With recent enactment of Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019, we have seen important changes made to the operation of the non-arm’s length income (NALI) provisions that now apply retrospectively from 1 July 2018. In this first blog post on the topic, we are focusing on the issue of non-arm’s length expenditure (NALE) and the broad impact that it will have across services being provided to SMSFs, in particular giving consideration to the application of section 17B in the SIS Act where a trustee/director is being remunerated for services in a non-trustee capacity. This is covered by the Australian Taxation Office (ATO) in their release of LCR 2019/D3 – NALI: expenditure incurred under a non-arm’s length arrangement.

When determining the application of the non-arm’s length income (NALI) rules within s.295-550 of the ITAA 1997, it is always necessary to determine the steps taken and the parties involved in the scheme to determine whether it is at arm’s length or not for tax purposes.

As part of determining the relevant steps of the scheme, it is necessary to consider whether the fund incurred NALE in gaining or producing ordinary or statutory income, or acquired a fixed entitlement to the income of a trust. Whilst there must be a sufficient nexus between the NALE and the derivation of income, it does not need to be deductible under section 8-1 of the ITAA 1997 for these provisions to apply. In fact, the non-arm’s length calculation (NALC) provisions can apply on either revenue or capital account, or where deductible under a specific provision (otherwise deductible) provided there is a specific nexus to the relevant income.

Non-arm’s length expenditure (NALE)

An amount of ordinary or statutory income will be NALI where:

there is a scheme in which parties were not dealing with each other at arm’s length;
the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing the income; and
the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm’s length in relation to the scheme.

Furthermore, it should be noted that income is also NALI if the fund does not incur a loss, outgoing or expenditure that the fund would have otherwise expected to have incurred (where dealing at arm’s length).

The ATO uses the following example to demonstrate how the NALI provisions can apply to all income of the fund as a result on a non-arm’s length arrangement:

Example 1 – NALI – non-arm’s length expenditure incurred with a nexus to all income of the fund

Keith is a partner within the accounting firm, KPT Accountants. He has a SMSF, which he engages his firm to provide accounting services for his fund to complete the ongoing compliance requirements. No fee is charged in respect to the completion of this work.

As a result of these NALI changes taking effect from 1 July 2018, section 295-550 of the ITAA 1997 will apply to this arrangement as the scheme involves the SMSF acquiring the accounting services under a non-arm’s length arrangement. The NALE (being nil incurred for the services) has a sufficient nexus with all of the ordinary and statutory income derived by the fund for the income year.

Following the guidance in PCG 2019/D6, the ATO’s transitional compliance approach will allow the fund to transition to an arm’s length arrangement to ensure compliance by 2020-21. Failure to comply by this time will result in all of the fund’s income for 2020-21 to be treated as NALI as taxed at the highest marginal tax rate.

Acting in capacity as trustee

It is an important distinction for the purposes of the NALI provisions to understand the interaction between section 17B of the SIS Act to help determine the application of s.295-550 of the ITAA 1997. The NALE provisions are not intended to apply to services provided by a trustee in their capacity as trustee – it is the capacity in which these activities are performed that becomes the critical here as to the NALI provisions.

Example 2 – internal arrangement- trustee provides services to the fund

Leonie is a trustee and sole member of her SMSF. She is an employee of KPT Accountants, which provides accounting and tax services. Leonie undertakes the preparation of her fund’s financial statements and tax return for her SMSF, which she does in her own time, not using any resources of the accounting business. She does not charge the fund a fee for the preparation of this work and is performing these duties in her capacity as trustee.

The NALE provisions do not apply here as Leonie is not acting in any capacity where the arrangement requires the parties to be dealing with one another on an arm’s length basis.

Duties in individual capacity for the fund

This is in contrast to the following example where the individual is relying upon the requirements within s.17B of the SIS Act to apply a fee to the services performed, albeit they do not demonstrate an arm’s length arrangement:

Example 3 – trustee carrying out duties in their individual capacity

Sharon is a trustee and sole member of her SMSF. She is a licensed real estate agent and runs a real estate business which includes property management services for rental properties. Her fund holds a residential property which it leases on commercial terms. Sharon provides property management services to the fund as a licensed agent, utilising the equipment and assets of the business to undertake these activities. Her actions are covered by her applicable insurance policies in respect of the business. Accordingly, Sharon provides property management services in her individual capacity to the SMSF with respect to her residential property. She is charging her fund 50% of the price she would normally charge to a non-related party.

For the purposes of the proposed subsection 295-550(1), the scheme involves the fund obtaining the services from Sharon and deriving the rental income. The price being charged constitutes a non-arm’s length dealing, which results in the expenditure being incurred being less than would otherwise be expected if they were dealing at arm’s length.

As such, there is sufficient nexus between the NALE and the rental income derived from the property resulting in the NALI provisions to apply for each income year the arrangement remains in place.

ATO’s compliance approach

As mentioned above, simultaneous with the release of LCR 2019/D3, the ATO has issued Practical Compliance Guidance, PCG 2019/D6 that outlines the Regulator’s transitional compliance approach regarding the amendments to the NALI provisions.

The release of this guidance by the ATO recognises that the proposed amendments will apply to NALE of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in an income year. It is also recognised that the proposed amendments apply in relation to the 2018-19 and later income years which may result in all income derived by a fund during the 2018-19 and 2019-20 income years being classified as NALI where it has incurred non-arm’s length expenditure of a general nature. In these circumstances, the ATO considers it is appropriate to apply a transitional compliance approach for these income year by not allocating compliance resources to determine whether NALI applies:

where the fund incurred NALE of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, non-arm’s length expenditure on accounting services); and
where the fund incurred NALE that directly related to the fund deriving particular ordinary or statutory income during the 2018-19 and 2019-20 income year

It is clear that the implications of the new measures will have much broader ramifications than initially thought, therefore, you should ensure that many of these arrangements are reviewed accordingly to avoid a gnarly outcome.