A solution of sorts

Treasury recently released a consultation paper covering the application of the non-arm’s-length expenditure rules pertaining to general expenses. Daniel Butler and Shaun Backhaus examine the details of the proposed framework.

Non-arm’s-length income (NALI) is currently a hot topic that impacts both large Australian Prudential Regulation Authority (APRA)-regulated superannuation funds and SMSFs.

This is largely due to the non-arm’s-length expenditure (NALE) provisions introduced from 1 July 2018 and the broad application of these changes reflected in the ATO’s Law Companion Ruling (LCR) 2021/2. In particular, the regulator considers that a lower, or nil, general fund expense has a sufficient nexus to taint all of a fund’s ordinary and statutory income, including capital gains and concessional contributions.

The regulator’s view has given rise to a need to refocus on NALI and how NALE is linked to it. Treasury also issued a NALE consultation document on 24 January 2023 with an aim to revise the legislation in relation to a general NALE nexus.

The ATO stated in LCR 2021/2 at [91]: “… the commissioner is alive to concerns that a finding that general fund expenses are non-arm’s length is likely to have a very significant tax impact on the complying superannuation fund, even where the relevant expenses are immaterial.”

NALI is found in section 295-550 of the Income Tax Assessment Act 1997 (ITAA). All further references to legislation in this article are to this ITAA section unless otherwise stated.

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Background

Previously DBA Lawyers has expressed the opinion the NALI provisions are exceedingly broad and provide the ATO with a wide opportunity to easily apply the NALI provisions without safeguards for trustees.

The ATO view is a lower expense in relation to a specific asset gives rise to NALI in respect of all future income and capital gains derived from that asset. This view can result in innocent oversights tainting an asset for life. For instance, Trang, the plumber, in example 9 of LCR 2021/2 renovated the bathroom and kitchen in her fund’s second rental property. While Trang’s services for such work may be valued at around $30,000 if outsourced to an arm’s-length supplier today, tainting all the income and capital gain in the future produces an unfair and disproportionate outcome.

In contrast, example 1 of LCR 2021/2 is where Armin sells a commercial property to his SMSF for $200,000, which has a market value of $800,000. While in this example, NALI also applies to all future net rental income and any net capital gain, at least Armin’s SMSF obtains a market value (substituted) cost base under section 112-20 of the ITAA of $800,000 in determining his fund’s future net capital gain.

The NALI treatment for Trang’s second property is far worse and has a retroactive application given any accrued capital gain is tainted. On the other hand, Armin at least benefits from a cost base uplift given the application of the market value substitution rule in ITAA section 112-20. Moreover, Trang’s treatment appears especially harsh given Sharon the real estate agent in example 11 of LCR 2021/2, who charges 50 per cent of her usual real estate management fee, only taints the particular financial years the 50 per cent fee is charged to her fund. There appears no logical distinction between the different treatment applied to Trang, property two tainted forever, compared to Sharon only tainting particular financial years of the fund’s revenue, given both of the expenses appear to be post-acquisition of the property. Perhaps the ATO considers Sharon’s discounted management fee is a recurrent expense, but a renovation is not. However, there is no law supporting or defined meaning of what a recurrent expense is.

A number of professional bodies submitted that NALI should not taint all future income for both general as well as specific expense purposes and a fairer, more proportionate measure should be introduced, including an ability for SMSFs to rectify for honest and inadvertent errors such as in Trang’s example.

We will examine some further issues with NALI before reviewing the Treasury consultation paper.

Employee share schemes and NALI Tax legislation has generally treated discounts on employee share scheme (ESS) shares as assessable income to the employee. Where the shares are nominated to an SMSF, the ATO has also previously treated any discount as a contribution. This is confirmed on the ATO webpage QC 26221 where it states: “A super contribution is anything of value that increases the capital of a super fund and is provided with the purpose of benefiting one or more particular members of the fund, or all of the members in general.

“For example, when shares acquired under an ESS are transferred to an SMSF at less than market value, the acquisition results in a super contribution because the capital of the fund increases and the purpose of the acquisition is to benefit a member, or members, of the fund.”

Further, the ATO notes in LCR 2021/2: “[18] [NALE] incurred to acquire an asset (including associated financing costs) will have a sufficient nexus to all ordinary or statutory income derived by the complying superannuation fund in respect of that asset. This includes any capital gain derived on the disposal of the asset ….”

