ATO takes expansive approach to NALI and CGT in new Determination

As part of an ongoing focus by the Commissioner of Taxation on the interpretation and administration of the ‘non-arm’s length income’ (NALI) rules in respect of superannuation funds, the ATO issued draft Determination TD 2023/D1 on 28 June 2023 (Determination). Importantly, the Determination provides some much needed clarity on how the NALI rules interact with capital gains in the context of self-managed superannuation funds (SMSFs).

The Determination outlines that a capital gain that derives from non-arm’s length dealings may impact all the capital gains of the superannuation fund for the income year and assessed as NALI, rather than just the capital gain that derives from the non-arm’s length dealing given it is applied to the ‘net capital gain’ calculated by the SMSF. Therefore, NALI may taint a genuine arm’s length capital gain made by a superannuation fund, exposing that gain to the top marginal tax rate that applies to NALI. The Determination is currently in draft form and will be finalised after the period for public comment closes on 28 July 2023.

This article analyses the draft Determination and the steps you can take to protect your SMSF. The article builds on previous ClearLaw articles on NALI provisions, including the NALI Rules and The ATO’s Approach in Law and NALE Quirks To Be Resolved By New Laws.

Tristram Feder, Maddocks Lawyers

What is NALI?

SMSFs are generally subject to a concessional tax rate of 15% on their investment earnings, which includes net capital gains derived by the SMSF.

However, this concessional rate is subject to the NALI rules which impose a penalty rate of 45%, being the highest marginal tax rate, in respect of income derived from transactions that were not transacted on an arm’s length basis. The purpose of the NALI provisions is to therefore encourage SMSF’s to transact on an arm’s length basis.

Broadly speaking, the NALI rules can apply to an SMSF if it derives income (including capital gains) from a scheme where the parties weren’t dealing with each other at arm’s length and the resulting income is more that the SMSF might have been expected to derive if the parties had been dealing with each other at arm’s length. This can include income derived from ‘non-arm’s length expenditure’ (referred to as NALE).

An example of NALI can include income from assets acquired for less than market value or income from a scheme where the expenses were less than what they would be if the parties had been acting at arm’s length.

The Commissioner has long had a particular focus on the NALI rules and their interpretation and administration, and has released a number of rulings and determinations setting out his views on their application in a number of different circumstances.

What does the Determination say?

The draft Determination outlines the Commissioner’s views on how the NALI provisions interact with CGT, in particular how and to what extent a non-arm’s length capital gain generated on the sale of a CGT asset may infect the ‘net capital gain’ of the superannuation fund.

The draft Determination deals with the following points (through a number of illustrative examples):

  • if there are capital losses to reduce the net capital gain to nil, no NALI arises even where there has been a NALI capital gain.
  • to calculate the amount of NALI capital gain amount, the CGT market value substitution rule is applied to the gain unless the proceeds have been inflated in which case the market value substitution rules do not apply.
  • NALI capital gains are adjusted to their arm’s length amount but the amount included as NALI and taxed at 45% cannot be higher than the ‘net capital gain’ for the fund for the income year.

In the draft Determination, the Commissioner has also considered alternative views. In doing so, the Commissioner has confirmed that:

  • NALI does not automatically impact the whole net capital gain;
  • where a non-arm’s length capital gain has been made in a previous income year, but there were capital losses that reduced the net capital gain to nil, the NALI provisions do not apply; and
  • the difference between an arm’s length and non-arm’s length capital gain does not comprise a ‘contribution’ to the fund.

What is the (proposed) effect of the Determination on SMSFs?

According to the draft Determination, where there is a sufficient nexus between an amount of NALE and the income of the fund, that income will be NALI.
However, in the Commissioner’s view, an amount of NALE that has a sufficient nexus to a capital gain is not necessarily quarantined to that particular gain. Rather, NALE may in certain circumstances also infect genuine arm’s length capital gains made by the superannuation fund for that income year. This is because, in the Commissioner’s view, NALE impacts the net capital gain (which is a calculation that includes all capital gains of the SMSF for that income year), rather than the individual capital gain.

For example, a SMSF sells two assets in the same income tax year, where the first asset was acquired for $10 on a non-arm’s length basis and the second asset was acquired for $100 on an arm’s length basis. While both capital gains comprise the net capital gain for that income tax year, the capital gain made on the non-arm’s length basis can taint the other capital gain.

According to the SMSF Association, an independent professional body representing the SMSF sector, the Determination contrasts with the industry’s long standing belief that a capital gain made on a non-arm’s length basis should be segregated from impacting the taxation of arm’s length capital gains.

What does this all mean for me?

While the Determination is in draft stage, there are several things that you can be doing now as the Determination will apply to past, current and future income tax years, such as:

  • ensuring that all superannuation fund dealings are made at arm’s length;
  • collecting and retaining evidence that proves that the dealings were at arm’s length; and
  • obtaining a valuation report from a qualified independent valuer consistent with the ATO guidance on market valuations.

More information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Commercial team.

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Qualifications: LLB (Hons), BCom, University of Melbourne

Andrew is a Partner in Maddocks Tax and Structuring team. He has significant experience in advising Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.

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