The current proposal

DBA Lawyers director Daniel Butler details the proposed rules regarding non-arm’s-length expenditure contained in the relevant draft bill released last month.

On 19 June, Treasury released Exposure Draft Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s Length Expense Rules for Superannuation Funds together with Exposure Draft Explanatory Materials.

The NALE changes in mid-2018

Paragraphs (b) and (c) of ITAA section 295-550(1) result in the ordinary and statutory income of a superannuation fund being taxed at 45 per cent if the parties to a scheme were not dealing with each other at arm’s length and one or more of the following applies:

(b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme,

(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.

Thus, broadly, where the parties are not dealing at arm’s length and a lower or nil expense is incurred, all the ordinary and statutory income of a superannuation fund for that financial year will be taxed at 45 per cent. In other words, NALE results in having the non-arm’s-length income (NALI) provisions apply.

NALE currently applies to all superannuation funds, both Australian Prudential Regulation Authority (APRA)-regulated funds and SMSFs. Note, however, the ATO provided an administrative solution by way of its Practical Compliance Guideline (PCG) 2020/5 where it did not apply its compliance resources for the 2019 to 2023 financial years to enforce NALE relating to general expenditure.

NALE relating to specific expenses relating to particular assets was not covered by PCG 2020/5 and therefore can result in a NALI penalty from 1 July 2018.

NALE changes effective 1 July 2018

The NALE bill proposes a cap on the amount of income that will constitute NALI from a non-arm’slength scheme involving a lower or nil general fund expense. This cap is in the form of a twotimes multiple of the amount of the lower general expense for an SMSF or a small APRA fund. The example below outlines how this cap is to apply.

The proposed changes do not apply to expenses relating to specific assets or income sources. The difference between a specific and a general expense is discussed below.

Example applying a two-times multiple:

If an SMSF trustee uses a member’s brother’s accounting firm’s services, which would usually cost $5000 under an arm’slength relationship but is not charged any fee, this is considered NALE as the parties were not dealing at arm’s length. Therefore, the tax payable would be calculated as follows:

• 2 x $5000 = $10,000 NALE

• $10,000 x 45% = $4500 tax payable by the fund.

Note where the product of two-times NALE formula is greater than the fund’s actual taxable income, an upper cap will be the fund’s taxable income for the financial year excluding any assessable contributions or any deductions against assessable contributions.

Referring to the above example of the SMSF member’s brother’s firm providing accounting services valued at $5000 for free, where the amount of NALI penalty under a multiple of two is $10,000 but the fund’s actual taxable income is only $6000, the upper cap would result in $6000 of actual taxable income being taxed at 45 per cent rather than $10,000 of notional NALI.

Other proposed changes

Capital expenses

The two-times multiple in the NALE bill will not apply to a loss, outgoing or expenditure of capital or of a capital nature. This is a new development as previously

NALE was focused on a general expense, whether of a revenue or capital character.

Advisers will therefore have to apply their tax skills to determine whether NALE will be capped by the two-times multiple if the NALE is not on the capital account. Thus, a general expense of a revenue nature should qualify for the two-times cap, but a capital expense of a general nature will not. While a capital expense of a general nature may not be common, the cost of certain equipment or software needed to administer the fund may fall into this category.

Specific v general expense

The NALE EM states:

1.5 Any [NALE] will be either a specific expense or a general expense. A general expense will be an expense that is not related to gaining or producing income from a particular asset of the fund. A specific expense will be any other expense.

1.6 For specific expenses the existing treatment will continue to apply, and the amount of income that will be taxed as [NALI] will be the amount of income derived from the scheme in which the parties were not dealing at arm’s length.

Example 1.4 of the NALE EM is relevant to SMSFs using the services of related members and parties as the example, among other matters, states: [Sam is a related party of an SMSF, whose assets include a rental property.]

… Sam is a licensed builder and blocks time out of their work calendar to conduct renovations on the rental property worth $3000 for which they charge nothing. The renovations were an expense incurred in deriving income from a particular asset, the asset being the rental property. The renovations are a specific [NALE].

Thus, given the lower $3000 specific expense, the net rental income from the SMSF’s rental property in example 1.4 is taxed at 45 per cent. The example gives no guidance on whether the property is tainted for life or just in relation to that particular financial year. However, the ATO’s Law Companion Ruling (LCR) 2021/2 suggests Sam’s work taints the property for the remainder of its life.

In example 9 in LCR 2021/2, Trang, a plumber, renovated the kitchen and bathroom of her SMSF’s rental property, which exposed the net rental income and future capital gain forever to NALI.

Note there is no express discretion for the tax commissioner to disregard honest or inadvertent oversights.

Contributions to be excluded

The NALI bill proposes to exclude contributions assessable under division 295-C of the ITAA from NALI. Note under current legislation, general expenditure NALE results in assessable contributions being taxed as NALI at 45 per cent.

Pre-1 July 2018 expenditure to be exempt

The NALE bill proposes expenditure incurred prior to 1 July 2018 will be exempt from NALI. Note under current legislation, NALE can apply retroactively.

APRA funds exempt from NALE

APRA-regulated funds will be exempted from NALE in relation to both general and specific expenses.

Conclusions

Many SMSF trustees are unaware of the breadth of these provisions and advisers should ensure there is ongoing education and monitoring for both NALI and NALE risks in their client base.

In particular, specific NALI remains a risk given it exposes all future ordinary and statutory income from a particular asset to a 45 per cent tax rate, including a future net capital gain on disposal of the asset.

A number of professional bodies representing both APRA-regulated funds and SMSFs requested a more proportionate treatment for NALI and the ability to rectify honest and inadvertent oversights.