Warning: the ATO rule that could plunder your super

Garreth Hanley:
This is With Interest, a business, finance, and accounting news podcast brought to you by CPA Australia.

Jen Duke:
Hello, and welcome to With Interest. I'm Jennifer Duke, External Affairs Lead at CPA Australia. In this episode, we're going to talk about a little known and even less well understood superannuation rule called the non-arm's length income rule. It could leave everyday Australians making mistakes that cost them thousands of dollars in tax on their super. Now, if you're a tradie or a professional services worker such as an accountant, real estate agent, or lawyer, here's the real kicker: one of the perverse outcomes of the rule is that if you apply your professional skills to your private life, for example, by doing your own books without charging your fund, you could trigger this penalty.

This situation has been a focus of a range of professional associations, including CPA Australia, who recently took their concerns to the public, issuing a joint statement about the potential damage to super balances for those who use their professional skills to assist their retirement fund. Joining me to discuss what these rules are, who is affected, and what needs to be done is CPA Australia's Policy Advisor for Superannuation and Financial Planning, Richard Webb. Welcome to With interest, Richard.

Richard Webb:
Thank you, Jen. It's lovely to be here.

Jen Duke:
Richard, can you give us the high-level explanation of what the non-arm's length rule is and how it works?

Richard Webb:
Sure. Thanks, Jen. A self-managed super fund is a small superannuation fund which allows for folks to manage a small amount of assets in a small fund themselves. But because superannuation is a concessionally taxed environment, there needs to be protections put in place so that when assets move into or out of that environment, it's done in a way that isn't unfair, whether that be artificially moving more assets than what is allowed under contribution caps or gaining tax advantages. So there is a requirement that when funds move assets in or out of the fund to related parties, and this could be in acquiring or disposing of assets, or just incurring ongoing expenses or fund income, that this be done at arm's length. That is, at a commercial rate, not some sort of mate's rate.

Jen Duke:
So how easy is it to fall afoul of this rule, and can you share some examples of how someone might get it wrong?

Richard Webb:
Sure. It's possible that one could be a qualified plumber who operates their own fund, and this fund could own an investment property. So if the tradie who's the trustee comes around to make a normal repair, such as connecting something of the tenants' to a troublesome tap, this would normally be okay. This would be a normal job, by the way, for a trustee to undertake. On the other hand, a full scale bathroom renovation by that tradie, where the tradie didn't charge, is likely to breach the rules, since this is essentially considered to be outsourcing an improvement job to the trustee in their capacity as a professional. Another example might be where a real estate agent has their own fund and provides property management services which her firm normally charges for, but charges only 50% of the usual cost of the fund. If the firm doesn't actually have a discount policy, this could also be a potential breach.

Jen Duke:
This sounds pretty complicated. Are there many cases of people actually being charged a penalty for getting this wrong?

Richard Webb:
Well, outside of the issue of matters involving limited recourse borrowing, we're not actually aware of any major number of incidents in this area.

Jen Duke:
So does this only affect those with self-managed super funds? What about super funds regulated by the Australian Prudential Regulation Authority?

Richard Webb:
I think that when the changes were made in 2018, the superannuation world felt that this was an SMSF issue. And to be fair, why wouldn't they? Because the examples which were given in the legislation and the supporting documentation suggested that it was limited recourse borrowing arrangements, which were primarily utilised by SMSFs, which were the issue. But we know now that something as innocuous as a trustee of a fund failing to indemnify an expense to an APRA-regulated fund would make the entire income of that fund subject to the non-arm's length tax rate, which is 45%. And there are no materiality thresholds, by the way, so this could be something like a few dollars worth of photocopying.

Jen Duke:
45% is pretty significant. How could this affect someone's balance in retirement?

Richard Webb:
Basically, it's possible to get something wrong that could affect one's entire fund income. But also, where a specific asset has been obtained, this could latch onto the entire capital value of the asset. It is possible to have an asset which isn't disposed of until the fund is well into the pension phase. This is supposed to be tax-free, but the tax on the capital gains from disposing of that asset would be taxed at 45%, whether the fund is in the accumulation phase or the pension phase.

Jen Duke:
So that's a pretty significant penalty. But those that are involved in this aren't always trying to do something dodgy, are they?

