The ATO has recently released an important ruling further clarifying when SMSF income will included in the non-arm’s length component (subject to top marginal tax rates).
Usually, SMSF income will be included in the low tax component subject to tax at 15% (or lower for SMSFs paying pensions).
So having any SMSF income considered non-arm’s length (NALI) is expensive and best avoided.
Previous ATO rulings have focussed on NALI by identifying situations where the SMSF income itself is inflated due to non-arm’s length arrangements. LCR 2021/2 shines the light on NALE (non-arm’s length expense) and how it impacts what SMSF income is considered non-arm’s length.
An expense in an SMSF will be NALE if it is less than it would be if the parties to the transaction had been dealing with each other on an arm’s length basis. It also includes outgoings and losses that are less than arm’s length, even situations where the amount is $Nil.
Specific Asset or General Expense
The ruling sets out that NALE tied to a Specific Asset makes any SMSF Income of that Specific Asset NALI, including capital gains.
For NALE that is not tied to a Specific Asset, for example General Expenses like accounting fees, all SMSF Income becomes NALI.
The distinction between the two is important. Using the example of purchasing a property, if the transaction doesn’t occur at arm’s length, then it will be the ongoing rental income and the future capital gain on that asset that will be subject to a 45% tax rate rather than 15%. Sounds like a better outcome than all income of the SMSF being affected but the stick is that the NALI will be subject to 45% tax for however long the SMSF holds the asset. The only fix is to get the Asset out of the SMSF.
If NALE exists in the second instance where the expense has a nexus with all assets of the SMSF, the NALI attracting the 45% tax rate will be ALL income of the SMSF. If an Accountant fails to invoice their own SMSF for Accounting services applying the amended ruling means that there is a nexus between the arm’s length accounting fees and all income of the SMSF. However, this will only impact the financial year that the NALE occurred and provided the accounting fees are arms-length in future years, NALI will not be present and the 15% tax rate will apply as normal.
Take care with In-Specie Transactions
Where the SMSF enters a contact to purchase 100% of an Asset and there is a difference between the consideration paid and the market value of the assets, under the ruling the difference cannot be treated and an in-specie contribution to avoid NALI. Unless the SMSF is only acquiring a part of the asset and that part of the asset is at market value.
Accountant or Trustee
When it comes to providing services or doing work for your SMSF, the ruling defines a difference between work performed in your capacity as an individual and work done in your capacity as Trustee of the SMSF. If you are doing things for the SMSF in the capacity of Trustee or Director of a Trustee Company can receive remuneration for duties or services performed by them if they:
- Perform the duties or services other than in their capacity as trustee or director of a body corporate that is a trustee, and
- Are appropriately qualified, and hold all necessary licences, to perform the duties or services, and
- Perform the duties or services in the ordinary course of a business, carried on by them, of performing similar duties or services for the public, and
- Receive remuneration that is no more favourable to them than that which it is reasonable to expect would apply if they were dealing with the relevant other party at arm’s length in the same circumstances.
As Trustee you can provide services to the SMSF with no remuneration but if you act in another capacity and you don’t receive market value remuneration for those services, the expense may be treated as NALE. Factors that indicate that the individual is performing their activities in their individual capacity and not in their capacity as a trustee, or a director of a corporate trustee, include:
- The individual charges the complying SMSF for performing the services. However, there can be circumstances where the individual can be acting in their individual capacity even though they do not charge the SMSF for performing the services.
- The individual uses the equipment and other assets of their business, or equipment and other assets used in their profession or employment in a material manner. However, minor, infrequent, or irregular use of equipment or assets will not, of itself, indicate the individual is acting in their individual capacity. For example, in the absence of any other factor indicating otherwise, minor, infrequent, or irregular use of a business computer at the office by an individual would not, of itself, indicate the individual is acting in their individual capacity.
- The individual performs the activities pursuant to a licence and/or qualification relating to their business, or their profession or employment. That is, the activity can only be performed due to the individual or business holding the relevant licence and/or qualification.
- The activity is covered by an insurance policy relating to their business, or their profession or employment (for example, indemnity insurance).
What’s not arm’s length
If acting in an individual capacity when providing services to you SMSF, the new ruling does provide some detail and examples of how to determine if the expense is arm’s length and how to avoid NALI. A standout being that providing discounts to staff is okay provided the discounts are on a commercial basis. In addition, it may still be possible to provide pro bono services or a cost recovery fee to an SMSF in certain circumstances.
Whilst the new ruling does confirm that NALE can have a nexus with all income of the SMSF, the great news is that it doesn’t have to be all doom and gloom when it comes to providing General Expense services to your SMSF. If you do get it wrong, NALI will only apply to the year in question and not future years. Importantly, the ruling also sets out the ATO’s compliance approach for General Expense NALE will only be directed towards determining that you made a reasonable attempt to determine an arm’s length expenditure for services provided.
NALE relating to Specific Assets however is terminal to the SMSF with no fix other than unwinding the investment.
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