The government has announced that it intends to make changes to tax law from 1 July 2022 to ensure that the Non- Arm's Length Expenses (NALE) provisions operate as originally intended (and not as set out in the ATO's LCR 2021/2). There will be a consultation process with industry stakeholders on the intended operation of NALE provisions prior to the government finalising its amendments to the relevant tax law.
This article explains the existing drafting of the law and the issues that arise from it in practice, particularly the concerns arising from the ATO's interpretation of the provisions in LCR 2021/2.
Obviously, the planned changes will need to be monitored and assessed depending on the outcome of the Federal Election on 21 May 2022.Alisha Wright, Maddocks Lawyers
The taxable income of a SMSF is made up of two components – a 'low tax component', which is taxed at 15%, and a 'non-arm's length component' known as NALI, which is taxed at the top marginal tax rate.
More recently, the operation of the NALI provisions has been extended to include circumstances where the fund incurs a loss or incurs an expense other than on an arm's length basis. In particular, the NALI rules now extend to outgoings or expenditure which are less than what would be expected if the parties were dealing at arm's length – this is referred to as NALE. These rules are governed by section 295-550 of the Income Tax Act 1997 (ITAA97).
Similarly, if the SMSF does not incur a loss, outgoing or expenditure at all, in circumstances where it would be expected that that SMSF might otherwise have incurred such an expense had it been dealing with counter-parties at arm's length, the SMSF has incurred NALE.
Where, for instance, a SMSF acquires shares from a related party for below market value (i.e. NALE), all subsequent income derived from those shares (such as dividends) will be deemed NALI and taxed at the top marginal rate in the hands of the SMSF. The subsequent capital gain on those shares will also be deemed NALI. This extends to every type of asset, including real property.
The ATO's LCR 2021/2 states that, where NALE was not incurred to acquire a particular asset, NALE is deemed to have been incurred for all income of the SMSF.
It gives the example of a trustee engaging an accounting firm to provide accounting services which includes managing the SMSF's income tax affairs and obligations. The accounting firm does not charge the SMSF for those services, not because of an arm's length discount offer or bargain, but as a result of non-arm's length dealings between the parties.
For the purposes of subsection 295-550(1) of the ITAA97, this is deemed NALE and the ATO's view is that this NALE has a sufficient nexus with all of the ordinary and statutory income derived by the SMSF for the 2020-21 income year.
As such, all of the SMSF's income for the 2020-21 income year is NALI and will be taxed at the top marginal rate in the hands of the SMSF.
At paragraph 19 of LCR 2021/2, the ATO includes a list of expenditure that may have a sufficient nexus to all income derived by a superannuation fund, including:
A detailed set of examples can be found in the ATO's Law Companion Ruling 2021/2.
Contrary to the ATO's interpretation in LCR 2021/2, it seems that parliament intended that the ITAA97 operate such that, in order to determine whether there is a 'sufficient nexus' between NALE and all ordinary and/or statutory income derived by the fund, the NALE must be incurred 'in gaining or producing the relevant income'.
The fact that all income of the SMSF may become NALI for fairly benign occurrences, such as the one described at Example 2 of LCR 2021/2, is not something explicitly stated in the ITAA97.
To ensure that the rules regarding NALI and NALE operate as parliament originally intended (as described above), the government has announced that, following consultation with industry stakeholders, it will make changes to the relevant tax law effective from 1 July 2022.
Notwithstanding the government's announcement, the ATO has stated that it will not extend the current relief for compliance with NALE past 1 July 2022 as is provided by PCG 2020/5 (which also announced that the ATO will not allocate compliance resources to determine whether the NALI provisions apply to NALE of a general nature for the previous 3 income years).
For more information, please contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.
You can read earlier ClearLaw articles on a range of topics, such as:
 S 295-550(1)(c) of the ITAA97.
Kate is a lawyer in Maddocks General Commercial Team. Kate joined the firm in 2010 as a paralegal and was admitted to practice in December 2012.
Kate has been involved in acting for a range of commercial, government and professional industry clients.
Her areas of expertise include:
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For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of their team.