Richard Webb:
No, well, that's right. It is possible that folks might be tempted to think that by moving large amounts of assets into a fund quickly, such as what's possible with property and limited recourse borrowing arrangements, they could accelerate their wealth in the fund by lending to themselves on a basis that is hugely favourable to the fund. This is the kind of thing that the rules are designed to catch. However, because there are no materiality thresholds, the rules as they currently are capture folks doing really basic things. But also, there are circumstances which can conspire to catch people out.

You might remember my earlier example where a trustee inadvertently forgets to indemnify the fund for a small amount of photocopying. It simply may not have been worth their time to be remunerated. But also, in the case of an APRA-regulated fund, best financial interests duty has a reversed onus of proof, which means they would have to come up with a reason to justify charging the expense to the fund at the time that this was incurred. There are, incidentally, penalties including up to five years in prison for breaches of best financial interests duty, so there is quite the disincentive to not breach this requirement. Anyway, if we fast-forward into the future, and the ATO becomes aware that this event occurred, they may really have no choice but to assess the fund's income as non-arm's length. And you know, the fact that the trustee couldn't come up with a basis for recouping the expense from the fund in the best financial interests of members is basically considered irrelevant to the ATO.

Jen Duke:
So how did a slightly bizarre rule like this come into being? What was the basis for it?

Richard Webb:
Jen, essentially, it's a fairness thing. Australia implemented non-arm's length income laws for superannuation to prevent individuals from using their self-managed super funds to avoid paying the appropriate amount of tax. The penalties ensure that SMSFs are not used to avoid tax obligations and all the taxpayers are treated fairly. The implementation of non-arm's length income laws for superannuation also ensures that the integrity of the superannuation system is maintained, and that SMSFs operate in accordance with the spirit and intent of the law.

Jen Duke:
But my understanding is that those risky borrowing arrangements are no longer available. So why do we still have these rules, and are they fit for purpose anymore?

Richard Webb:
Yeah, that's right, Jen. The ATO's guidance in 2016 provided clarity around the compliance requirements for LRBAs and the potential risks associated with them. It also outlined the ATO's views on how LRBAs should be structured to comply with superannuation laws. And this guidance, incidentally, was introduced prior to the 2018 changes to the arm's length expenses rules. So we think that the problems here were largely addressed back then. It's still important, I think, to ensure that the spirit of the laws are retained, so that arrangements to circumvent things like contribution caps or the transfer balance cap or just income tax generally can be minimised. I think this is what the public interest requires.

Jen Duke:
And obviously ensuring some services are provided at arm's length is important, but being practical is also critical. How do we strike the right balance here?

Richard Webb:
This is a really tough question. How do we ensure that we are able to provide superannuation to the Australian public at a rate that reduces fees, which, by the way, is government policy, and combine that with a prevention mechanism for tax avoidance? CPA Australia has been working with a variety of other accounting, tax, financial advice, actuarial, and superannuation groups to come up with a solution. And I think, Jen, that we have an idea which we believe has the potential to satisfy everyone wrestling with this problem, and at the same time, strikes the correct balance.

Jen Duke:
So we'll come to that in a minute, but there is consultation underway about these rules, which could bring about some change. So what's the consultation paper proposing?

Richard Webb:
The consultation paper proposes exempting APRA-regulated funds from the general expenditure part of the non-arm's length rules. At the same time, it caps the non-arm's length income from a general expenditure breach by SMSFs and small APRA funds at a maximum of five times the level of the breach. Specific expenses, on the other hand, would be treated in the same way as they currently are across all funds. There will be no changes there.

Jackie Blondell:
If you're enjoying this podcast, you should check out our in-depth business and finance show, INTHEBLACK. This month, in our career hack series, we're talking with recruiters, job market experts, and career coaches to get their advice on the best way to navigate 2023's employment and workplace landscape. Search for INTHEBLACK on your favourite podcast app today. And now, back to With Interest.

Jen Duke:
So let's try and start with the positives. Which parts of the consultation do you agree with?

Richard Webb:
We don't agree with either proposal, Jen.

Jen Duke:
Ouch. So what parts of the proposal are you not particularly supportive of?

Richard Webb:
So I guess this is going to sound negative. That's not, by the way, a reflection of the fact that we welcome the engagement by the government and the regulators in this process. The fix suggested for APRA funds is messy, and it fractures the tax regime into two different sectors. Additionally, because APRA-regulated funds would continue to be subject to the non-arm's length expenditure rules for specific expenses whilst being exempted for general expenses will mean that different rules will apply if conducting transactions with different related entities.

