Non-arm’s length rules put opportunities out of reach

Author: Richard Webb, Policy advisor - Financial planning and superannuation, CPA Australia

Recent changes to the rules on non-arm’s length requirements may impose a heavy tax burden on super funds which acquire assets at a discount. They may also render employee share schemes inaccessible to self-managed super funds. Here’s what you need to know.

In 2017 changes, designed to bring non-arm's length expenses - where these expenses did not necessarily give rise to non-arm's length income (NALI) - into the non-arm’s length tax regime, introduced considerable uncertainty.

The NALI regime is designed to provide disincentives to trustees against arbitraging between tax rates. Essentially, they penalise "mate's rates" by imposing a 45 per cent tax rate on income or capital gains related to transactions which are undertaken with a related party at anything other than at a commercial or market rate.

Ostensibly aimed at limited recourse borrowing arrangements, the changes have since been the subject of Law Companion Ruling LCR 2021/2. This ruling considered services provided to a fund by the trustee or their associates. A consultation is also presently underway on consequential amendments to Tax Ruling TR 2010/1-DC.

LCR 2021/1 has received a great deal of coverage for several reasons. One of the key sources of dissatisfaction has been the treatment of assets once they have been the subject of a non-arm's length arrangement. In certain cases, this may only affect income generated by the asset. However, where the acquisition of the assets themselves was undertaken on a non-arm's length basis, it has been held that the assets themselves will be taxed at the non-arm's length rate of 45 per cent on both income and on capital gains. This occurs regardless of whether the assets are in the accumulation or pension phase, and continues to apply to income received from the asset regardless of how long the asset is held.

This makes the circumstances by which a fund acquires assets very important, as this could determine how any proceeds from the asset are taxed. Any kind of discount could trigger a NALI event and “tarnish” the assets for the entire period they are held by a fund. One such event where a discount could be provided is where shares are acquired by an SMSF through an employee share plan.

The ATO's consultation on TR 2010/1-DC considered the dual question of the acquisition of assets by an SMSF, together with in specie transfers. Up until the ATO issued LCR 2021/2, the ATO's view of assets acquired by a fund at a discount to market value was that the transaction was a combination of an acquisition and a contribution. In cases such as this, the discounted amount became a contribution as a balancing item. Consequently, the assets were deemed to be acquired at their market value. Any discounts on acquisition were treated as assessable income by the employee.

However, the proposed TR 2010/1-DC states that it is no longer the case that such a discount will be assessed as a contribution, with the assets concerned now to be subject to NALI. To this end, LCR 2021/2 states that the income generated by the shares into the future, and any capital gains from disposal of the assets, would now be NALI and taxed accordingly. Not only this, the NALI rate applies to the assets in full, and not a smaller rate to reflect the amount that the shares were discounted by.

Employee share schemes are often not widely available to employees. Commonly, they may only be available to senior executives or other personnel with special remuneration arrangements. The potential exception offered by LCR 2021/2 could allow an affected employee to claim such a discount is in accordance with normal commercial practice. Yet, they would have to convince the ATO that, in the instance that only a small number of employees are eligible for the discount, this is "normal commercial practice", which may be somewhat difficult.

Even though LCR 2021/2 offers this possibility, it’s not a scenario contemplated by the proposed TR 2010/1-DC, which appears to outlaw any arrangement where the fund acquires assets at a discount.

Unfortunately, this means that trustees are now going to need to be even more careful of how their fund acquires assets. It may also mean that employee share schemes are inaccessible to SMSFs in the immediate future, unless shares are acquired at market value.