Non-arm's length income provisions for SMSFs
By Janet Manzanero-Caruana, Senior Technical Manager
Financial advisers of SMSF clients must be alert to how transactions deemed to be non-arm's length can impact the concessional treatment of SMSF income, resulting in a significantly higher tax bill.
Law companion ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement, released by the Australian Taxation Office (ATO) on 28 July 2021 clarifies how incurring non-arm's length expenditure (NALE), can result in a complying super fund's ordinary or statutory income being treated as non-arm's length income (NALI), resulting in a significantly higher tax rate. This can also occur where a loss or no expense is incurred by the super fund.
Incurring NALE can result in a significantly higher tax bill for an SMSF as NALI, less any related deductions, is taxed at 45%, the highest tax rate. Income derived by retirement phase pensions, which are usually tax exempt, can also be included in NALI.
LCR 2021/2 applies to NALE resulting from transactions between a party (or parties) and a super fund from the 2018/19 income year onwards, even if the scheme was entered into prior to 1 July 2018.
In some situations, an expense cannot be easily determined as NALE. This is where it is unclear whether a person delivers the service in their capacity as trustee (or as director of a corporate trustee) of the fund.
When does NALE result in super fund income being treated as NALI?
A super fund's ordinary or statutory income, including distributions of fixed entitlements to trust income, will be treated as NALI if:
- a scheme exists where parties don't deal with each other at arm's length and
- the SMSF incurs an expense (including no expense or a loss) in generating the fund's income and
- that expense is less than what the super fund might have incurred if parties were dealing at arm's length.
NALE, which may be revenue or capital in nature and may or may not be deductible, that has sufficient connection to certain SMSF income can cause that income to be NALI.
Impact NALE has on income and a subsequent capital gain of an SMSF asset
Where NALE is incurred in connection with the acquisition of an asset it can result in both income and any subsequent capital gain relating to the asset to be classified as NALI.
- The SMSF purchases a property under a limited recourse borrowing arrangement with a related party loan which requires interest only payments.
- Even if the SMSF refinances the loan with a commercial lender, net income for all income years the SMSF holds the property and any net capital gain realised relating to the property will be classified as NALI because the initial loan terms were deemed to be non-arm's length.
- The SMSF acquires units in a unit trust (whether purchased, as a contribution, or a combination of both) at less than market value. The SMSF receives the same amount of distribution per unit as the other unit holders, so deemed to be non-arm's length.
- A builder's SMSF has a property. He and his employee renovate the bathroom and kitchen of the property during work hours. In this case, the use of the builder's tools of trade is material. Considering all the work done by the builder and his employee, the builder provides services in his individual capacity (not as trustee for his SMSF). With no fee charged, the works are classified as NALE because the transaction is not arm's length, and significantly increases the value of the property. This results in any net income and subsequent capital gain relating to that property being taxed as NALI.
Market substitution rules apply where the super fund acquires an asset at less than market value. While the cost base of the asset will be higher (at market value), non-arm's length rules will still apply to the transaction which can make any income or capital gain realised from that asset NALI.
Tech Tip: A super fund should always acquire an asset at market value, whether it is a purchase, in specie contribution, or a combination of both.
If the super fund cannot fully pay for a permitted asset acquired from a related party, the shortfall amount may be, if eligible, a contribution by the member, if eligible. Records supporting the asset's valuation and details of the transaction must be kept.
Example: An SMSF acquires business real property from a member at $500,000. The SMSF purchases 50% of the property at $250,000 and a $250,000 in specie contribution of the other 50% is made by the member as a non-concessional contribution. The property continues to be rented at commercial rates to a third party. The net rent and any capital gain realised from the property will not be NALI.
NALE impact on income of an SMSF asset
In some instances NALE will only impact on the income of the relevant asset, not the whole fund. This can be where acquisition costs (including loans) and income is at arm's length but certain costs which only having a nexus with income related to the asset are not arm's length.
Example: A licensed real estate agent is a partner in a property management business which manages leases for a portfolio of rental properties. One of the properties managed is owned by the agent's SMSF and was acquired and is being leased at market rates.
The business does not have a discount policy for partners, office holders and employees. The SMSF is charged only half the usual rate for the services which relates to the property's rent only. Net rental income for the income years where the SMSF paid discounted management fees will be NALI. In this example, the NALE incurred does not have sufficient nexus to any future capital gain.
Treatment of expense based on whether activities are performed as SMSF trustee or in the person's individual capacity
In some cases, expenses for services rendered to the fund may not specifically relate to certain fund income, but rather to all fund income in general (such as actuarial, accountancy and audit fees or other administrative costs).
Where these services are provided by the trustee (or director of the corporate trustee) in their individual capacity or by a related party for free or at discounted rates, the expense can be NALE. It is possible that a small amount of NALE can have very large tax consequences for the fund as a whole, with all income in the SMSF taxed at the 45% rate.
On the other hand, where a person delivers services in their capacity as trustee (or director of a corporate trustee) of the fund, the Superannuation Industry (Supervision) Act 1993 prohibits payment for the service. In this case, income will not be NALI.
