ATO’s non-arm’s length income ruling causes SMSF uproar

This article was current at the time of publication.

The Australian Taxation Office (ATO) has issued its final decision on the application of the law on non-arm’s length expenditure outside of non-arm’s length income (NALI) in superannuation funds.

The Law Companion Ruling LCR 2021/2 – first issued as a draft in September 2019 and which applies to self-managed superannuation funds (SMSFs) as well as those regulated by the Australian Prudential Regulation Authority (APRA) – adopts the principle that if a fund incurs non-arm’s length expenditure which has no nexus to a specific item of fund income, it may have a nexus to all of it and incur tax at the non-complying rate of 45 per cent.

How did it come to this?

Professional bodies, including CPA Australia, are calling on the ATO to redress what they say is an overly broad interpretation of the law’s original intent, which ostensibly was to prevent SMSF members using limited recourse borrowing arrangements to get around limits such as the then-new total superannuation balance limit.  

“There was also a problem in that the previous definition of non-arm’s length income did not capture expenses incurred in dealing with related parties which were at less than commercial rates, where there wasn’t a connection between that expense and an item of income,” explains CPA Australia’s Policy Adviser Superannuation and Financial Planning, Richard Webb.

“It meant that general expenses could theoretically be gamed.”

Webb believes the new ruling will make things even harder when trying to establish arm’s-length rates for certain expenses.

“It will increase the time needed to undertake a lot of tasks involving trustees and their financial advisers,” he says. 

“It will not only affect tax agents and auditors, but other third parties such as administrators and the trustees themselves, in turn adding to the costs they face.”

Director at DBA Lawyers, Daniel Butler, notes that many professional bodies submitted that a general expense such as a lower accounting fee has little, if any, nexus to income derived.

“Any connection at best could be described as tenuous and remote,” Butler maintains. 

He believes the ATO has taken a pro-revenue construction of the legislation.

“That was certainly a view that was open to it based on the breadth of the legislation, however, I query whether it was the better view,” he says. 

Unresolved grey areas

The ruling also refers to a recurrent expense as typically only tainting the income year or years in which such an expense is less than arm’s length. 

However, where an expense relates to the acquisition of an asset, that expense will forever taint the ordinary and statutory income flowing from that asset. 

“The ATO provides the example of a low interest, non-arm’s length LRBA [limited recourse borrowing arrangement] used to acquire an asset and a subsequent refinance to place interest [which is a recurrent expense] will not rectify that NALI tainting,” Butler says. 

“This recurrent theory gives rise to further queries such as what happens if an LRBA was on arm’s length terms but is subsequently refinanced. Would that result in no NALI being applied on a future net capital gain?”

The compliance component

The ATO has indicated it will take a softer approach to compliance, noting that where trustees have made a reasonable attempt to determine an arm’s length rate, it will not dedicate compliance resources. 

According to Webb, however, this is unlikely to placate ATO auditors already in the process of an audit where they come across an instance of a non-arm’s length expense, regardless of its materiality.

Notably, the ATO does not give any guidance on what a “reasonable attempt” to determine an arm’s length expenditure is.

Principal at Sladen Legal, Phil Broderick, agrees that a lack of clarity in some aspects of the ruling could have severe and disproportionate consequences. In its ruling, the ATO has referred to an accountant not charging for the preparation of the tax return and financial statements of an SMSF.

“Let’s say that’s circa $1000 in savings for the SMSF under this non-arm’s length dealing or non-arm’s length expenditure,” Broderick says. 

“If the fund sells an asset or has significant income – perhaps a million dollars – in a particular year, because that expenditure is non-allocated, all the income is subject to NALI.”

Another issue is difficulty [in determining] the difference between a trustee expense or a trustee action. Broderick uses the example of a person with two rental properties. On one, they undertake major repairs and then on the way home stop off at the other to fix a couple of taps. 

“In the ATO’s eyes [the latter] is OK in their role as a trustee, but the more extensive works are as a builder or service provider. How does a trustee navigate that? What am I doing in my trustee or non-trustee position? It’s very murky.”

“This issue cries out for legislative amendment,” Butler adds. He points out that the ruling also suggests most SMSFs acquiring shares under an employee share plan where there is any discount would result in NALI, even for shares acquired prior to mid-2018, as the NALI changes apply regardless of when the scheme was entered. 

“This is a real step back with seeking to encourage the growth of employee share plans,” Butler says.

Smaller practices at risk

“Relatively minor expenditures might be missed in practices that don’t deal with them day in and day out, especially without the proper benchmarking material that the ATO often expects,” Broderick continues. 

“With non-allocated expenditure, the whole income of the fund is taxed at NALI rates and that’s a real disaster for trustees and their advisers.

“APRA-regulated funds will probably adjust their affairs so they’re not treated by these rules. With the example I gave of the million dollars of non-allocated expenditure, an APRA-regulated trust being tripped up like that is unimaginable.”

Regardless, Butler recently reviewed one APRA fund with more than A$5 billion in it, which, averaging over a 20 per cent return for the 2021 financial year, could have a 45 per cent tax imposed on it. 

“The ATO is aware that NALI being applied to a large APRA fund could cause substantial damage, which in this case means that even a $100 discount could result in a $450 million tax liability. I would like to see whether a judge would adopt the ATO’s view in relation to that.”

However, Broderick insists it is the little funds that will suffer most and says the next step is to seek a law change with the government and Treasury.

“One change that would make a big difference is to make NALI proportionate,” he suggests. 

“Going back to my example of that $1000 tax return charge, if it worked on a proportionate basis, we’d say that the benefit I have is $1000, so I only pay NALI tax on that, so it’s $450, not $450,000 as it is now.

“That might help a lot of this go away.”

A bridge too far? 

Indeed, the history of non-arm’s length income court cases has been around egregious “money for nothing” scenarios such as distributions from discretionary trusts into super funds. In one decision, a super fund bought listed shares for 10 per cent of their market value and had to pay NALI tax on the capital gains. 

“No one has a problem with what [essentially equates] to anti-avoidance provisions, but what’s proposed with NALI covers almost everything,” Broderick says.

“If that example of the $1000 tax return went to court, the court might well take the view that this unallocated expense isn’t in the legislation, so it doesn’t apply at all. I certainly don’t think any court would be happy with the disproportionate consequences.”

How to survive scrutiny

“If a fund is engaging in a transaction with a related party, the best thing to do is to ensure you have done your homework to see what the commercial basis for the transaction looks like and to save your work,” Webb says. 

“It’s easy to say no ‘mate’s rates’ deals, but even where you’re 100 per cent certain something is on a commercial basis, lack of any visible homework documentation in, for example, notes, calculations, correspondence with your adviser and so on, may cost your fund dearly.”