The government has recently passed legislation that gives clarity around the effect of SMSF non-arm’s length expenditure (NALE). Where a fund incurs less (or nil) expenditure by participating in a scheme where the parties do not deal with each other at arm’s length, it will result in:
- The income is taxed at the top marginal rate.
- Any eventual capital gain on disposal of the asset being treated as non-arm’s length income (NALE).
This new addition to the NALE rules means that where the fund incurs a loss, outgoing or expenditure that 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, the NALE provisions will apply.
The legislation applies to all fund activities and assets that are not undertaken on commercial terms from the 2019 financial year onwards, regardless of whether the scheme was entered into before 1 July 2018.
What are the Audit implications of NALE?
NALE is a tax issue more than a compliance issue. There can be significant tax implications for SMSFs that result in fund income being taxed at the highest marginal rate and applies regardless of whether the fund is in pension mode.
In the event of non-arm’s length expenditure, the Auditor is likely to issue a Management Letter notifying trustees that the tax calculation has been misstated. If this misstatement is material, Part A of the audit report will be Qualified, and this will need to be reported on the fund’s income tax return.
Professional Auditor judgement and the sentiment of NALE rules
The principal behind the NALE rules is that all fund activities must be undertaken on commercial terms and all assets purchased at market value.
Each situation is assessed on its own merit as to whether NALE applies to the income of a particular asset, or to all of the income of the fund. The professional opinion of the Auditor is therefore paramount to avoid falling foul of NALE rules.
It can be challenging to determine the exact price of an arm’s length price, as this may fall within a range of commercial prices. Similarly, parties may enter into commercial arm’s length arrangements that result in discounted prices or favourable terms, making a “market price” difficult to establish.
A closer look at NALE rules:
Market value substitution rules
Where the scheme involves the acquisition of an asset at less than market value, the cost base of the asset will be modified by the market value substitution rule in s112-20 SIS.
As a result, the amount of any capital gain will be affected, as the cost base must be treated by the SMSF as having acquired the asset at market value. It is irrelevant whether the asset was purchased directly or is accounted for through an in-specie contribution.
The ATO has provided examples of how the new legislation applies with the following situations: (Source: LCR 2019/D3)
Asset purchased less than market value
A property is purchased for $200,000 while the market value is $800,000. This provides sufficient connection between the NALE incurred in acquiring the property such that all rental income is NALI and any capital gain from the disposal of the property is also NALI.
Trustee uses their professional services firm (non-asset related)
The partner of an accounting firm who is the trustee of their SMSF uses the firm to provide accounting services to the fund, but no fee is charged. In this case, the trustee is not acting as a trustee but has provided services that are undertaken by a third party.
The SMSF has acquired the services under a non-arm’s length agreement, providing a connection between the NALE and fund income that classifies all of the SMSF’s income for the financial year as NALI.
Trustee uses their professional services firm (asset related)
The trustee of a fund is a licensed real estate agent and provides property management services to the SMSF as a licensed real estate agent. The fund is charged 50 per cent of the fee than would be otherwise charged to a non-related party.
There is sufficient nexus between the NALE and rental income derived from the residential property such that all rental income will be NALI as long as the non-arm’s length deal remains in place.
Related-party LRBA financed on non-arm’s length terms
A related-party LRBA involved a 25-year term and a 1.5 per cent interest rate. The terms of the LRBA constitute a non-arm’s length dealing between the fund and the lender. All rental income derived from the property is NALI, and any capital gain that might arise from a subsequent CGT event happening is also NALI.
Acquisition of fixed entitlement in unit trust
The trustee of a fund entered into a non-commercial related-party LRBA to acquire units in a listed unit trust. There was no interest being charged to the loan and repayments were not required until the end of the 25-year term. The units provide the fund with a fixed entitlement to the income of the unit trust.
The terms of the LRBA constitute a non-arm’s length dealing between the trustee as the lender and the fund, which results in the fund incurring NALE that would otherwise be expected if they were dealing on commercial terms. All distributions from the units in the unit trust and any future distributions is NALI.
Nailing the NALE
Considering the ATO’s increased data-matching capabilities, it is vital that Accountants and SMSF trustees are very careful about NALE activity and very clear in any justification for NALE transactions. As always, we advise professional advice from an independent auditor.
The Saul SMSF Team
1300 551 261
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