It wasn’t necessarily the outcome that the SMSF industry strategy was hoping for, but we have seen the Australian Taxation Office (ATO) finalize its public guidance, LCR 2021/2, on the application of the NALI provisions where expenditure is incurred under a non-arm’s length arrangement.

It has arguably been one of the most consulted public rulings impacting superannuation, with the initial draft ruling dating back to 2018.  Since this time we have seen:

• a revised draft in 2019 (due to introduction of new laws); and
• regular updates to the Commissioner’s public compliance guidance (PCG 2020/5), which provides relief to arrangements where there is a sufficient nexus of the non-arm’s length expenditure (NALE) to all of the fund’s income – this relief is currently available until 30 June 2022.

What’s all the fuss about?

The concept of NALE was introduced from 1 July 2018 into section 295-550 of the ITAA 1997 to address arrangements where the result of the income derived was higher due to the level of expenditure incurred (including where no expense was incurred) where the parties had been dealing at arm’s length.

Where NALE exists, this will taint some or all the fund’s income, resulting in a non-arm’s length tax rate of 45%.

The sticking point over the past years in finalising the ruling has been the Commissioner’s position on the application of the NALI rules to expenditure where there is a sufficient nexus to all of the fund’s income. A determining factor to this is the capacity in which the trustee is undertaking work in respect to their fund – that is, in either:

• their capacity as trustee, where no fee can be charged for trustee services under s17A of the SIS Act; or
• alternatively in their individual capacity, where a fee may be charged under s17B of the SIS Act, subject to a number of conditions being satisfied.

It is the latter outcome that creates the potential NALE problems where a fund isn’t incurring an expense that is at arm’s length.

The ATO, having consulted with the public advice and guidance panel to finalize this ruling, now provides us with an outcome, albeit not exactly the desired result we wanted.

So, with the finalisation of LCR 2021/2, let’s explore the impacts of this ruling.

The NALE nexus remains 

The Commissioner’s position in this final ruling has remained mostly unchanged – that is, where the fund incurs NALE, the nexus between the expenditure and all the fund’s income derived is sufficient to be treated NALI.  This includes expenditures incurred such as actuarial costs, accountancy fees, audit fees, adviser fees, and other administrative costs incurred in managing the fund.

Importantly, a distinction is made in the final ruling with NALE of a recurrent nature, which effectively limits the NALI provisions to the income year in which the fund has expenditure which is deemed to be not at arm’s length – example 2 within the ruling expands on this item further.  This is not necessarily the case with other aspects of the ruling where the market substitution rules may apply to an asset acquisition that may have been acquired at less than market value (where the asset is tainted for both income and CGT purposes).

Capacity in which services are performed

Understanding the capacity in which the services may be performed within an SMSF does play a significant role in determining whether the NALI provisions will apply.  This is particularly relevant for professionals that ordinarily satisfy the definition contained within s.17B of the SISA, allowing for a fee to be charged at arm’s length for non-trustee duties. 

Importantly, the ruling makes clear that the NALI provisions will not be enlivened due to a trustee or director not charging for services performed when doing so in a trustee capacity.  It also acknowledges that utilising such skills and knowledge of itself does not indicate that the individual is not acting in their capacity as trustee – the ruling refers to an example of a financial adviser who is a trustee, acknowledging that they can utilise their skills and knowledge in deciding the fund’s investment strategy in their capacity as a trustee.  It is not this clear cut though, as a number of additional factors need to be considered that may create a contrary view, including activities performed pursuant to a license and/or qualification or activity being covered by an insurance policy (to name a few).

The good news is that where a discount is provided under a discount policy within the firm and is provided to all employees, partners, shareholders, or office holders then the NALE provisions will not apply.  However, if generally a fee is charged (for accounting services) that does not reflect what may be charged to the public, then the NALE provisions will apply.  There are a number of examples (6 – 11) that work through the various machinations on internal arrangements, discounts, and the different capacities in which the services are being performed.

ATO’s compliance approach

With the ATO stating that instances will arise where NALE will have sufficient nexus to all of the fund’s ordinary and statutory income, it is the Commissioner’s view that to avoid the application of the NALI provisions, parties must be dealing at arm’s length and that arm’s length expenditure amounts be incurred by the fund.

At this time, certain trustees can rely on PCG 2020/5 for existing arrangements in place to 30 June 2022.  However, from 1 July 2022, changes to existing arrangements may need to occur.  The ATO will look to apply compliance resources for SMSFs in respect to this matter to ascertain whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the fund, other than services provided by an individual either acting in their capacity as a trustee/director of the fund.  

The ATO will not allocate compliance resources to determine whether those expenses are in fact arm’s length expenses.

The ruling does expand into a number of other key issues that formed part of the previous LCR 2019/D3.  We will explore the implications of this ruling in our webinar on Thursday, 26 August 2021.