It therefore appears an SMSF that purchases an asset, like a share at a discount, will result in all future dividends and net capital gain on disposal being NALI and broadly taxed at 45 per cent. Moreover, the amendments introducing the NALE changes to ITAA section 295-550(1)(b) and (c) apply retroactively regardless of when the scheme was entered into. Thus, it appears SMSFs may be exposed to NALI on dividends and net capital gains for shares attained at a discount under an ESS despite those shares being acquired prior to 1 July 2018.

This analysis would appear to provide an adverse impact on SMSFs obtaining shares from an ESS at less than market value.

SMSFs with unit trust investments

An important issue not dealt with in LCR 2021/2 is the status of an SMSF trustee/ director who provides services to a unit trust. For example, consider an SMSF that is invested in a non-geared unit trust holding a factory and the SMSF trustee/director oversaw the collection of rent and dealings with the tenant (which may be a related party where the property constitutes business real property), attended to bookkeeping

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Continued from previous page and instructed the accountant regarding the trust’s annual financial statements. Will the ATO apply the same distinction it applies at the SMSF level to the unit trust or is all the trust distribution received by the SMSF tainted? There is no clarity on this issue in the ATO’s ruling.

Some prior NALI cases

Let us now examine some cases involving NALI to see what types of arrangements have been dealt with by the courts and the tribunal.

Two notable cases where NALI was applied to dividends derived by an SMSF from private companies include Darrelen Pty Ltd v Commissioner of Taxation [2010] FCAFC 35 (Darrelen) and GYBW and Commissioner of Taxation [2019] AATA 4262 (GYBW).

Darrelen involved an SMSF that acquired shares in a private company at less than 10 per cent of their market value. The stocks were acquired for $51,218, paid in October 1995, and the investment yielded over $800,000 plus franking credits in eight years.

In GYBW, a $200 investment yielded over $1.8 million in dividends plus franking credits in three years.

Allen (Trustee), in the matter of Allen’s Asphalt Staff Superannuation Fund v FCT [2011] FCAFC 118 (Allen’s) involved a discretionary trust distribution of around a $2.5 million capital gain being made to a unit trust that was owned by a superannuation fund.

The three cases are clear examples of how advisers previously understood the NALI provisions would apply prior to the 1 July 2018 changes. Moreover, the superannuation industry is comfortable having an appropriately targeted integrity measure in place to minimise opportunities to exploit the tax concessions available to super funds. This includes introducing suitable measures to target schemes involving low and no interest limited recourse borrowing arrangements, which was the focus of the 2018 Treasury consultation paper on NALI.

However, what came as a surprise after the mid-2018 changes was the position the ATO adopted via LCR 2021/2 to apply NALE and NALI to any discount no matter how trifling in amount.

As such, even a $1 discount can result in substantial NALI consequences. Thus, a previously considered and rarely used tax integrity measure NALI from 1 July 2018 could easily be invoked for small or trifling discounts.

Given the existing tax regime on contributions, including division 293 tax, a nominal tax rate of up to 75 per cent can apply if both NALI and the excess contribution provisions apply.

Moreover, a nominal tax rate of up to 120 per cent can apply if both NALI and excess non-concessional contributions apply. In Treasury’s 2023 consultation paper, a 225 per cent tax rate is now proposed for NALE of a general nature with a five times multiple of any discount on a general expense being taxed at 45 per cent subject to a cap of the fund’s income for the relevant income year.

The 2023 consultation paper

Treasury’s proposed amendments are only intended to apply to general expenses that have a sufficient nexus to all ordinary and statutory income derived by an SMSF or a small APRA fund (SAF). The proposed amendments to the NALI provisions are as follows:

• SMSFs and SAFs would be subject to a factor-based approach, which would set an upper limit on the amount of fund income taxable as NALI due to a general expenses breach. The maximum amount of fund income taxable at the highest marginal rate would be five times the level of the general expenditure breach, calculated as the difference between the amount that would have been charged as an arm’s-length expense and the amount that was actually charged to the fund. Where the product of five times the breach is greater than all fund income, all fund income will be taxed at the highest marginal rate.

• Large APRA-regulated funds would be exempt from the NALI provisions for general expenses.

How will this apply?

