SMSF NALE | Non-arm’s length expenditure rules | Heffron SMSF

In last night’s Federal Budget, the Government provided a long awaited update on its proposed amendments to the non-arm’s length expenditure (NALE) rules. Unfortunately it wasn’t the answer we were hoping for.

The investment income of both APRA regulated funds and SMSFs is generally taxed at the concessional rate of 15%, or even 0% where the assets of the fund are solely supporting retirement phase pensions. But any amounts regarded as “non-arm’s length income” or NALI are taxed at 45%.

The NALI rules were initially designed as a deterrent to taxpayers channelling income, which would otherwise be taxable at company/individual rates, into concessionally taxed superannuation funds. They had been unchanged for many years until 1 July 2018 when they were expanded to include a focus on a fund’s expenses as well as their income. In essence, if a fund’s expenses were lower than they would have been in an arm’s length situation (ie they were non-arm’s length expenses or NALE), all or part of the fund’s income (including contributions) could be regarded as NALI and taxed at 45%.

The 1 July 2018 changes seemed harmless enough until you realised they could be applied to very common fund arrangements. For example, an SMSF trustee undertaking a renovation on the fund’s property and not charging the fund for their labour. Or administrative services being provided to APRA regulated funds at discounted rates.

Ever since the 1 July 2018 changes were introduced, industry has been lobbying for change. It now seems that lobbying has fallen on deaf ears. 

The only concessions made last night were:

• Large APRA regulated funds will be exempted from these rules. That is, none of their income will be considered non-arm’s length income (NALI) even if the fund’s administrative or investment related expenditure is lower than it would have been in an arm’s length situation.
• The news was not so good for SMSFs. If an SMSF’s general expenditure (eg accounting fees) is lower than would be expected in an arm’s length situation, instead of all of the fund’s income being taxed as NALI, the amount of NALI will be limited to twice the general expense shortfall. For example, a $2,000 expense shortfall in a single year could result in tax of $1,800.
• In addition, when calculating NALI, a fund’s contributions will be excluded.

So what does this mean?

In the case of general expenditure, the ATO has made it clear it will not be extending its current “no compliance activity” approach beyond 30 June 2023. Given the Government’s tweaks above could still result in a not insignificant tax bill for an SMSF, SMSF trustees and their advisers should review their expense arrangements before 30 June 2023.

For any services (eg accounting services) provided post 30 June 2023 (regardless of the year to which the service relates):

• If the services are provided to the SMSF by anyone other than a trustee/director of the corporate trustee, the SMSF needs to be charged an “arm’s length amount” for that service.
• If the services are provided to the SMSF by the trustees/directors of the corporate trustee, the question of whether the NALE provisions apply in respect of those services depends on the capacity in which the trustees/directors undertook those activities, as follows:
  • if the services are performed in the trustee’s capacity as trustee, no amount can or should be charged. This is because the super law prohibits a trustee or director from receiving remuneration for any duties or services performed as trustee/director, however,
  • if the services are performed in a non-trustee capacity (eg because the trustee used their personal tax agent registration to provide the service), the SMSF needs to be charged an arm’s length amount for that service.

So how does one determine the arm’s length amount to charge?

SMSF trustees simply need to ensure there is a sound commercial basis for amounts charged to the fund and that the pricing policy used is documented. An example of a commercial pricing policy would be ensuring the fund is charged the same amount that the provider charges independent clients.

Discounted rates (eg discounts for staff and relatives) (including pro bono) are acceptable provided they are consistent with the provider’s documented discount policy and normal commercial practices. The ATO has confirmed to Heffron that individuals who have influenced the creation of the discount policy can also benefit from that discount, provided such arrangements are consistent with normal commercial practices (eg a discount policy where the same discounts are provided to all employees, partners, shareholders or office holders, or a particular “group” of them who satisfy certain criteria). However, a discount policy influenced by an individual for their own benefit only or with limited advantage to others would generally not be consistent with normal commercial practices.

So for example, there would be no NALE issues if employees of Heffron who had their own SMSF were charged discounted accounting fees (including no fee at all) provided the discounts were available to all employees or a particular group only (eg senior staff). However, a discount policy available only to Meg Heffron wouldn’t be acceptable.

What about investment related expenditure?

The same rules apply to expenditure relating to specific fund investments/assets, except trustees have not had the benefit of the “no compliance activity” approach. The “no compliance activity” approach was specific to general fund expenditure only.

As the Government has decided not to repeal the 1 July 2018 changes, SMSF trustees will have a NALE risk if the fund has not been paying an “arm’s length amount” for services relating to specific fund investments/assets since 1 July 2018. As with general fund expenditure, discounts for staff and relatives etc would be acceptable provided there is a documented discount policy.

Not sure how to differentiate between services provided by someone in their trustee capacity vs their non-trustee capacity? You can read more, including exploring a number of examples, in the Heffron Super Companion.