Tax Files: Self-managed super funds

Self-managed super funds: Beware of NALI!

BRIONY HUTCHENS, DW FOX TUCKER LAWYERS

Non-arm’s length income, commonly referred to as NALI, is not a new concept for superannuation funds. However changes made to the provisions in 2018, combined with the Commissioner’s views as published in Law Companion Ruling 2021/2 as to how those changes apply, are causing significant concerns and potential tax implications for many superannuation funds.

What is NALI?

A complying superannuation fund’s taxable income is split into 2 components – a low tax component which is taxed at 15%, and non-arms length income (NALI) which is taxed at the top marginal rate.

NALI is defined in section 295-550 of the Income Tax Assessment Act 1997 and can arise a number of different ways, including: • dividends received from a private company; • distributions from a trust other than by reason of holding a fixed entitlement to that income (e.g. distributions from a discretionary trust); • income derived from a non-arm’s length dealing; and • income derived from a trust as a result of holding a fixed entitlement to that income where either the entitlement was acquired under a non-arm’s length dealing, or the trust itself derived income under a non-arm’s length dealing.

Importantly, where a non-arm’s length dealing is required, that dealing must result in the relevant amount of income of the complying superannuation fund being more than would otherwise be expected had the parties been dealing at arm’s length.

2018 Amendments

Section 295-550 was amended in 2018 to expand the definition of NALI (in so far as it relates to non-arm’s length dealings and income derived from a trust as a result of holding a fixed entitlement to that income) so that the relevant issue was not just the amount of income directly derived by the superannuation fund from that dealing or fixed entitlement, but also whether the superannuation fund, as part of a scheme involving the acquisition of the fixed entitlement or the gaining or producing of the income: • incurred a loss, outgoing or expenditure which was less than might have been expected had the parties been dealing at arm’s length in relation to the scheme; or • did not incur a loss, outgoing or expenditure that the entity might have been expected to incur if the parties had been dealing at arm’s length in relation to the scheme.

In each of the above instances, the effect is that the net income of the fund (i.e. income less expenses/deductions) would be greater than it would otherwise be, resulting in potential NALI.

This significantly expanded the scope of NALI and brought into focus not just the income derived by superannuation funds, but also the expenses that the funds incurred. More significantly, the Commissioner’s views on how these provisions apply have the potential for income from a particular investment to be NALI for the life of the investment or, alternatively, for the whole of the income of the superannuation fund to be treated as NALI.

LCR 2021/2

The Commissioner has released Law Companion Ruling 2021/2 which provides guidance on the application of the legislative changes referred to above. This ruling is in addition to the previous Taxation Ruling 2006/7 (which is still valid and in force) which provides wider guidance in relation to the NALI rules in general.

The ruling addresses a number of issues in relation to the application of the non-arm’s length expenditure provisions. Significantly, the ruling provides that: • there must be a sufficient nexus between the non-arm’s length expenditure and the relevant ordinary or statutory income; • the relevant expenditure may be of a revenue or capital nature and does not have to be deductible under section 8-1 for the non-arm’s length expenditure provisions to apply; • where the initial expenditure incurred to acquire an asset (including associated financing costs) is considered to be non-arm’s length, that expenditure taints all of the ordinary or statutory income derived by the superannuation fund in respect of that asset, including any capital gains on disposal of the asset, forever more. This remains the case even where any initial non-arm’s length borrowings are refinanced subsequently to be on arm’s length terms. • In some instances, the non-arm’s length expenditure will have a sufficient nexus to all of the ordinary and/or statutory income derived by the fund, meaning that all of the income of the fund could be NALI in the year in which the expenditure was incurred (or not incurred). Examples given include: ○ Certain actuarial costs ○ Certain accounting fees ○ Audit fees ○ Certain costs of complying with regulatory provisions under the Superannuation Industry (Supervision) Act 1993 ○ Fees and premiums under an indemnity insurance policy ○ Investment adviser fees and costs ○ Other administrative costs

Acquisition costs

Some of the widest reaching implications from these amendments arise from the Commissioner’s position that any non-arm’s length expenditure in relation to the acquisition of an investment will cause all income and capital gains derived from that investment to be NALI for the life

of the investment, regardless of whether the terms are subsequently amended or refinanced to be on arm’s length terms.

