reportable to the ATO.

Finally, we come to the plain “ugly”, which is the severity of the NALI rules in relation to specific investments (or income sources). The draft legislation fails to deal with the disproportionate outcome that can arise when a specific expense taints future capital gain derived by the fund when the asset to which the specific NALE relates is eventually sold.

Another “ugly” feature is the uncertainty surrounding how the NALI provisions interact with the long-established CGT provisions. The ATO’s recently published draft tax determination on this matter is just a further illustration of the complexity and, many would argue, inequities of the NALE provisions.

What is being forgotten in all this is that the primary goal behind the initial NALE amendments was to target SMSFs that enter borrowing arrangements with related parties on non-arm’s-length terms.

The release of a subsequent ATO contribution ruling and safe harbour guidelines has meant this risk, and the broader risks associated with NALE are now so insignificant, and the likely outcomes so innocuous, that such a complex and costly legislative response is not justified. There remains a strong argument that the 2019 NALE changes should be repealed altogether.