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NALI rules and the ATO's approach in Law Companion Ruling 2021/2

The ATO has issued LCR 2021/2, which sets out the ATO's approach in relation to the non-arm's length income (NALI) rules, as well as the effect of relatively recent changes to those rules. Income which is earned by the fund which is NALI is taxed at 45%, which now also takes into account income that has a nexus with non-arm's length expenses.

The ATO's interpretation of the NALI rules in LCR 2021/2 has the potential to treat the entirety of an SMSF's income as NALI, and therefore trustees must be acutely aware of this new ruling. This article will outline the LCR 2021/2 and discusses the ATOs approach and potentially harsh outcomes.

Ari Armstrong, Maddocks Lawyers

What is NALI?

The taxable income of an SMSF is made up of two components - a 'low tax component', which is taxed at 15%, and a 'non-arm's length component', which is taxed at the top marginal tax rate.

More recently, the operation of the NALI provisions has been extended to include circumstances where the fund incurs a loss. The NALI rules extend to outgoings or expenditure which is less than what would be expected if the parties were otherwise dealing at arm's length as set out below (NALE).

These rules are governed by section 295-550 of the Income Tax Act 1997 (ITAA97). Similarly, if the SMSF does not incur a loss, outgoing or expenditure at all, in circumstances where it would be expected that that SMSF might otherwise have incurred such an expense had it been dealing with counter-parties at arm's length [1], the SMSF has incurred NALE.

What are the practical implications of NALI and NALE?

Where for instance an SMSF acquires shares from a related party for below market value (i.e. NALE), all subsequent income derived from those shares (such as dividends) will be deemed NALI and taxed at the top marginal rate in the hands of the SMSF. The subsequent capital gain on those shares will also be deemed NALI. This extends to every type of asset, including real property.

The NALI/NALE rules also apply where the SMSF:

  • derives income as a beneficiary of a related-party fixed trust and the distributions received are greater in value than would be expected had the parties been dealing with each other at arm's length; or
  • acquires an entitlement without incurring an outgoing that the SMSF might have been expected to incur if the parties were dealing with each other at arm's length. [2]

NALE incurred is deemed to have a nexus to all income of the SMSF

LCR 2021/2 states that where NALE was not incurred to acquire a particular asset, then NALE is deemed to have been incurred for all income of the SMSF.

It gives the example of a trustee engaging an accounting firm to provide accounting services which includes managing the SMSF's income tax affairs and obligations. The accounting firm does not charge the SMSF for those services, not because of an arm's length discount offer or bargain, but as a result of non-arm's length dealings between the parties.

For the purposes of subsection 295-550(1) of the ITAA97, this is deemed NALE and the ATO's view is that this NALE has a sufficient nexus with all of the ordinary and statutory income derived by the SMSF for the 2020-21 income year.

As such, all of the SMSF's income for the 2020-21 income year is NALI.

At paragraph 19 of LCR 2021/2, the ATO includes a list of expenditure that may have a sufficient nexus to all income derived by a superannuation fund, including:

  • actuarial costs - except those incurred in complying with, or managing, the fund's income tax affairs and obligations;
  • accountancy fees - except those incurred in complying with, or managing, the fund's income tax affairs and obligations which are ordinarily deductible;
  • audit fees;
  • trustee fees and premiums under an indemnity insurance policy;
  • costs in connection with the calculation and payment of benefits to members;
  • investment adviser fees; and
  • other administrative costs incurred in managing the fund.

Example 2 in LCR 2021/2 goes on to state that:

  • "Subsection 295-550(1) would cease to apply if the arrangement changes for the 2021-22 income year so that the SMSF incurs expenditure for the accounting services provided by the accounting firm of an amount that would have been expected to be incurred where the parties were acting at arm's length. In this situation, none of the SMSF's income for the 2021-22 income year is NALI."

ATO's interpretation vs Parliamentary intent

It seems that parliamentary intent in the ITAA97 is that in order to determine whether there is a 'sufficient nexus' between NALE and all ordinary and/or statutory income derived by the fund, the NALE must be incurred 'in gaining or producing the relevant income'.

The fact that all income of the SMSF may become NALI for fairly benign occurrences, such as the one described at Example 2 of LCR 2021/2, is not something explicitly stated in the ITAA97. The ATO has reportedly stated that it will not allocate compliance resources to determine whether or not SMSF expenses are, in fact, arm's length expenses and that most SMSF trustees should simply make a reasonable attempt to ensure all expenses/income of the SMSF are not NALE/NALI.

A detailed set of examples can be found in the ATO's Law Companion Ruling 2021/2.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics, such as:

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[1] S 295-550(1)(c) of the ITAA97.

[2] S 295-550(5) of the ITAA97.

 

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