NALI not over yet

The government is likely to believe the recent passing of legislation regarding non-arm’s-length income and expenditure has effectively addressed this contentious issue. The SMSF Association head of technical Mary Simmons outlines why additional examination and legal amendments are still required to achieve more optimal outcomes.

From the perspective of Treasury and the ATO, it’s fair to assume the recent passing of amendments to the non-arm’s-length income (NALI) rules has finally put our issues with the 2019 amendments to bed.

NALI and its bedfellow, non-arm’s-length expenditure (NALE), have been a bugbear of the SMSF sector since the NALE rules were introduced back in 2019, so the passing of the Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Bill 2023 surely is the end of the matter.

The end of the matter? The SMSF Association would beg to differ and so would our members. We are firmly of the view further changes are needed. As our CEO, Peter Burgess, said at our recent Technical Summit: “I’m not sure these outstanding issues remain unresolved in Treasury’s mind. Having addressed the issue of general expenses, it seems they have now moved on to other legislative priorities and getting them back to the table to discuss our unresolved issues with the NALE rules will be no easy task.”

In particular, applying NALI rules to specific fund expenses remains a vexed issue. How is it fair or equitable the entire capital gain from the sale of a property held for many years could be NALI simply because the trustee did not incur an expense on commercial terms for a minor renovation completed just before the property was sold?

Similarly, how is it possible the entire capital gain from the sale of a property could be tainted as NALI simply because of an improvement completed on non-arm’s-length terms, regardless of its value or materiality? In many cases like this the value of the improvement has long since dissipated and is no longer reflected in the property’s value.

Another example of the harshness of the current law is where the trustees of an SMSF wholly in retirement phase are preparing to sell a property the fund has owned for 15 years to provide liquid funds to keep meeting pension liabilities, but make an error when doing so. Specifically, the member pays an unrelated contractor $500 to clean the property for open house inspections, but forgets to get reimbursed. The $500 NALE can taint the entire net capital gain from the disposal of the asset. So, if the net capital gain was $1 million, not only can the fund not claim exempt current pension income (ECPI), but tax of $450,000 may be triggered for the failure to pay a $500 expense.

Of course, all these issues can be avoided by assuring all transactions occur on commercial arm’s-length terms. But what constitutes a commercial arm’s-length dealing is not always a straightforward concept, particularly when related parties are involved or inadvertent mistakes are made.

These issues, as well as others relating more generally to the application of the NALI rules to specific expenses, are now, at least for the SMSF Association, the new frontline in the ongoing battle to ensure the NALE provisions introduced in 2019 work appropriately for SMSFs and small Australian Prudential Regulation Authority (APRA) funds.

But before going into the details about what we believe is needed to fix these issues, we happily acknowledge the recent NALE law changes have given the industry much needed relief and certainty. And, after a gestation period approaching five years, so it should.

The recent amendment to the NALI rules removing the potential for NALE to be applied retrospectively is commendable. Before this change was made it was possible for income received on or after 1 July 2018 to be taxed as NALI because of a transaction triggering the NALE provisions occurred before 1 July 2018.

Despite the bill predominately focusing on general expenses, from what we can ascertain this amendment also applies to specific fund expenses. It seems fair to assume a capital gain that has been impacted by a non-arm’s-length expense, other than an expense relating directly to the acquisition of an asset, incurred before 1 July 2018 would not be taxed as NALI if the asset were sold today.

With the NALE changes also came the finalisation of the ATO’s position on how the NALI provisions interact with the capital gains tax (CGT) rules. The ATO’s recently released Taxation Determination (TD) 2024/5 only fuelled our call for a legislative fix that ensures fairness, prevents disproportionate outcomes and avoids the tainting of arm’s-length capital gains. This TD explains how the NALI and CGT rules interact in situations where a fund incurs an arm’s-length capital gain, a non-arm’s-length capital gain and a capital loss all in the same income year.

However, before we get stuck into the challenges, let’s first take a moment to acknowledge some of the positives in TD 2024/5. These include:

• the amount of a capital gain that is classified as NALI cannot exceed the net capital gain for the fund for the income year,

• when calculating net capital gains, NALI capital gains are eligible for the one-third CGT discount,

• NALI capital gains are reduced by capital losses and carry-forward capital losses. For example, if there are capital losses, the net capital gain can reduce to nil, which means there may be no NALI even if there has been a non-arm’s-length capital gain, and

• the cost base of assets that trigger the non-arm’s-length rules can be increased by the market substitution rule, which, in essence, reduces the amount of NALI. For example, where an asset is acquired for less than market value, the market substitution rule applies to adopt a higher cost base when calculating CGT (noting the market value substitution rule doesn’t apply if proceeds are inflated).

So what changes are needed to ensure the 2019 NALI amendments work appropriately for SMSFs and small APRA funds? In our view, a legislative change is required to enable trustees to remedy the undercharging of a specific asset expense in situations where the NALE was due to a genuine oversight or mistake.

We also believe a threshold-based approach should be considered for specific expenses so NALE below a certain dollar threshold or percentage of the market value of the asset is deemed not to taint all of the income or capital gains from that asset.

In other situations, the NALI capital gain could be determined by applying a proportionate approach rather than treating the entire capital gain as NALI. That is, the NALI capital gain could be determined by determining the proportion of the market value of the asset that comprises the capital expenditure not charged on commercial terms.

We also believe a proportional approach could be used to address many of our concerns with TD 2024/5.

The association acknowledges the ATO’s position, as set out in the TD, accords with how the legislation currently stands, adding the operation of the law is complex.

Under the TD, the amount of capital gains that is NALI cannot be greater than the SMSF’s overall net capital gain. However, it’s our contention a proportionate approach could be considered where the NALI capital gain is calculated as a percentage of the fund’s total capital gain. This percentage would then be applied to the fund’s capital losses and the one-third CGT discount to determine the fund’s net NALI capital gain.

Table 1 provides a comparison of the two approaches. It assumes a fund receives a $1.3 million NALI capital gain, a $500,000 arm’s-length capital gain and incurs a $200,000 capital loss for the income year.

There are well-established examples contained within the taxation law that seek to apply a proportionate approach in a superannuation context. One example is the calculation of ECPI. This allows for the proportionate taxation treatment of both ordinary and statutory income.

The association recognises any legislative changes are a policy consideration and outside of the ATO’s remit. We would therefore encourage the regulator to engage with Treasury for an appropriate legislative solution.

Certainly we will be speaking with government and Treasury to advocate for a legislative amendment that will allow a proportionate approach to be applied both when determining the capital gain and the net NALI capital gain in income years when the fund also receives an arm’s-length capital gain and incurs capital losses. This, in our view, will provide more appropriate outcomes while still achieving the desired policy objectives.

So while it’s disappointing Treasury did not tackle this issue considering they were in the process of amending the non-arm’slength provisions for general expenses, we are hopeful it will be just as receptive to the CGT issue as it was about the disproportionate tax treatment of general expenses.

And in the event we cannot get a law change, we will shift our focus to the ATO to advocate at a minimum for safe harbour provisions allowing trustees to rectify non-arm’s-length arrangements within a set timeframe without triggering the full application of NALI in relation to a specific asset.