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Financial Insights with Australian Unity (Non-arm’s length expenses and income – the new line in the sand)

After seeking independent, specialist advice from a panel of tax expects and three years of uncertainty in the industry, the ATO has finally issued its final ruling (LCR 2021/2) providing guidance on non-arm’s length income (NALI) and non-arm’s length expenditure (NALE).

Non-arm’s length expenses & income

After seeking independent, specialist advice from a panel of tax experts and three years of uncertainty in the industry, the ATO has finally issued its final ruling (LCR 2021/2) providing guidance on non-arm’s length income (NALI) and non-arm’s length expenditure (NALE).

To many people in the SMSF industry’s disappointment, the ATO largely maintained its previous stance, albeit with some softening on the treatment of NALE of a general nature.

Anyone who has an SMSF should seek to understand from their Financial Adviser, the NALE provision covered in LCR 2021/2 because once triggered, it can bring significant tax consequences to a SMSF.

What is NALE and what is NALI?

The taxable income of a complying superannuation fund 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 (currently 45%).

The non-arm’s length component for an income year is the amount of a fund’s NALI less any deductions to the extent that they are attributable to that income. NALI includes both ordinary and statutory income i.e. net capital gains, rental income from real property. NALI are excluded from the tax exemption that would normally apply to assets supporting retirement phase income stream.

The NALI provision has been with us for many years. Prior to the 2018/19 financial year an amount of ordinary or statutory income will be non-arm’s length income of a complying super fund where:

  • there is a scheme in which the parties were not dealing with each other at arm’s length, and
  • the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing the

In 2019, the following was added to section 295-550(1) of Income Tax Assessment Act 1997, effective and applicable retrospectively from 1 July 2018:

in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.”

The implication of the amendment is that an amount of ordinary or statutory income of a fund will be NALI where NALE applies.

NALE applies if:

  • there is a scheme in which the parties were not dealing with each other at arm’s length, and
  • 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

For example, if a SMSF sells a real property it owns to a related party of the fund i.e. a member of the fund below market value, the rental income and any capital gains derived on the disposal of the property will be NALI and subject tax at 45%. Similarly, if a SMSF is borrowing money from a related party under a related party LRBA and the interest rate charged is less than what a commercial lender would’ve charged. In that case, any income and capital gains derived from the single acquirable asset will be NALI.

The income is also NALI if the fund does not incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties have been dealing with each other at arm’s length.

Issues with ‘general expenses’

In identifying whether the SMSF has incurred NALI, there must be a sufficient nexus between the NALE and the relevant ordinary or statutory income. That is, the expenditure must have incurred ‘in’ gaining or producing the relevant income. The expenditure can be either of a revenue or capital nature and whether the fund is able to claim a tax deduction or not is of no bearing.

The ATO has indicated that in some instances the NALE will have a sufficient nexus to all the ordinary and/or statutory income derived by the fund. For example, a fund may incur expenditure that does not specifically relate to a particular amount being derived by the fund but still has a sufficient nexus more generally to all income derived by the fund such as actuarial costs, accountancy fees, audit fees, investment advice fees, trustee fees, administrative costs incurred in managing the fund etc.

When the ATO first came out with this stance in its draft Law Compliance LCR 2019/D3 it raised a lot of eyebrows in the industry and instigated a lot of uncertainties. The most common criticism is that the potential tax penalty in the form of NALI is disproportionate to the NALE when it relates to general expenses. For example, if the trustee of a SMSF, who also happens to be an accountant, provides free or discounted accounting services to his own SMSF, all ordinary and statutory income of the fund could become NALI.

The approach set out in draft LCR 2019/D3 also created a tension between the NALE provision and section 17A of the SIS Act which prohibits trustees from receiving any remuneration from the fund for any duties or services performed by the trustee in relation to the fund (unless under limited circumstances as stipulated in s17B of the SIS Act). LCR 2019/D3 suggested that where a trustee/director performed work for a business conducted by the SMSF but didn’t charge for their work to avoid breaching s17A, they would be caught by the NALI provisions.