The 2023 consultation paper provides the following examples:

• In Example 1A, an SMSF trustee uses his brother’s accountancy services, which would usually cost $5000 if provided under an arm’s-length arrangement. As his brother does not charge the SMSF for these services, under the proposed change, the following would be tainted as NALI:

• Given there is a lower-than-arm’slength expense of $5000, this is

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Continued from previous page multiplied by five resulting in a $25,000 amount of deemed NALI which is taxed at 45 per cent with $11,250 of tax payable.

• The SMSF’s income, net of relevant expenses, for FY2023/24 is $100,000 which would usually give rise to a 15 per cent tax rate without any non-arm’s-length transactions.

• Example 1B is also given where the SMSF’s income, after relevant expenses for the 2024 financial year is only $20,000.

• Under the proposed change, the trustee would pay 45 per cent tax on all of the fund’s income, as five times the NALE breach, that is, $25,000, is greater than the fund’s total income of $20,000. That is, $20,000 x 45 per cent = $9000 of tax payable on the deemed amount of NALI.

What is the effect of the change?

Under the current legislation, a lower-thanarm’s-length expense, even a $100 discount, would result in a tax of 45 per cent on a fund’s entire ordinary and statutory income, including large APRA-regulated funds. Given NALI applies to statutory income, this would also tax a net capital gain and concessional contributions at 45 per cent.

NALE amnesty to 30 June 2023

Broadly, the ATO’s current administrative practice in Practical Compliance Guideline (PCG) 2020/5 is not to apply its compliance resources towards general expense NALE leading up to 30 June 2023.

However, from 1 July 2023, reasonable benchmark evidence will need to be shown for related-party services.

However, the 2023 consultation paper confirms for all funds where a NALE is related to a specific asset, the current NALI rules continue to apply.

Naturally, SMSF trustees and advisers need to be mindful that, on closer examination, some general expenses may be challenged as not being general in nature but may relate to specific asset acquisitions such as typical adviser fees where, for example, specific investments are purchased or sold.

Some further observations

While the Treasury proposal is welcome, a number of professional bodies made submissions claiming the NALI provisions need a total overhaul given there are a range of other shortcomings, including a lack of flexibility to rectify honest and inadvertent errors and that the commissioner should be required to issue a NALI determination rather than it being automatically invoked.

There are also various other methods of dealing with general fund expenses rather than relying on a five times multiple.

Some commentators have suggested if Treasury does not undertake an entire overhaul of NALI, taxing the discounted amount instead and applying the existing penalty regime in the Taxation Administration Act 1953, for example, a 25 per cent primary tax uplift if the trustee has not exercised reasonable care and a 50 per cent uplift for recklessness, would provide a fairer and more proportionate outcome.

The following points should also be noted:

• The taxpayer carries the onus of disproving and challenging a NALI assessment, for example, if the ATO challenges the value paid for the asset or service, this is a difficult, costly and time-consuming task to refute.

• The ATO is in a conflicted position in relation to SMSFs as the prudential regulator and the tax collector/ administrator. In contrast, a conflict does not exist in relation to large funds that are regulated by APRA.

• There should be an incentive for voluntary disclosure and providing a rectification system so that Trang and others like her, especially those who have made an honest and inadvertent error, can come forward and pay an appropriate and proportionate adjustment.

• NALI should be invoked by a determination issued by the tax commissioner and not automatically. The general anti-tax avoidance provision in Part IVA of the Income Tax Assessment Act 1936 is invoked by the commissioner issuing a determination. The current NALI and NALE provisions increase the overall compliance burden on SMSF auditors and registered tax agents as they need to be continuously on the lookout for NALI/E issues.

It is important to note the five times proposed penalty in the 2023 Treasury consultation paper is a potential change and the law will not be amended until legislation is passed. An extension to the ATO’s PCG 2020/5 administrative relief to 30 June 2024 may also be required if this revision to the law is not implemented by 30 June 2023.

Conclusions

The NALI provisions have broad application as extended considerably by the ATO’s views in LCR 2021/2 following the NALE amendments applying from mid-2018. There is an increasing focus on NALI and it can prove costly, time-consuming and challenging to respond to a NALI review and, if a NALI assessment results, it is even more difficult, time-consuming and costly to defend.

Ongoing management is needed in relation to both general and specific expenses that can trigger NALI and advisers should view every transaction involving an SMSF and a related party carefully to minimise risk.