SISFA

NALI, NALE draft ruling needs work

MIKE GOODALL is a board member of the Self-managed Independent Superannuation Funds Association. In 2019 the ATO issued a draft law companion ruling (LCR) setting out, for public comment, clarifications to how amendments to sections of the Income Tax Assessment Act 1997 would operate in a scheme where the parties do not deal with each other at arm’s length.

Specifically, the LCR covered situations where the trustee of a complying superannuation entity incurs non-arm’s-length expenditure (NALE), or where expenditure is not incurred, in gaining or producing ordinary or statutory income. It determined these circumstances would trigger the non-arm’s-length income (NALI) provision of the act, resulting in the SMSF being taxed at the top marginal tax rate. Due to the severity of the penalty, it is unsurprising there is much interest in these amendments.

However, there is the view, held by the Tax Institute, and with which the Self-managed Independent Superannuation Funds Association (SISFA) agrees, that there are a number of flaws in the amendments. The institute has been engaging the ATO since the issuance of its draft rulings to point out the difficulties in their application.

A key item is the ATO’s view in relation to some fund expenses, which under the draft ruling could result in the entire earnings of many SMSFs being exposed to the NALI penalties. This could happen if the nexus between the expenses in question cannot be matched directly to a specific source of income.

The ATO takes the view such expenses taint all of the fund’s income. This interpretation has been the most controversial aspect of the regulator’s position on the NALI changes, resulting in its first draft ruling, LCR 2018/D10, being withdrawn and replaced with the revised draft LCR 2019/D3.

The regulator’s view, that a general expense taints all of a fund’s income as NALI, also ignores the fact the taxable income of a complying superannuation fund is made up of two components: namely a low-tax component and a non-arm’s-length component. If the ATO’s view was correct, that is, a general expense can taint all income, there would subsequently only be one component: namely the non-arm’s-length one. The nexus of what expense gives rise to NALI needs considerably more technical analysis as the Tax Institute’s and ATO’s views still differ considerably.

Both the institute and SISFA consider there are substantial grounds for the ATO to delete references to general expenses being able to taint all income. For an expense to give rise to NALI, there must not only be a nexus, but it must also be a nexus to the relevant income, not just the assessable income, and it must be a sufficient nexus to that income. As it stands, the ATO’s current view would result in an SMSF with a $10 million diversified asset portfolio consisting primarily of blue-chip Australian equities being exposed to NALI due to a $100 discount in an accounting fee – an outcome that can only be described as absurd.

A logical solution is the deletion of general expenses from the concept of NALI, which would likely simplify the application of it. This will also overcome of a lot of the controversy that has hampered the finalisation of this ruling to date.

With the ever-increasing compliance requirements of our superannuation system, SMSFs are becoming more complex to administer. In a rather heavy-handed approach, the proposed LCR also does not allow for an opportunity to rectify a genuine mistake due to an oversight or human error that may trigger NALI or NALE as if there is an assumption the mistake or oversight was intentional. SMSFs need to be given the opportunity to rectify an error in line with arm’s-length terms as soon as practicable after the mistake is detected.

Given the significant impact a NALI assessment can have, the Tax Institute and SISFA believe there should be further oversight of the application of any NALI allegation or assessment. This would involve establishing a NALI board that would operate in a similar manner to the General Anti-Avoidance Rules Panel. Such a group could bring the same level of consistency and independence to the application of rulings in relation to NALI assessments.

The discussions between the professional bodies representing the interests of SMSFs and the ATO have been ongoing for nearly 18 months. The approach of the draft ruling to non-arm’s-length income and expenses is just one of a number of issues and resolution of this situation is clearly some way off yet.