It is therefore important to consider whether services are delivered in the person's capacity as trustee and whether the amount of expense (including nil or a loss) incurred is non-arm's length.
Indications that services are not performed in a person's capacity as trustee or director of the corporate trustee can include:
- The person charges the SMSF for performing the services. A person can be acting in their personal capacity even if they do not charge the SMSF for the services.
- The person uses equipment or other business assets, or equipment and other assets used in their employment in a material manner.
- The person or the business holds the necessary licence and/or professional qualifications to deliver such services.
- The activity is covered by an insurance policy relating to the business, profession, or employment such as indemnity insurance.
Bookkeeping and accounting can be undertaken by a person in their capacity as trustee of the fund and not be paid for it. However, if the person regularly uses their business or employer's equipment or assets in providing services to the SMSF and the use is material, income may still be classified as NALI.
Examples of services provided in the person's individual capacity that can have sufficient connection to all income of the SMSF and can result in NALI for that income year include:
A firm provides audit services to a partner's SMSF for free where the service is not available for free to anyone else in the firm.
A financial adviser frequently uses his employer's computer and software in formulating and executing trades in line with their own SMSF's investment strategy.
When an expense is not considered NALE
'Minor, infrequent or irregular' use of business equipment or other assets by the person in providing a service will not, of itself, indicate the person is not acting in their capacity as trustee.
The relevant facts, situation and factors of each case must be considered to determine whether the person is acting in their capacity as trustee or not. What is unclear though is how to determine whether the use of business or professional assets is 'minor, infrequent, or irregular'.
For an accountant or a financial adviser who works from home, does this mean a separate computer and separate software must be used for their SMSF to avoid NALE? Would a person using their personal computer for work during lockdown for most of the financial year be providing services in their capacity as trustee if the same computer was used to do the SMSF's bookkeeping?
If the trustee has not induced the service provider to provide the service for free, services will be considered to be at arm's length. While a trustee can negotiate for discounted prices, discounts must be consistent with normal commercial practices. For example, a trustee may use a staff discount which is available to all staff, partners, and shareholders of their firm.
Examples where a SMSF does not incur NALE for services delivered are:
- An SMSF trustee engages the business he works for to fumigate his SMSF's rental property. He avails of a 10% discount which is available to all employees.
- A chartered accountant who is employed in an accounting firm prepares the accounts and annual return for her SMSF and does not use the employer's equipment or assets. She does not lodge the annual return using her tax agent registration and does not charge her SMSF for the work. The work is performed in her capacity as trustee.
- An SMSF trustee is a financial advisor and works from home using the company computer and software. Occasionally the SMSF trustee uses the company's computer and software to do bookkeeping and online trading for the SMSF outside of work hours. There is no charge for the work which is performed in their capacity as trustee for the SMSF.
- A licensed electrician does electrical work on her SMSF's rental property which was acquired at market value and is rented at arm's length terms to a third party. Commercial rates are charged to the SMSF.
- A plumber who runs a business as a sole trader installs a stand-alone water filter in her SMSF's property. The filter is provided by the tenant (to be taken by the tenant at the end of the lease). The plumber's own tools are used for installation. The use of her business tools is minor. The work is performed as trustee of her SMSF, so she receives no payment.
Tech Tip: When providing services to the SMSF, it is important to distinguish whether services are delivered by the person in their capacity as a trustee (or a director of the SMSF's corporate trustee). If it is not, the person providing the service must charge professional fees at commercial rates for these services.
An alternative is to engage a third party to perform these services and pay market rates.
Trustees must establish the necessary measures to enable them to show there were reasonable attempts to establish that transactions and payments were at arm's length when acquiring assets and paying for services. Trustees should keep supporting records to show that any decisions, valuations and transactions were at arm's length.
ATO compliance approach
The ATO recognised that there is concern that a small amount of NALE for general fund services, may have a sufficient connection to all of an SMSF's income, resulting in all income being taxed as NALI.
From 1 July 2022, ATO compliance resources relating to general fund expenses will only be directed to services that are provided in the person's individual capacity, not as trustee. If trustees can show that they made reasonable attempts to ensure expenses are incurred at arm's length, the ATO will not allocate compliance resources to further ascertain if those expenses are at arms' length.
Practical Compliance Guideline PCG 2020/5 Applying the non-arm's length income provisions to 'non arm's length expenditure' will continue to apply. This outlines that the ATO will not allocate compliance resources to determine whether NALI provisions apply to a super fund where NALE, that has a sufficient connection to all fund income, is incurred on or before 30 June 2022.
NALE that is of a general nature can have significant tax consequence if it has sufficient connection to all fund income. The line between minor and regular use of business equipment or other assets is not clearly prescribed, and this can also have significant bearing on whether an activity or service is performed in the person's capacity as trustee (or director of the corporate trustee) or in their individual capacity which may result in NALE.
To avoid expense being treated as NALE, SMSF trustees should avoid all non-arm's length transactions. Engaging third parties to provide services can help trustees satisfy the ATO's requirements. Remind your SMSF clients to keep valuations and supporting documents for transactions or services to document that reasonable attempts were made to ensure transactions were at arm's length.
If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.