Non-arm's length income rules for SMSFs has been a hot topic in recent years, particularly in the context of limited recourse borrowing from related parties.
We have seen the ATO issue interpretative decisions, consult with industry and issue Practical Compliance Guidelines ('safe harbour') - together with the rush on the part of funds and their advisors to bring LRBAs into line with the safe harbour guidelines. There have also been attempts to amend the relevant legislation to provide clarity, the most recent of which lapsed when the 2019 Federal Election was called.
However, those clarifying laws have now become law, and they now expand the definition of 'non-arm's length income' so that funds which incur non-arm's length expenses - as a means of circumventing the contribution caps and augmenting income - are more clearly caught by the rules.Jack Coventry, Maddocks Lawyers
Australian taxation law splits the taxable income of complying super funds into two components: a low tax component, and a non-arm's length income (NALI) component. A concessional rate (15%) applies to the low tax component, while the NALI component is taxed at the highest marginal rate.
Under the current rules, an amount of ordinary income or statutory income is NALI of a super fund if:
The first component of the definition – that the income be derived from a scheme – is particularly broad and will capture a range of transactions and formal and or informal arrangements.
To date, this limb has been ambiguous in that it fails to clearly identify that expenditure incurred on non-arm's length terms could also result in NALI income – even where the resulting gross income generated is the same as might be expected had the dealing been at arm's length.
The new amending act (Act) extends the second component of the NALI definition to capture non-arm's length losses, outgoings and expenses. The idea is to ensure that super funds can't increase their income by accessing or incurring non-arm's length expenditure.
The Act extends the second component of the above definition to situations in which a super fund earns income and, in gaining or producing that income, the fund:
The circumstances where these provisions provide clarity include purchasing an asset using a non-arm's length loan, or generating rent while incurring non-arm's length expenses, such as management fees, repairs and capital works.
Notably, expenses may be of a revenue or capital nature in the same way that NALI may be statutory or ordinary income.
The result of an LRBA being a non-arm's length dealing is that the income will be subject to tax at the highest marginal tax rate, as opposed to the concessional superannuation rate. This penalty rate applies even if a fund is in pension mode and would otherwise pay no tax on pension earnings.
For example, a fund that acquires a commercial property under a limited recourse borrowing arrangement (LRBA) that includes no interest, no repayments until the end of the term and borrowing the full purchase price, will be subject to the amended NALI rules. This is because under the LRBA the fund incurs less expenditure than it might be expected to incur if the borrowing was on a commercial, arm's length basis. In those circumstances, the income generated from the scheme will be within the fund's NALI component and so will any eventual capital gain on disposal of the property.
The ATO's current position is set out in the interpretative decision ATO ID 2016/16.
This decision states that, to determine the amount of NALI income a fund has derived from a scheme, a determination must first be made of the terms on which the borrowing arrangement may have been entered into if the same parties had been dealing with each other on an arm's length basis. Once this hypothetical borrowing arrangement is identified, consideration is given to whether or not it is objectively reasonable to expect that the fund could have, and would have, entered into the hypothetical arrangement.
The ATO considers there are then two possible consequences:
A previous ClearLaw article examined the ATO's position in two predecessor interpretative decisions and is available here: SMSFs and related party borrowings: ATO waves a red flag on non-arm's length arrangements.
For more information, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Markets and Revenue team.
You can read earlier ClearLaw articles on a range of topics, including the following related articles:
Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2019.
Andrew is a Partner in the Maddocks Tax & Revenue team.
Andrew provides advice on:
His advice covers both direct and indirect tax considerations.
Prior to joining Maddocks, Andrew was a tax consultant at a Big 4 Chartered Accounting Firm.
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For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of their team.