This tension has been addressed in the finalised LCR 2021/2. ATO  has  clarified  that  the  NALE provision will not apply where a trustee, acting in that capacity, performs services i.e. bookkeeping or accounting services for the fund for no charge. For example, a financial adviser who is a trustee of a SMSF can utilise their skills and knowledge in deciding the investment strategy of the SMSF in their capacity as trustee. However, when the trustee operates in another capacity, either does not receive remuneration for those services or receives remuneration, NALI will apply.

Trustee versus individual capacity

A trustee of a SMSF will be required to perform particular actions in order to fulfil various duties and obligations imposed on them including:

  • any duties or obligations imposed under the trust deed of the SMSF,
  • any fiduciary conditions imposed under the law, and
  • any conditions imposed under the SIS Act and any other relevant

In LCR 2021/2, ATO has indicated that it is appropriate to presume that an individual is acting in their capacity as a trustee to fulfil the above-mentioned obligations, unless there are factors that suggest a contrary conclusion. When assessing whether an individual is acting in their capacity as an individual or as the trustee, it is necessary to carefully weigh up all the relevant facts and circumstances.

Factors that would indicate the individual is acting in a capacity other than the trustee of the SMSF include:

  • The individual charges the complying SMSF for performing the services. However, there can be circumstances where the individual can be acting in their individual capacity even though they do not charge the SMSF for performing the
  • The individual uses the equipment and other assets of their business, or equipment and other assets used in their profession or employment in a material manner. However, minor, infrequent, or irregular use of equipment or assets will not, of itself, indicate the individual is acting in their individual capacity. For example, in the absence of any other factor indicating otherwise, minor, infrequent or irregular use of a business computer at the office by an individual would not, of itself, indicate the individual is acting in their individual
  • The individual performs the activities pursuant to a licence and/or qualification relating to their business, or their profession or employment. That is, the activity can only be performed due to the individual or business holding the relevant licence and/or
  • The activity is covered by an insurance policy relating to their business, or their profession or employment (for example, indemnity insurance).

In the appendix of LCR 2012/2, the ATO noted that from 2 July 2022, where the ATO applies any compliance resources to SMSF for such general fund expenses, they will only be directed towards ascertaining 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 the capacity as trustee of the SMSF. However, the ATO does not provide any guidance as to what a ‘reasonable attempt” to determine an arm’s length expenditure is. Practically speaking this means keeping evidence or records to demonstrate arm’s length dealing will be crucial.

ATO’s transitional compliance approach

In recognition that many trustees may not have realised that the NALE amendments will apply to NALE of a general nature to all ordinary and/or statutory income derived by the in an income year, the ATO issued Practical Compliance Guideline PCG 2020/5 in 2020.

Under PCG 2020/5, the ATO noted they would not allocate compliance resources to determine whether the NALI provisions apply to a fund for the 2018/19, 2019/20 an 2020/21 income year. ATO further extended this period to the end of 2021/22. This means the ATO will not allocate compliance resources in the 2021-22 financial year to determine whether the NALI provisions apply to all the income of the fund where it incurs NALE of a general nature.

However, it is important to recognise the transitional compliance approach does not apply in other circumstances where the fund incurs non-arm’s length expenditure that directly relates to that particular income.

Summary

These changes have a significant impact on trustees where the fund has not been charged an arm’s length fee for services provided or charged a fee at all.

Advisers providing SMSF advice to clients should apply great care to ensure an arm’s length fee is charged for services provided by members or associates of SMSF trustees, where it is possible to do so.

Individuals across various industries and professions (e.g. lawyers, accountants, brokers, agents, builders, tradespeople) who may have skills and knowledge they can use in managing their SMSF’s investments should carefully consider when to charge their fund for such services. The risk of the fund’s income being treated as NALI will arise where an individual uses the assets, equipment, or registrations of the business that they operate or are employed with.

It is critical that all funds consider the changes, especially given that the non-charging of professional fees could potentially result in the application of the NALI rules to all of the income of the fund.

Trustees should review their existing arrangements and the parameters of the PCG to ensure compliance.

Regulatory update

This section aims to keep you up to date with the latest Government announcements, legislative changes and information relevant to the financial advice sector in general.

