· Ordinary NALI (includes non-arm’s length expenditure (NALE) that is not covered by s 295-550(8) and (9)) found in s 295-550(1).

· Dividend NALI found in s 295-550(2) and (3).

· Non-fixed trust entitlement NALI found in s 295-550(4).

· Fixed trust entitlement NALI found in s 295-550(5).

· NALE (but not in relation to a particular asset, where the loss, outgoing or expenditure is less than an arm’s length amount, ie, general NALE) found in s 295-550(8).

· NALE (similar to s295-550(8) but where there is no or a nil loss, outgoing or expenditure) found in s295-550(9).

Section 295-545 provides that the taxable income of an SMSF is split into a non-arm's length component and a low tax component. While the low tax component of a superannuation fund is subject to a 15% rate of tax (or zero on assets in pension or retirement phase) the non-arm’s length component is subject to a 45% tax rate (Income Tax Rates Act 1986 (Cth), s 26).

There is a two times multiple to the lower loss, outgoing or expenditure that is deemed to be the NALE amount that is taxed as NALI under s 295-550(8). The NALE amount that is taxed under s 295-550(9) is two times the amount that the entity might have been expected to incur had the parties been dealing at arm’s length.

Further, where the entity is an SMSF or a Small APRA Fund, the non-arm’s length component is subject to s 295-545(2A) that has the effect of reducing the deemed amount that might otherwise be taxed under s 295-550(8) and (9) by capping the amount to the fund’s actual taxable income as adjusted under s 295-545(2A)(b).

Background to NALI

Earlier NALI provisions

Section 273 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) was initially introduced to counter higher than arm’s length dividends in private companies being paid to superannuation funds and to counter certain other non-arm’s length transactions.

On 25 November 1997, s 273 of the ITAA 1936 was expressly amended so that NALI caught certain trust distributions to superannuation funds.

Section 273 largely remained unchanged from 25 November 1997 to mid-2007 when it was replaced by s 295-550, which took effect on 1 July 2007. The 1 July 2007 superannuation reforms broadly resulted in part IX of the ITAA 1936 being replaced by part 3-30 of the ITAA 1997 and s 295‑550 was largely a restatement of s 273 of the ITAA 1936 in more modern language.

2018 Treasury consultation and subsequent amendments

In 2018 Treasury carried out a consultation process regarding changes to the NALI rules as part of the Superannuation Taxation Integrity Measures Consultation Paper (2018 Treasury Consultation Paper). Treasury considered that the rules in place did not take into account fund expenditure incurred that would normally apply in a commercial transaction. The 2018 Treasury Consultation Paper and exposure draft legislation was aimed at assessing non-arm’s length related party limited recourse borrowing arrangements (LRBAs).

The impetus for the NALE changes in mid-2018 was an increase in low or no interest LRBAs in use by certain SMSFs. The ATO had issued several favourable private rulings (confirming certain low and no interest LRBAs) prior to the ATO issuing the safe harbour LRBA guidelines in PCG 2016/5 called ‘Income tax - arm's length terms for Limited Recourse Borrowing Arrangements established by self-managed superannuation funds’.

The Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2019 (2019 Bill) received royal assent on 2 October 2019. The 2019 Bill re-cast ss 295-550(1) and (5) to expressly provide for arrangements where an SMSF trustee incurred lower or no expenses than might have been expected to incur had it been dealing at arm’s length.

This 2019 Bill proved controversial as a lower or nil expense of a general nature could result in all of the ordinary and statutory income of an SMSF (including assessable contributions) being NALI for a particular income year. The ATO provided some administrative relief in PCG 2020/5 which stated that the ATO would not allocate compliance resources to determine whether the NALI provisions applied to a complying superannuation fund for FY2019 to FY2023 where a fund incurred NALE of a general nature. However, the ATO administrative relief in PCG 2020/5 ceased on 30 June 2023 leaving SMSFs open to general NALE risks from 1 July 2023.

Following years of industry consultation, the Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Bill 2023 (2023 Bill) was introduced and finally passed as law on 24 June 2024 with royal assent being received on 28 June 2024. Broadly, the 2023 Bill included the following changes and applied with retroactive effect from 1 July 2018:

· Large APRA funds were excluded from the operation of the NALE rules for both specific and general NALE.

· The amount of NALI taxed due to a lower or nil general expense was subject to the application of the ‘twice the difference’ in subsections 295-550(8) and (9) respectively.

