The final NALE Position

The final NALE position

Non-arm’s-length expenditure has been an issue on the table between government and industry for some years, with little movement until the start of this year. In the space of four months a new model was devised, revised, and turned into a draft law and Jason Spits examines whether the industry takes what’s on offer or presses for more.

In the world of superannuation, the end of the financial year not only draws a line under what has passed, but also is a reminder of changes to come from the first day of the new year. These typically include changes to various caps, rates, and thresholds, but the start of the 2024 financial year also includes the commencement of a compliance regime that has not been policed for five income years – the application of certain non-arm's-length expenditure (NALE) provisions and the associated non-arm's length income (NALI) penalties.

From 1 July 2023, Practical Compliance Guideline (PCG) 2020/5, under which the ATO stated it would not act against some NALE breaches, no longer applies and the regulator will begin taking action against SMSFs and small Australian Prudential Regulation Authority (APRA)-regulated funds (SAF) in the event they incur general expenses on a non-commercial basis.

The key issue with the NALE rules is every SMSF has expenses, of both a general and specific nature, and since the issue of NALE first came to light in 2019, the question has been how to apply the NALE provisions and what financial disincentives will apply when they are breached.

The initial position of government was a nexus would exist between NALE and the ordinary and/or statutory income of a fund impacted by the transaction in question, triggering the NALI provisions and a penalty tax levied at the highest marginal tax rate or 45 percent. However, when applied to general expenses the approach had the potential to taint all fund income as NALI – a scenario that caused a great deal of industry consternation.

The situation was further complicated in February this year when the government instead suggested the NALE penalty in regards to general expenses would be five times the difference between the

discounted expense and the market value of the expense in question. While some movement on the issue was welcomed, many were quick to point out this would result is a five times 45 percent tax, or 225 percent, and was significantly disproportionate to the particular transgression.

Following industry consultation, three months later in the federal budget the penalty tax to be applied for general expenses was reduced to two times the discounted amount of the expense. This is the position the government has included in the draft NALE legislation, for which consultation closed on 7 July. (See breakout box: What’s in the draft NALE bill?)

As good as it gets?

The question now to be asked is should the industry accept the two-times factor as the best it can expect from the NALE rules governing general expenses or continue to push for the complete removal of the entire NALE regime.

SMSF Association chief executive Peter Burgess says the two-times factor put forward by the government is not what the SMSF sector was hoping for and it would prefer to see the entire NALE system repealed (see breakout box: Rolling back the clock), but concedes the current status is a large step forward.

“The 2019 changes are no longer needed and the mischief that led to the non-arm’s-length arrangements has been addressed and it still remains a mystery as to why we need to have provisions relating to NALI and NALE,” Burgess explains.

“Despite this, the draft legislation has broken the nexus to all the income of a fund, which would have been a very harsh outcome if it had been maintained.”

Institute of Financial Professionals Australia head of superannuation and financial services Natasha Panagis also sees the two-times factor in the draft legislation as a better outcome than the five-times factor first presented, but would also prefer a repeal of the NALE provisions and a return to pre-2019 rules.

“What we have is better than the five times model presented earlier this year, but it is not ideal and not required because the superannuation system has rules in place to deal with non-arm’s-length arrangements,” Panagis says.

“The ATO has the rectification powers and tools at hand so there is no need to even adopt the two-times model to deal with NALE.”

Yet, looking at the progression from a position where the entire income of a fund would be taxed at penalty rates to the two-times model presented in the draft legislation it would appear the government, while aware of the super sector’s concerns, will not be taking NALE off the table.

“Scrapping the NALE provisions is not going to happen,” SuperConcepts SMSF technical and strategic solutions executive manager Phil La Greca notes.

“The government is more likely to scrap related-party transactions before NALE, and that is unlikely to occur.

“At the end of the day the government had to resolve the matter and we can see its thinking in the draft bill which contains the two-times factor first presented in the budget.