Government announced temporary and targeted relief on ASIC levies for financial advisers

The Morrison Government announced on 30 August 2021 a two-year temporary and targeted relief for financial advisers by reducing the ASIC levy. The relief will see ASIC levies charged on financial advisers restored to their 2018-19 level of $1,142 per adviser for the next two years (relating to 2020-21 and 2021-22). This represents a substantial reduction relative to the level estimated in ASIC’s 2020-21 Cost Recovery Implementation Statement of $3,138 per adviser.

TPD insurance report

ASIC has released Report 696 on total and permanent disability insurance focusing on how insurers are addressing the issues identified in ASIC’s Report 633 Holes in the safety net: A review of TPD insurance claims. Summary of key findings in the report:

  • Most insurers have completed self-assessments against REP 633, some committing further,
  • Insurers have started work on TPD definitions, particularly for insurance within superannuation,
  • Insurers have improved some claims handling practices, lowering many hurtles, and
  • Insurers found shortcomings in their data capabilities, particular in the use of d

Tax treatment of COVID-19 Disaster Payments

The Treasury Laws Amendment (COVID-19 Economic Response No. 2) Bill 2021 has received Royal Assent.

Payments received by eligible businesses under certain COVID-19 business support programs will be categorised as non-assessable non-exempt income ensuring payments are not subject to income tax. This applies to assessments for income years ending on or after 1 July 2021.

The same tax treatment will apply to COVID-19 disaster payments made to individuals and will apply to the 2020-21 income year and later years.

Recontribution of COVID-19 super released amounts

Updates on the recontribution process have been released by the ATO:

  • CRT Alert 008/2021 Re-contribution of COVID-19 early release amounts approved form requirements for funds, and
  • CRT Alert 009/2021 Administrative arrangements for COVID-19 re-contribution amounts

Members who accessed their super under the COVID-19 early condition of release can re-contribute that amount back to superannuation without it counting towards their non-concessional cap.

Members must complete the approved form and provide it to the fund before, or at the time, of making the contribution. Approved forms are currently being finalised by the ATO.

The ATO has also confirmed the following information:

  • COVID-19 re-contribution amounts are not a new type of contribution, rather a personal contribution that receives a treatment to exclude it from an individual’s non-concessional contribution
  • The ATO will be applying the treatment to exclude eligible COVID-19 re-contributions from the non-concessional contribution cap
  • Individuals can make COVID-19 re-contribution amounts to any fund of their choice where the fund rules

Each COVID-19 re-contribution amount must be detailed on a separate approved form and must not exceed $20,000 per approved form.

Your Future, Your Super

Three regulations were registered in final form on 5 August 2021:

Addressing underperformance, this regulation details when APRA must conduct the annual performance test, the form and content requirements for the notice a trustee is required to give to beneficiaries who hold a product that has failed the performance test, circumstances where APRA may list a prohibition on a trustee from accepting new beneficiaries into an underperforming product etc.

Improving accountability and member outcomes, this regulation details the information that must be provided with a notice for an annual member meeting, and the removal of an exception to the revised prohibition influencing employers.

Regarding stapled funds, this regulation sets out the requirements that a stapled fund must meet and procedural matters relating to request to and responses from the ATO about stapled funds.

Impact of compensation payments on contribution caps

In a recent fact sheet, the ATO addressed how compensation received by a client’s superannuation fund impacts contribution caps. Whether compensation is a contribution and therefore counted towards contribution caps will depend on the circumstances in which the compensation is received, including:

  • where the super fund engaged the financial service provider and has a right to compensation – compensation allocated to the client’s super account will not be a contribution. Therefore, it will not affect contribution
  • where the member personally engaged the financial services provider and has a right to compensation – the compensation will be a concessional contribution in the financial year it is received by the
  • where there is no right to compensation – the amount will be a concessional contribution in the financial year it is received by the

If compensation from financial institutions is being paid directly to individuals, please refer here. This includes compensation for loss on an investment and refund or reimbursement of adviser fees.

 

Important information

This is a publication of Australian Unity Personal Financial Services Limited ABN 26 098 725 145 (AUPFS), AFSL 234459. Its contents are current to the date of publication only, and whilst all care has been taken in its preparation, AUPFS accepts no liability for errors or omissions. This report is general in nature and does not take into account the objectives or circumstances of any particular individual or entity. It cannot be relied upon as a substitute for personal financial, taxation or legal advice. 

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