NALE quirks to be resolved by new laws

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.

What is NALI?

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,[1] the SMSF has incurred NALE.

What are the practical implications of NALI and 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.

NALE incurred is deemed to have a nexus to all income of the SMSF

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:

• actuarial costs – except those incurred in complying with, or managing, the fund's income tax affairs and obligations;
• accountancy fees – except those incurred in complying with, or managing, the fund's income tax affairs and obligations which are ordinarily deductible; and
• audit fees.

A detailed set of examples can be found in the ATO's Law Companion Ruling 2021/2.

ATO's interpretation vs Parliamentary intent

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.

Changes to tax law

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).

More information from Maddocks

For more information, please contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics, such as:

• NALI Rules and the ATO's Approach in Law Companion Ruling 2021/2
• Changes to Insolvency Laws Mean SMSF Directors May Become Disqualified
• Transfer Balance Account Reporting and ATO Community Consultation

Order related document packages

• SMSF Minutes and Resolutions Package
• Superannuation Trust (SMSF)

[1] S 295-550(1)(c) of the ITAA97.