Opinion piece written by Peter Burgess, Deputy CEO / Director of Policy & Education, SMSF Association
New guidelines for self-managed superannuation funds from the Australian Taxation Office could have important implications for SMSFs that, under normal commercial arrangements, could be expected to incur expenses linked to a particular investment of the fund.
More broadly, the ATO’s new guidelines explain its compliance approach in terms of applying the non-arm’s-length income (NALI) provisions to non-arm’s-length expenditure. These guidelines are the finalised version of the draft guidelines released in October last year.
The NALI provisions require income received by an SMSF to be taxed by the fund at the highest marginal rate when that income is higher than would normally be expected if the parties had been dealing with each other at arm’s length.
So far, much of the attention has focused on the ATO’s transitional compliance approach and its decision not to allocate compliance resources to checking whether the recently-amended NALI provisions have been correctly applied in certain situations.
These situations related to general expenses or “fund-level” expenses, such as accounting fees, which have either not been incurred or have been incurred on non-arm’s-length terms by an SMSF. The new guidelines say the ATO will not allocate compliance resources to determine whether the NALI provisions have been applied when the fund incurs non-arm’s-length expenditure of a general nature that has a sufficient connection to all the income received by the fund.
The guidelines say the ATO will apply this transitional compliance approach to income derived by the fund during the 2018-19, 2019-20 and 2020-21 income years.
Importantly, the ATO’s transitional compliance approach does not apply to SMSFs which, under normal commercial arrangements, could be expected to incur expenses linked to a particular investment of the fund.
Trustees are expected to apply the new NALI provisions as they were intended to apply. That is, if an activity or service is performed for the SMSF by a third party, or by the trustees themselves in their individual capacity (as opposed to their capacity as a trustee), and the non-arm’s-length expense to which it relates can be linked to a particular investment of the fund, the income the fund receives from that investment will need to be taxed as NALI.
In other words, it will need to be taxed at the highest marginal rate.
For example, when an SMSF owns direct property and does not incur an expense on arm’s-length terms for the property management services provided by a third party, then the rental income and/or realised capital gains that the fund receives from that property for that income year will need to be taxed as NALI. This is the case for the 2018-19 income year and beyond.
There was certainly no indication in the guidelines that the ATO is looking to take a relaxed approach to the application of the new NALI rules to expenses that relate directly to a particular investment of the fund – only a transitional compliance approach to non-arm’s-length expenses that have no such direct relationship.
In fact, in the compendium to the guidelines, the ATO provides a gentle reminder that it expects the industry to be applying the new NALI rules from the 2018-19 income year and beyond where the fund incurs non-arm’s-length expenditure that directly relates to the fund deriving particular ordinary or statutory income in those income years.
This is the case where the activity or service, that would normally give rise to an arms-length expense being incurred by the fund, has been provided by a third party or by the trustees in their individual capacity.
In the compendium, in response to a request by the industry to extend the transitional compliance approach beyond just general expenses, the ATO stated its transitional compliance approach would not be extended beyond that outlined in the guidelines.
Further, that the final guidelines confirm that the transitional compliance approach will not apply when the fund incurred non-arm’s-length expenditure that directly related to the fund deriving particular ordinary or statutory income.
This brings me to the ATO ruling on this matter released in draft format in October 2019, and the many issues raised by industry about the application of the new NALI rules in situations where the non-arm’s-length expense may be immaterial or trivial.
This ruling is yet to be finalised and, given the extensive industry feedback received by the ATO after the release of this draft ruling, the SMSF Association has proposed a further round of consultations to ensure the outcome is balanced and practical.
In the compendium to the guidelines, in response to industry requests to adopt a de minimis or safe harbour rule to avoid nonsensical outcomes where the failure to charge a small or immaterial expense could result in NALI, the ATO stated it was considering a further practical compliance guideline as part of the finalisation of the draft ruling.
While we wait for the ATO ruling to be finalised, it’s important not to overlook the application of the new NALI rules in situations where an SMSF does not incur an arm’s-length expense for an activity performed by a third party, or by the trustees in their individual capacity, and which directly relates to a particular investment of the fund.
We also suggest a common-sense approach when determining whether those expenses are trivial and therefore should invoke the new NALI rules.