The ATO has issued LCR 2021/2, which sets out the ATO's approach in relation to the non-arm's length income (NALI) rules, as well as the effect of relatively recent changes to those rules. Income which is earned by the fund which is NALI is taxed at 45%, which now also takes into account income that has a nexus with non-arm's length expenses.
The ATO's interpretation of the NALI rules in LCR 2021/2 has the potential to treat the entirety of an SMSF's income as NALI, and therefore trustees must be acutely aware of this new ruling. This article will outline the LCR 2021/2 and discusses the ATOs approach and potentially harsh outcomes.Ari Armstrong, Maddocks Lawyers
The taxable income of an SMSF is made up of two components - a 'low tax component', which is taxed at 15%, and a 'non-arm's length component', 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. The NALI rules extend to outgoings or expenditure which is less than what would be expected if the parties were otherwise dealing at arm's length as set out below (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 an 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 NALI/NALE rules also apply where the SMSF:
LCR 2021/2 states that where NALE was not incurred to acquire a particular asset, then 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.
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:
Example 2 in LCR 2021/2 goes on to state that:
ATO's interpretation vs Parliamentary intent
It seems that parliamentary intent in the ITAA97 is 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. The ATO has reportedly stated that it will not allocate compliance resources to determine whether or not SMSF expenses are, in fact, arm's length expenses and that most SMSF trustees should simply make a reasonable attempt to ensure all expenses/income of the SMSF are not NALE/NALI.
A detailed set of examples can be found in the ATO's Law Companion Ruling 2021/2.
For more information, 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.
 S 295-550(5) of the ITAA97.
Leigh is a partner in the Maddocks Tax & Revenue team.
Leigh regularly provides advice on:
His advice covers both direct and indirect tax considerations.
Leigh advises Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.
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For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of their team.