All an SMSF’s income could be NALI under new expense rules: ATO

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New Non-Arm’s Length Income (NALI) rules applying to expenses could mean an SMSF pays the top rate of tax on its income, according to a new ATO draft ruling.

In September the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 passed the Parliament. One of the measures in this piece of legislation was to change NALI to include expenses. Though, based on a draft ATO ruling, this could have wider implications than many thought.

The ATO has released a draft ruling – Draft Law Companion Ruling (LCR) 2019/D3 Non-arm’s length income – expenditure incurred under a non-arm’s length arrangement – setting out some implications of the new rules.

The NALI changes apply to the 2018/19 and later years “regardless of whether the scheme was entered into prior to 1 July 2018”, says the ATO. Though there will be a “transitional compliance approach”. Several examples in the draft ruling involve an SMSF purchasing an asset for less than its market value from the member, leading to the income and capital gains from the asset being NALI.

Though one example given by the ATO has all the income of the SMSF being NALI. In this example an SMSF trustee is also a partner in an accounting firm, and engages the firm to provide accounting services to the fund – for which the firm doesn’t charge.

“For the purposes of proposed subsection 295-550(1), the scheme involves the SMSF acquiring the accounting services under a non-arm’s length arrangement. The non-arm’s length expenditure (being the nil amount incurred for the services) 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,” says the ATO in LCR 2019/D3.

Though the ATO does draw a distinction between activities performed by the trustees in their capacity as trustee versus as individuals.

“The non-arm’s length expenditure provisions are not intended to apply to services provided by a trustee (or a director of a corporate trustee) of a complying superannuation fund in their capacity as trustee (or director of a corporate trustee).”

An example given by the ATO has a trustee who is an accountant and tax agent preparing the accounts and returns for their SMSF, without charging the fund, and without using the assets of their employer or their tax agent registration. The ATO says this example doesn’t lead to NALI

Though such determinations will be “highly fact dependent and requires an objective consideration of the circumstances in each case”.

Additionally, the ATO is being flexible in how it enforces the new rules, at least initially.

ATO Practical Compliance Guidelines (PCG) 2019/D6 – Compliance approach for complying superannuation funds in respect of applying the non-arm’s length income provisions to ‘non-arm’s length expenditure’, says that the tax office recognises that SMSF trustees may not have realised how the new rules would apply to non-arm’s length expenses of a general nature.

Given the new law could mean that the whole income of an SMSF for the 2018/19 and 2019/20 being NALI, the ATO considers it appropriate to apply a “transitional compliance approach”.

“The ATO will not allocate compliance resources to determine whether the NALI provisions apply to a complying superannuation fund for the 2018-19 and 2019-20 income years where the fund incurred non-arm’s length expenditure… of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, non-arm’s length expenditure on accounting services).”

But, “this transitional compliance approach does not apply where the fund incurred non-arm’s length expenditure that directly related to the fund deriving particular ordinary or statutory income during the 2018-19 and 2019-20 income years”.

With this compliance approach only applying, once finalised, for those two income years, the ATO expects trustees impacted to “alter their arrangements in order to ensure that the proposed amendments will not apply to their fund after the expiry of the ATO’s transitional compliance approach”.

Another example in the draft ruling has an SMSF entering into a “non-commercial” Limited Recourse Borrowing Arrangement (LRBA), with the member, to buy a property. The LRBA has a 100% LVR, a low rate of interest, and annual repayments over 25 years. The ATO says this would result in the rental income from the property and any capital gain being NALI.

The ATO is inviting comment on the draft ruling, until 15 November 2019.

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