“At the end of the day the government had to resolve the matter and we can see its thinking in the draft bill which contains the two-times factor first presented in the budget.

“The two-times factor is a reasonable basis for NALE compared with the five times factor and is a behaviour-change penalty that recognises the government is out of pocket when NALE occurs within a fund.”

A two-speed regime

While settling on the NALE model put forward in the draft bill may be as good as it gets for now, Chartered Accountants Australia and New Zealand (CAANZ) superannuation leader Tony Negline points out it will create distortions in the super sector depending on who conducts a transaction and where that transaction is carried out. As such, CAANZ has supports the call for a repeal of the entire NALI regime.

“Distortion number one takes place such that if you carry out a transaction in a certain way you will have a certain tax outcome. If within the fund you carry out a transaction in a certain way that may or may not be at arm’s length, you will end up with a different tax outcome, which doesn't make a lot of sense to me,” Negline says.

“Distortion number two arises from whether you execute that transaction through an APRA-regulated fund or through an SMSF because any similar NALE transactions will create distortions or inconsistencies between those two environments and the law around this should be entity neutral.”

The exclusion of APRA-regulated funds from the draft NALE bill is also of concern for IFPA, with Panagis labelling it as preferential treatment due to the supposed complexity of applying the provisions to these larger funds.

“The reasons for the exemption, according to the explanatory memorandum to the draft bill, is that APRA funds will only enter into non-arm's length arrangements that provide general services because their primary intention would be to reduce costs and pass those on to their members rather than gaining a tax benefit,” she suggests.

“We completely disagree with that fact because superannuation fund trustees are required to act in the best financial interests of their members. Smaller funds such as SMSFs and SAFs are also required to act under that interest and reduce cost savings to their members so it's completely unfair this consideration is being applied only to APRA-regulated funds.”

Coming back to his preferred view of what should happen to NALE, Burgess indicates the SMSF Association does not have problems with APRA-regulated funds being exempted from the NALE provisions, but wants it to apply to all superannuation funds.

“The argument is these provisions around general expenses should apply to SMSFs because the trustees are in a better position to influence and control the arrangements more so than members in large funds,” he says.

“We accept that but also note the general expense shortfall amounts are quite small and ask why a member of an APRA-regulated fund can benefit from a discounted fee negotiated with a related entity while members in an SMSF can’t.

“It is concerning that we seem to have inconsistencies here and the government is happy to treat funds differently when it comes to some parts of the law.”

Things left unsaid

While the exemption for APRA-regulated funds may be a question of fairness, the lack of information on key practical and operational matters also contributes to the view the draft bill is only half a solution, with the absence of benchmark general expense costs being a leading concern.

La Greca notes the SMSF sector has raised the need for benchmark general expense costs and while the draft bill recognises what those general expenses will typically be, the onus is on the ATO to provide that information to the sector.

“We are potentially looking at the use of benchmarks, which the ATO could draw from tax returns, applying an average or median cost for use by the industry which would act as a safe harbour guideline, which we have in other areas related to expenses,” he explains.

“However, this leads to the question of who is going to ask whether a NALE figure is consistent with a benchmark. Will it be the tax agent or the fund auditors, who are complaining already about all the extra things they are being asked to do? But having something to measure against is the biggest stumbling block in making this work.”

Smarter SMSF technical and education manager Tim Miller also sees the need for the SMSF sector to have some guidance as to what will be a fair general expense, but it may also highlight the irrelevance of the NALE regime.

“Costs across the industry will vary for different services and which one will be right? None of them, but none of them will be wrong either because they are what people are charging and what is fair and reasonable is going to be different in everybody's eyes,” Miller points out.

“Yet when you start to put a value on things such as general fund expenses, you start to table the real impact. Then the reason for introducing the provisions in the first place has to be questioned.

“Many general expenses for an SMSF are typically low and have minimal impact on a fund’s income and so it seems like we have been chasing shadows because we are not really talking about people trying to abuse their contribution caps, which was supposedly the whole concept behind NALE.”