For example, the way an APRA-regulated fund will conduct business with a related investment entity will be more tightly scrutinised than their interactions with related administration entities, and that is suboptimal for a variety of reasons. The proposal to cap taxable non-arm's length income at five times the amount of the breach still means that a breach is subject to a tax rate of up to 225%. We still think that this is disproportionate and requires unnecessary trustee paperwork for small expenses. It also doesn't resolve the issue of specific expenses, which remain unaddressed and are still a problem.

Jen Duke:
So it sounds like there's an awfully long way to go. What is CPA Australia's proposal to make the rules work better for consumers?

Richard Webb:
Well, Jen, as I mentioned earlier, we came up with a solution which we believe has the potential to satisfy everyone. We suggested that the amendments made to Section 295-550 of the Tax Act in 2019 should be repealed and returned to its previous terms, as this would be the most ideal and least disruptive solution. Any concerns about non-arm's length arrangements in superannuation funds could still be addressed by bringing non-arm's length amounts under the contributions regime, which, by the way, is covered in the current version of tax ruling TR 2010/1.

If the government feels additional safeguards are necessary. Section 109 of the SIS Act, which is an operating standard, by the way, could be amended to prohibit trustees from conducting any transactions with any party other than on arm's length terms. Trustees are expected to comply with Section 109 of the SIS Act at all times, and external auditors check for compliance each year. If a breach is found to be material, regulators have the power to determine penalties, and in extreme cases, a fund could be deemed non-complying, with most of its assets taxed at 45%.

Jen Duke:
So as you mentioned before, one of the possible options is for a carve out for APRA-regulated funds. Is there any way you would support this carve out?

Richard Webb:
Not at all. This would create a two-speed sector and create a new bureaucracy for APRA-regulated funds themselves, as they create parallel processes for ostensibly the same tasks. They may also be incentivized in the short term to engage in costly restructuring to centralise clerical functions, and this may result in increased costs to members.

Jen Duke:
So you have been working with numerous associations to try and improve the current rules. So who's in this group, and what's the aim?

Richard Webb:
Well, ultimately, we are working together to fix what is poor law design, which has led to inequitable outcomes. We have been working with other accounting bodies such as Chartered Accountants Australia and New Zealand, as well as the Institute of Public Accountants. Members would be aware that we have a great relationship with these bodies, and this helps us make the profession a better place to work. We also worked with financial advice and tax groups such as the Tax Institute, the SMSF Association, the Institute of Financial Professionals Australia, and the National Tax and Accountants Association.

But over the past couple of years, we have also benefited from the assistance from the Financial Planning Association, the Actuaries Institute, and the bodies representing APRA-regulated super funds, the Financial Services Council, the Association of Superannuation Funds of Australia, and the Australian Association of Superannuation Trustees, even if some of these bodies were not able to ultimately come to the same conclusions as us in relation to this consultation paper. And for that, we are grateful.

Jen Duke:
So a lot of people involved in this, and very recently, CPA Australia's CEO Andrew Hunter, along with the CEOs of several other associations, many of which you just mentioned, jointly wrote a letter to Financial Services Minister Stephen Jones raising the concerns that we've been talking about today. There was also a joint submission made. Are you confident these concerns are being heard by government?

Richard Webb:
I would like to hope that this is the case, Jen. A lot of work is being done to ensure that our concerns are heard, and we have had terrific opportunities to make our case in speaking to the ATO, APRA, Treasury, and ministerial representatives over the past couple of years.

Jen Duke:
Well, I hope you have really good luck in getting your case heard by the government. Unfortunately, that's all we've got time for today. Thanks very much to our guest, CPA Australia's Richard Webb. Links to our joint statement will be available in the show notes. With Interest is a weekly podcast. If you like what you've heard today, why not subscribe to With Interest on your favourite podcast app? By subscribing, you'll receive notifications when a new episode becomes available. From all of us here at CPA Australia, thanks for listening.

Garreth Hanley:
You've been listening to With Interest, a CPA Australia podcast. If you've enjoyed this episode, help others discover With Interest by leaving us review and sharing this episode with colleagues, clients, or anyone else interested in the latest finance, business, and accounting news. To find out more about our other podcasts and CPA Australia, check the show notes for this episode. We hope you can join us again for another episode of With Interest.