SMSFs and related party borrowings: ATO clarifies scope of non-arm’s length income rules
Non-arm’s length income rules for SMSFs is a hot topic, particularly limited recourse borrowing from related parties.
We have seen the Australian Tax Office issue interpretative decisions, consult with industry and issue Practical Compliance Guidelines (‘safe harbour’) – together with the rush on the part of funds and their advisors to bring Limited Recourse Borrowing Arrangements into line with the safe harbour guidelines. There have also been attempts to amend the relevant legislation to provide clarity, the most recent of which lapsed when the 2019 Federal Election was called.
Those clarifying laws have now become law, and they expand the definition of ‘non-arm’s length income’ so that funds which incur non-arm’s length expenses - as a means of circumventing the contribution caps and augmenting income – are more clearly caught by the rules.
"Non-arm’s length income rules for Self Managed Super Funds (SMSF) has been a hot topic in recent years, particularly in the context of limited recourse borrowing from related parties."
Jack Coventry, Lawyer
The current rules relating to NALI
Australian taxation law splits the taxable income of complying super funds into two components: a low tax component, and a non-arm’s length income (NALI) component. A concessional rate (15%) applies to the low tax component, while the NALI component is taxed at the highest marginal rate.
Under the current rules, an amount of ordinary income or statutory income is NALI of a super fund if:
- There is a scheme: it is derived from a scheme, the parties to which were not dealing with each other at arm's length.
The first component of the definition – that the income be derived from a scheme – is particularly broad and will capture a range of transactions and formal and or informal arrangements.
- The fund derives more income: the amount of income is more than the amount that the fund might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme.
To date, this limb has been ambiguous in that it fails to clearly identify that expenditure incurred on non-arm’s length terms could also result in NALI income – even where the resulting gross income generated is the same as might be expected had the dealing been at arm’s length.
The new amending act extends the second component of the NALI definition to capture non-arm’s length losses, outgoings and expenses. The idea is to ensure that super funds can’t increase their income by accessing or incurring non-arm’s length expenditure.
NALI losses, outgoings and expenditure – clarification under the new Act
The Act extends the second component of the above definition to situations in which a super fund earns income and, in gaining or producing that income, the fund:
- incurs a loss, outgoing or expenditure that is less than it might be expected to have incurred in an arm’s length dealing
- does not incur a loss, outgoing or expenditure that it might have been expected to incur in an arm’s length dealing.
The circumstances where these provisions provide clarity include purchasing an asset using a non-arm’s length loan, or generating rent while incurring non-arm’s length expenses, such as management fees, repairs and capital works.
Notably, expenses may be of a revenue or capital nature in the same way that NALI may be statutory or ordinary income.
Consequences of breaching the NALI rules
The result of an LRBA being a non-arm's length dealing is that the income will be subject to tax at the highest marginal tax rate, as opposed to the concessional superannuation rate. This penalty rate applies even if a fund is in pension mode and would otherwise pay no tax on pension earnings.
For example, a fund that acquires a commercial property under a LRBA that includes no interest, no repayments until the end of the term and borrowing the full purchase price, will be subject to the amended NALI rules. This is because under the LRBA the fund incurs less expenditure than it might be expected to incur if the borrowing was on a commercial, arm’s length basis. In those circumstances, the income generated from the scheme will be within the fund’s NALI component and so will any eventual capital gain on disposal of the property.
What is the ATO’s position?
The ATO’s current position is set out in the interpretative decision ATO ID 2016/16.
This decision states that, to determine the amount of NALI income a fund has derived from a scheme, a determination must first be made of the terms on which the borrowing arrangement may have been entered into if the same parties had been dealing with each other on an arm’s length basis. Once this hypothetical borrowing arrangement is identified, consideration is given to whether or not it is objectively reasonable to expect that the fund could have, and would have, entered into the hypothetical arrangement.
The ATO considers there are then two possible consequences:
- if the fund cannot establish that it could have, and would have, entered the arrangement then the ATO’s view is that all of the earning derived by the fund from the asset are to be taxed as NALI at the highest marginal rate
- if the fund can objectively establish with evidence that it could and would have entered into the hypothetical arrangement, a comparison is made between the fund’s actual income and the income derived under the hypothetical arrangement: with the difference comprising the NALI component.
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