Beginning of the end or the end of the beginning

Miller adds the draft NALE bill also includes no scope for rectification or makegood provisions compared to other parts of the tax regime, but does not believe the industry effort to date has been wasted.

“I hate to say any consultation was a waste of time because if you don't have that period, you don't have the opportunity to push the same narrative and we saw that with the five-times factor where the industry questioned how Treasury came up with that,” he acknowledges.

Panagis also sees the draft bill as a step in the right direction, but not the destination, and notes the industry has only dealt with general expenses and not NALE related to specific expenses.

“We are still in limbo in terms of what will apply to specific expenses because at the moment they will be subject to the normal NALI rules, which means a 45 percent tax rate instead of one treatment for both sets of expenses,” she acknowledges.

“This seems odd given we have been talking about non-arm's-length arrangements for years, but only landed on the expenditure side for general expenses. The specific expenses have not been ignored, but there's been no move on that from the government side.”

Negline believes the SMSF sector has to date received a fair hearing even if it has not received its preferred outcome and will push forward towards that goal.

“The government gave some ground and listened in part and we accept that, but the SMSF sector still feels its model is regulatory overreach and there is a better way forward. We have stated that in submissions and will continue to meet with Treasury and prosecute the case for the repeal of NALE,” he says.

What's in the draft NALE bill?

After more than four years of waiting, the superannuation sector has been given an insight into how the government will apply the NALE provisions by releasing on 20 June a draft bill: Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s Length Expense Rules for Superannuation Funds, which states how it plans to enact those rules via amendments to the Income Tax Assessment Act 1997. These amendments include:

• limiting the application of the NALE rules to SMSFs and small APRA funds (that is, excluding APRA-regulated funds from the general expense provisions),

• making a distinction between the specific and general expenses of the fund for the purposes of NALE,

• limiting the amount of income taxable due to a NALE general expense breach as twice the difference between the amount that would have been charged as an arm’s length expense and the amount actually charged to the fund,

• limiting the potential income of the fund that can be taxed under the provisions to the fund’s taxable income less contributions and related deductions, and

• exempting expenses that were incurred or might have been expected to be incurred before the 2019 income year.

The explanatory memorandum to the draft bill adds a general expense is one not related to gaining or producing income from a particular asset of the fund and may include actuarial costs, audit, accountant, trustee, and investment adviser fees, administrative costs to manage the fund and costs to comply with the regulatory obligations of the fund. At the same time, the explanatory memorandum notes a specific expense “will be any other expense” and “the existing treatment [of a 45 percent tax expense] will continue to apply” with the amount to be taxed being the amount of income derived from the scheme where the SMSF was not dealing at arm’s length.

Rolling back the clock

Is it possible to live in a NALE and NALI-free world? Yes, it is, according to a collection of industry associations that have put forward a case for repealing the entirety of the NALI regime and using existing tax and superannuation law to tackle non-arm’s-length arrangements within superannuation.

The argument, which forms part of a joint submission made by CPA Australia, Chartered Accountants Australia and New Zealand, the Institute of Public Accountants, the SMSF Association, and the Tax Institute in regards to the draft NALE legislation, calls for a repeal of the 2019 NALE amendments to section 295-550 of the Income Tax Assessment Act 1997

This would be possible because the issue that led to the amendments, zero interest loans from related parties for limited recourse borrowing arrangements, has been addressed by Practical Compliance Guideline 2016/5, which introduced safe harbour parameters for related-party loans.

As such, the government could use the existing provisions of the Superannuation Industry (Supervision) (SIS) Act, namely section 109, which already prohibits trustees from engaging in transactions with any party unless they are conducted on arm’s-length terms, to address NALE.

At the same time, any expense shortfall amount as a result of undercharging or non-charging could be treated as a contribution in accordance with ATO Taxation Ruling 2010/1.