Navigating tax concessions and the pitfalls of non-arm’s length income
An essential aspect of the Australian superannuation system is its provision of various taxation concessions designed to encourage individuals to save for retirement. However, these concessions come with restrictions, such as the inability to access these retirement savings without meeting strict conditions.
As a result, from a taxation standpoint, individuals with the capacity and willingness to do so, aim to maximise their superannuation savings. This can be achieved through:
- Maximising the income derived by their superannuation fund.
- Minimising the fund’s expenses.
While achieving such outcomes in most types of superannuation funds is essentially impossible, it becomes more feasible in SMSFs. This is due to the fact that SMSF members also act as controllers, allowing them to determine the acceptable terms and conditions for funds dealing with third parties. Where transactions involve third parties associated with or related to the SMSF or its members, there is a greater opportunity to manipulate the terms and conditions compared to dealings with arm’s length parties.
For this reason, income tax law contains rules penalising SMSFs, along with other types of superannuation funds, that have derived non-arm’s length income (NALI) or incurred non-arm’s length expenses (NALE). NALI includes:
- Dividends from private companies and distributions from fixed trusts which are inconsistent with arm’s length dealings.
- Distributions from discretionary trusts.
- Income from schemes in which the SMSF and another party were not dealing at arm’s length and which is greater than that which would otherwise have been derived.
NALE broadly includes any non-arm’s length expenditure, whether of a capital or revenue nature, incurred in deriving the fund’s income. This includes circumstances where no expenditure was actually incurred but could have been reasonably expected to incur if the transaction was on arm’s length terms.
Consequently, it’s easy to see how, in many instances, an SMSF may find that it has derived NALI or incurred NALE. For example, this could occur in situations where an individual who is a member of the SMSF performs work to improve a rental property owned by the fund, and the individual receives no payment for the work performed.
The consequences of deriving NALI or incurring NALE can be potentially disastrous. Aside from the usual powers of the Commissioner of Taxation to impose administrative penalties and interest, deeming the fund to be non-compliant, and the potential banning and prosecution of its trustees, the most significant repercussion is that a portion, if not the entirety, of the fund’s income (including capital gains) will be taxed at a rate of 45 per cent.
The Commissioner has no discretion in this context. If an amount is considered NALI or NALE, the above-mentioned penalty taxation consequence applies, and the Commissioner cannot make exceptions, even if there are ‘special circumstances’. It’s important to note that many situations leading to NALI or NALE require a finding that parties were not dealing on arm’s length terms, in which the Commissioner is likely to have already considered any purported special circumstances before concluding that there was NALI or NALE.
There is uncertainty surrounding what proportion of a fund’s income would be subject to tax at 45 per cent when it incurs NALE of a general nature, that is, expenditure not directly attributable to a specific component of the fund’s income.
It’s important to note that a bill has been introduced to parliament aimed at providing clarity on this matter. Although the bill proposes to exclude the NALE rules for most APRA-regulated superannuation funds, such as retail and industry funds, it also proposes subjecting SMSFs (and small/private APRA-regulated funds) to a ‘two times multiple’ formula where they incur NALE of a general nature.
In those cases, rather than potentially taxing the entire fund’s income at 45 per cent, only an amount equal to two times the shortfall between an arm’s-length and non-arm’s length general expense will be subject to this penalty.
Finally, the Commissioner’s current approach, wherein compliance resources would not be allocated in respect of the financial year ended 30 June 2023, to determine whether the fund’s income qualifies as NALI where it incurs NALE of a general nature, up to that date has ended. Unfortunately, the risks and compliance responsibilities associated with NALI and NALE will continue to be a concern for the trustees and members of SMSFs.
