In the 2023 Budget the Federal Government announced how it intended to solve the problem of non-arm’s length general expenses in super funds. An exposure draft of relevant legislation has been released for comment, and it seems likely that it will be enacted. But the proposed solution leaves many issues unresolved and imposes additional responsibilities on fund trustees to avoid ATO action.
For many years the income tax law has contained a provision which taxes at a penalty rate of 45% any income of a super fund which is artificially inflated above an arm’s length amount (non-arm’s length income, or NALI). This is intended to prevent income from being diverted into the tax-advantaged super environment. Readers may be aware that the law was amended with effect from 1 July 2018 so that where a super fund incurs an expense (of either a capital or revenue nature) less than an arm’s length amount (non-arm’s length expenses or NALE), any income connected with that expense is also treated as non-arm’s length income and taxed at the penalty rate.
The Problem of General Expenses
The NALE provisions can potentially apply to any expenses incurred by super funds. The issue of “general expenses” is of particular concern. A number of super fund expenses such as accounting, audit and actuarial fees potentially relate to all income derived by a fund. In a situation where, for example, the fund is provided with free accounting services by a firm related to a member, the non-arm’s length nature of this relatively minor expenditure could result in the entire income of the fund being treated as non-arm’s length income (NALI).
The NALE debate
There continues to be a long-running debate between the Federal Government and professional bodies about the problems associated with the 2018 NALE provisions and whether there is a need for them at all. In February this year seven tax and accounting bodies including CA ANZ, the Tax Institute and the SMSF Association released a Joint Submission to Treasury on NALE Rules for Superannuation, arguing that the NALE amendments created more problems than they solved, and that the potential tax avoidance issues could be dealt with by existing provisions of the law.
The Federal Government seems to be intent on implementing the NALE provisions in some form or another, but intends to limit the potential amount of fund income that could be NALI because of a general NALE expense.
The proposed amendments
The amendment offered in the exposure draft, in line with the earlier Budget announcement, proposes that the NALE rules will only apply to funds with 6 or fewer members (that is, SMSFs and small APRA funds). Large APRA funds (mainly retail funds, industry funds and tax-exempt public sector funds) will be completely exempted from the NALE rules for both general and specific expenses, but will still be subject to the original NALI provisions. For funds with 6 or fewer members, a distinction will be made between expenses that do not relate to any particular asset or assets of the fund (general expenses) and expenses that relate to a particular asset. Where a NALE general expense has been incurred, the maximum amount of fund income that can be treated as NALI will be twice the difference between the amount that would have been incurred as an arm’s length expense and the amount that was actually incurred by the fund, but this will be capped at a maximum of the fund’s taxable income not including assessable contributions.
The proposed “twice the difference” cap will only apply to general expenses, and not to NALE expenses incurred in relation to specific assets. Where, for example, a property is acquired by a fund for less than its market value, all the rental income and any capital gain on ultimate disposal will be regarded as NALI. An even more severe example would be that of a tradie member of a super fund who gives his labour for free to make repairs to a property owned by the fund. As the fund was not charged an arm’s-length fee for the member’s labour, this is an example of a NALE expense which relates to a specific asset. All income arising from the property concerned, and any ultimate capital gain, will be regarded as NALI and subject to tax at penalty rates without the restriction of the “twice the difference cap”, even if the member’s work on the property was relatively minor.
It should also be noted that where the income from a long-term asset has been tainted as NALI, there is currently no provision to allow this to be rectified. In the example above of a property, there is nothing the fund can do to reverse the problem of a non-arm’s length expense.
A further problem is that the proposed “twice the difference” cap will only apply to general expenses of a revenue nature, and not to general expenses of a capital nature. One example of a general expense which might be of a capital nature is the cost of updating the fund’s trust deed. It is possible that if a fund does not pay an arm’s length fee for updating its trust deed, the entire income of the fund in that year could be rendered NALI and taxed at 45%.
The decision to exempt large funds from the NALE rules means that the rules are clearly focused on SMSFs. This seems hard to justify, and the joint accounting bodies have argued that this will create a two-tiered superannuation sector with a tax differential between the tiers.
The operation of the NALI and NALE provisions also raises the issue of the need to document that expenses incurred by the fund were arm’s length. There are two external parties who might call for such documentation: the fund’s auditor and the ATO.
The auditor of a super fund is required to report on two aspects of the fund’s operation each year. The first (Part A) is a financial audit of the fund, with an expression of opinion as to whether the financial report presents fairly the financial position of the fund at year end and the results of its operations for the year. The second (Part B) is a compliance audit, with an expression of opinion as to whether the fund complied with the SIS regulations. The question of whether some part of a fund’s income is NALI, and therefore subject to a higher rate of tax, is not a breach of SIS compliance. Instead, it is a matter of whether the provision for income tax in the fund’s financial statements is materially correct. The fund’s auditor is not required to (but may choose to) report to the ATO that a fund has not recognised the effect of NALI in its tax provision. Further, the auditor will probably assess whether it is reasonable to investigate NALI issues on the basis of materiality. The auditor may choose to take no action where there is only a low risk that the trustees have not detected or not disclosed a significant NALI issue.
Even so, it would be wise to obtain and keep documentation supporting the arm’s length nature of fund expenses in case the ATO wishes to review the fund’s operations.
In terms of application, these latest amendments are intended to operate in relation to NALE general expenses in the 2023-24 and later tax years. In relation to the 2018-19 to 2022-23 years, funds will need to rely on the ATO’s earlier statements that it will not devote compliance resources to investigating NALE general expenses.
Please contact your Nexia Edwards Marshall advisor if you have any questions in relation to NALI or NALE and your super fund.