Examples of where non-arm’s length expenditure on acquisition of an investment could invoke the NALI provisions include: where the terms of the acquisition are not arm’s length, e.g. the superannuation fund pays less than market value for the acquisition; where any borrowing or finance obtained to fund the acquisition was on non-arm’s length terms. For this purpose, the Commissioner considers the relevant comparison to be terms that would be expected had the borrowing or finance been obtained from a commercial lending institution. In this regard, the Commissioner expresses a view that it is expected that an arm’s length arrangement would require: ○ commercial rates of interest; and ○ monthly repayments of both principal and interest.

In relation to the Commissioner’s requirement for monthly repayments of both principal and interest, it is noted that this seems to ignore various lending arrangements provided by commercial lending institutions including, for example, interest only loans, and therefore it remains to be seen whether the view that principal and interest payments are required for an arm’s length dealing is sustainable.

The types of examples given by the Commissioner to demonstrate a non-arm’s length borrowing or finance are generally focussed on related party borrowings, and include limited recourse borrowing arrangements under which any of the following is present: • a lower than commercial rate of interest is charged; • the amount of the loan exceeds commercial loan to market value ratios (e.g. if the fund borrows 100% of the purchase price and acquisition costs); • repayments are required to be made annually, not monthly; • repayments of principal are not required until the end of the loan term.

Further, as noted above, it is the terms of any borrowing or finance arrangement at the time of acquisition of the investment that are relevant. This means that any subsequent refinancing of the borrowings or finance arrangements to be on arm’s length terms will not make any difference to whether the income from the investment is NALI. This is likely to results in a significant number of superannuation funds suffering NALI assessments from 2018 onwards in relation to investments made well before the amendments came into effect without any ability for the superannuation funds to rectify its position to avoid ongoing NALI consequences.

This approach is extremely harsh and a more reasonable approach would be for the income to be NALI for only so long as the non-arm’s length arrangements remain in place. Unless and until the Commissioner changes his approach, however, practitioners and clients need to be mindful of the consequences of the Commissioner’s stated position.

General expenditure

Where the non-arm’s length expenditure does not relate to a specific asset, it can taint the income of the fund as a whole. Importantly, where the expenditure relates to services provided to the fund by a member or trustee of the fund, it must be determined whether those services were provided to the fund in the capacity as a trustee (including as a director of a corporate trustee), or in some other capacity. If they are provided in the capacity as trustee, then no expenditure is required for the services and the arrangement will not be non-arm’s length as a result of no fee being charged. If they are provided in another capacity, however, then commercial rates of fees and expenditure must be charged in order to avoid NALI.

The capacity in which the services are provided will be a question of fact in each case, but relevant considerations include the extent to which tools and equipment of a person’s business are used in providing the services, and whether the services are required to be provided by a person with a relevant licence or qualification.

Examples given of where general expenditure may cause problems include: • accounting services provided by an accountant or his or her accounting practice to that person’s superannuation fund (other than services provided to fund to in relation to compliance with and management of income tax affairs and obligations) for either no fee or

for a fee less than the discounted fee offered to staff; • renovations performed by a plumber to a rental property held by his or her superannuation fund for no consideration and performed using the equipment and staff of the plumber’s business. It is noted that in this example, it is only the rental income from that rental property that would be

NALI, not all income of the fund; • property management services provided by a licenced real estate agent to his or her superannuation fund through their business for 50% of the market rate in circumstances where this is either less than the discounted rate or where the business does not have a discount policy for staff. It is noted that in this example, it is only the rental income from the properties that would be NALI, not all income of the fund.

Arguably, these sorts of arrangements, or at least some of them, would not have been caught by the NALI provisions pre amendment as they do not necessarily involve the superannuation fund “deriving” income from the arrangement, even though they indirectly result in the superannuation fund producing more income overall (as a result of reduced expenditure). The amendments therefore ensure that the rules will apply in these instances.

Conclusion

The expansion of the NALI rules and, more particularly, the Commissioner’s views on how these rules apply, have the potential for wide reaching implications for many superannuation funds, and the harsh consequences of a perceived breach of the rules have caused a number of concerns amongst practitioners and clients alike. With regular audit activity for superannuation funds, it is likely that many funds are going to find themselves in the sights of the Commissioner. Practitioners and their clients should review any existing and proposed arrangements to determine whether those arrangements present any risk for the fund in light of the amendments, and whether any action is required to be taken in respect of those arrangements.

Tax Files is contributed by members of the Taxation Committee of the Business Law Section of the Law Council of South Australia. B February 2022 THE BULLETIN 37