ATO finalises ruling on non-arms's length tax rules for Super Funds
The ATO has released a key ruling, LCR 2021/2, which confirms the application of non-arm’s length income provisions where expenditure is incurred under a non-arm’s length arrangement. This ruling, which takes effect retrospectively from 1 July 2018, applies to all super funds, including self-managed super funds (SMSFs).
The ruling separates non-arm’s length expenses (“NALE”) in to two categories as follows:
1) Asset specific expenses – where there is a sufficient nexus between the expense and an asset. These could include acquisition costs or ongoing annual costs associated with an asset. The consequence of asset specific NALE is that all income and capital gains from the specific asset would be taxed at the top marginal rate.
2) General Expense – where the expense is not connected to an asset e.g. Accounting Fees. The consequences for general NALE are far more severe as the entire income including capital gains of the SMSF would be taxed at the top marginal rate.
NALE would exist in a SMSF where expenses incurred are lower than what would have been incurred if the parties had been dealing with each other on an arm’s length basis, including services provided free of charge.
Trustees of SMSF’s who provide services to their own SMSF free of charge could potentially be caught out by these new provisions if they are not careful. It is important to note that the determining factor here is the capacity in which the trustee is undertaking the work in relation to their SMSF as either trustee capacity or individual capacity.
Factors which determine whether a trustee is considered to have provided a service to their SMSF in their individual capacity is if the person is required to hold a licence or qualification in order to provide that service or the service that is being provided is covered by an insurance policy. It will be important in those situations for the trustee to charge a fee for the service provided, otherwise the SMSF will be deemed to have incurred NALE.
As an example, a licenced electrician who undertakes electrical work on a property owned by their SMSF and charges a commercial rate for the work would not be caught by the NALE provisions.
However, a licensed real estate agent who uses all their business services and equipment to manage a property owned by their SMSF and charges the SMSF only 50% of the price would be caught by NALE and as a result all income associated with the property would be taxed at the top marginal rate.
One area often overlooked under the NALE provisions is where a company or trust in which a SMSF has invested in engages a non-arm’s length party to provide services to the entity. As with services provided to the SMSF itself, it is important to ensure that arm’s length rates are charged to the entity for those services, otherwise this may result in the income generated by that entity being subject to non-arm’s length tax rates.
The ATO’s Practical Compliance Guide says that the ATO will not consider the impact of the new non-arm’s length rules for general expenses for all financial years between 1 July 2018 and 30 June 2022. However, it will consider this issue for specific expenses or outgoings from 1 July 2018.
Due to the severe tax penalties that could arise as a result of this ruling, care must be taken by SMSF trustees to ensure that all expenses and outgoings incurred by their SMSF, whether on a revenue or capital basis, have occurred on arm’s length terms.
If you are interested in knowing more about how these proposed superannuation measures will impact you or your superannuation fund, please reach out to your adviser.