· Concessional contributions would not be subject to NALI.

Ordinary NALI

Legislative overview

Section 295-550(1) provides:

(1) An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation entity if, as a result of a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme, one or more of the following applies:

(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme;

(b) if the entity is of a kind referred to in paragraph (8)(a) (about certain small entities):

(i) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme; and

(ii) subsection (8) does not apply to the loss, outgoing or expenditure;

(c) if the entity is of a kind referred to in paragraph (8)(a) (about certain small entities):

(i) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme; and

(ii) subsection (9) does not apply to the loss, outgoing or expenditure that the entity might have expected to incur.

This subsection does not apply to an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust.

Scheme

The first step for the ordinary NALI provisions to be applied requires that the parties to the scheme were not dealing at arm’s length.

The definition of scheme in s 995-1 of the ITAA 1997 is so broad as to render little assistance. It provides:

"scheme" means:

(a) any arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

Based on this definition, in practice it can usually be assumed that the SMSF trustee is a party to a scheme. At times, identifying what steps or actions form the relevant scheme and the parties to the scheme can be contentious.

Meaning of arm’s length

Section 995-1 of the ITAA 1997 provides the following as a definition of arm’s length:

"arm's length": in determining whether parties deal at arm's length consider any connection between them and any other relevant circumstance.

It has been said that this definition contains a direction about how to determine whether parties are dealing at arm's length rather than a definition or explanation of the expression (The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation [2012] AATA 527 (Ghali), [48]).

A useful explanation of ‘arm’s length’ is stated in APRA v Derstepanian (2005) 60 ATR 518, [18]):

… a dealing that is carried out on commercial terms. … a useful test to apply is whether a prudent person, acting with due regard to his or her own commercial interests, would have made such an investment.

Another explanation was provided in Granby Pty Ltd v FCT [1995] FCA 259 as follows:

… the term "at arm's length" means, at least, that the parties to a transaction have acted severally and independently in forming their bargain.

Application of Ordinary NALI — LCR 2021/2

Although the 2023 Bill has provided some relief in respect of general NALE, the ATO view is that a lower expense in relation to a particular asset will generally give rise to NALI in respect of all future income and capital gains derived from that asset. This is extremely broad and can result in innocent oversights tainting an asset for life, as demonstrated in example 9 of LCR 2021/2. In this example, Trang, a plumber, renovated the bathroom and kitchen of a rental property owned by her SMSF without charging an arm’s length fee. This resulted in all of the future net rental income and any net capital gain in respect of a disposal of that property in the future being taxed as NALI.

In contrast, in example 1 of LCR 2021/2 Armin sells a commercial property to his SMSF for $200,000 which has a market value of $800,000. While NALI applies to all future net rental income and any net capital gain, the SMSF trustee obtains a market value (substituted) cost base under s 112-20 of the ITAA 1997 of $800,000 in determining his fund’s future net capital gain.

Note that the CGT market value substitution rules for the amount of capital proceeds apply differently in a superannuation context. In particular, s 116-30(2C) does not limit the capital proceeds from a CGT event to the market value of a CGT asset in a superannuation fund context. This rule was examined in Kilgour v Commissioner of Taxation [2024] FCA 687 in a non-superannuation context but the parties were deemed to be dealing at arm’s length. Section 116-30(2C) can therefore result in a superannuation fund being taxed on capital proceeds that exceed the market value of the CGT asset.

We have examined a number of aspects of NALI in this Part 1 article. Our next Part 2 article on NALI and NALE will cover dividend NALI and fixed entitlement NALI. Our Part 3 article will examine general NALE and other NALI interactions (ie, CGT and contributions).

Conclusions

The NALI provisions can be applied to a wide range of situations. The result of such a broad application is the potential for significantly disproportionate outcomes for SMSFs particularly where the Ordinary NALI provisions under s 295-550(1) are enlivened in respect of a particular SMSF asset. When enlivened, SMSFs that incur nil or lower expenses in relation to a particular SMSF asset can result in a 45% tax rate on all that asset’s ordinary net income as well as on any net capital gain when the asset is finally realised.

A number of professional bodies are seeking revised provisions to make NALI fairer and more practical. Advisers naturally need to be careful in advising clients of the risks and downsides of getting NALI or NALE wrong. We hope the provisions will be revised soon to provide more practical and appropriate law.