In earlier editions of Superannuation Solutions we have described the effects of the non-arm’s length expense (NALE) rules which were introduced into the income tax law with effect from 1 July 2018. The rules as originally introduced suffered from a number of major problems. Federal Parliament has recently passed the changes proposed by the Federal Government in an attempt to remedy some of these issues. Trustees of SMSFs should understand how these rules operate and the potential compliance challenges that may arise.
Background
The NALE rules target expenses, losses, or outgoings that are not incurred by a super fund on arm’s length terms. If a fund incurs an expense that is less than what would have been incurred had the parties been dealing at arm’s length, the income of the fund related to this expense may be treated as non-arm’s length income (NALI). This income is taxed at the highest marginal tax rate, rather than the concessional rate typically applied to super funds.
The NALE provisions can potentially apply to any expenses incurred by super funds. In the provisions as originally enacted, the issue of “general expenses” was of particular concern.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 changes just passed
Under the new rules, which will be deemed to operate from 1 July 2018, 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 non-arm’s length income (NALI) provisions.
For funds with 6 or fewer members (including SMSFs), 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.
There are still problems
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 the updating its trust deed, the entire income of the fund in that year could be rendered NALI and taxed at 45%.
It would be wise for trustees 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.
There are also situations in which the “twice the difference” cap rules clash with the calculation of capital gains in the fund, and these will need further legislative changes to be fixed.
Please contact your Nexia Edwards Marshall NT advisor if you have any questions in relation to NALI or NALE and your super fund.
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