A recent amendment to legislation has resulted in some important changes to the operation of the non-arm’s length income (NALI) provisions, with these changes applying retrospectively – from 1 July 2018.
Prior to the recent amendments, the NALI provisions applied where a SMSF incurred income under a scheme where the parties were:
- not dealing with each other at arm’s length, and
- the amount of income is more than what might have been expected to have been derived if those parties were dealing at arm’s length.
Income that falls under these NALI provisions is taxed at the top marginal tax rate – 45%, not the concessional tax rate of 15%.
While the above rules have been retained, the provisions now apply where an SMSF incurs a loss, outgoing or expenditure (or does not incur a loss, outgoing or expenditure) when dealing on a non—arm’s length basis. This is NALE.
These new NALE provisions mean that income will be NALI, and taxed at 45%, where:
- there is a scheme in which the parties were not dealing with each other at arm’s length
- the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing the income, and
- the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm’s length in relation to the scheme
Further, the income is also NALI if the fund doesn’t incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties had been dealing on an arm’s length basis.
Acting in capacity as trustee:
The NALE provisions are not intended to apply to services provided by a trustee in their capacity as trustee. You will see in the examples below that it is the capacity in which these activities are performed that becomes critical in determining whether NALI provisions apply.
Example 1: Non-arm’s length expenditure incurred with a nexus to ALL income of the fund
Keith is a partner within the accounting firm, KPT Accountants. He has a SMSF, which he engages his firm to provide accounting services for his fund to complete the ongoing compliance requirements. No fee is charged in respect to the completion of this work.
As a result of the changes taking effect from 1 July 2018, NALI will apply to this arrangement as the scheme involves the SMSF acquiring the accounting services under a non-arm’s length arrangement. The NALE (being nil incurred for the services) has a sufficient nexus with all of the ordinary and statutory income derived by the fund for the income year.
In this example, ALL of the Fund’s income would be taxed at 45% due to the non-arm’s length dealings – not 15%. Because the resources of the firm are used in preparing the accounts, and the outgoing/expenditure was not on an arm’s length basis, NALE provisions apply.
In contrast NALE provisions do not apply in the following example, because the Trustee is acting in the capacity as trustee, and not utilising any resources of the Accounting firm she works for – therefore the Funds income will be taxed at the normal concessional rate of 15%.
Example 2: internal arrangement- trustee provides services to the fund
Leonie is a trustee and sole member of her SMSF. She is an employee of KPT Accountants, which provides accounting and tax services. Leonie undertakes the preparation of her fund’s financial statements and tax return for her SMSF, which she does in her own time, not using any resources of the accounting business. She does not charge the fund a fee for the preparation of this work and is performing these duties in her capacity as trustee.
The NALE provisions do not apply here as Leonie is not acting in any capacity where the arrangement requires the parties to be dealing with one another on an arm’s length basis.
Example 3: trustee carrying out duties in their individual capacity
Sharon is a trustee and sole member of her SMSF. She is a licensed real estate agent and runs a real estate business which includes property management services for rental properties. Her fund holds a residential property which it leases on commercial terms. Sharon provides property management services to the fund as a licensed agent, utilising the equipment and assets of the business to undertake these activities. Her actions are covered by her applicable insurance policies in respect of the business. Accordingly, Sharon provides property management services in her individual capacity to the SMSF with respect to her residential property. She is charging her fund 50% of the price she would normally charge to a non-related party.
For the purposes of the NALI provisions, the scheme involves the fund obtaining the services from Sharon and deriving the rental income. The price being charged constitutes a non-arm’s length dealing, which results in the expenditure being incurred being less than would otherwise be expected if they were dealing at arm’s length.
As such, there is sufficient nexus between the NALE and the rental income derived from the property resulting in the NALI provisions to apply for each income year the arrangement remains in place.
In this instance, the income derived from the property/s would be taxed at NALI rate of 45%.