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NALI - Non arm's length income new rules and implications
The new NALI provisions have been passed by Parliament and received Assent on 2 October 2019. The new rules are complex and many SMSFs may have to reorganise due to the introduction of the non-arm’s length expenses (NALE) segment. This article provides information on the new rules, implications, interpretation issues and strategies going forward.
NALI of a superannuation entity now comprises the original NALI i.e. inflated income derived directly as a result of a non-arm’s length scheme and the new NALE segment. NALI includes both ordinary and statutory income of the scheme.
What is NALE?
Under the new rules, NALI is broadened to include income amounts derived by a superannuation entity under a scheme that involves the fund incurring expenditures, outgoings or losses that are less than the amount it might have been expected to incur under normal arms-length dealings to produce that income. Nil expenses or not charging the fund is also NALE. Similar provisions are in place for fixed trust entitlements of the entity.
The NALI component is taxed at the highest rate of tax. If the NALI component includes exempt current pension income (ECPI), the ECPI would lose its tax exemption status.
As an example, a SMSF trustee using the resources of their separate business entity to provide services to the fund as an outsourced third party without charge is NALE and the applicable income of the fund is NALI. A related party that charges a below market rate of interest to the fund under a limited recourse borrowing arrangement (LRBA) on a non-arm’s length basis is also NALE.
In the amendment legislation, the commencement date is 1 July 2018. The ATO has proposed a transitional period of two years for general expenses NALI (draft PCG 2019/D6). If it is finalised, general expenses NALI will have a commencement date of 1 July 2020. The new rules will apply retrospectively to all other NALI from 1 July 2018.
At this juncture, it is important that the SMSF trust deed should be reviewed to examine its position under NALI, to broaden its provision to accommodate NALE and to re-structure if potential NALI is involved.
The new NALI has significant repercussions for SMSFs. This is not only because NALI dealings are more rampant in SMSFs (for example, a related party lender charges a lesser rate of interest to the fund), but mums and dads who are trustees may have at various times provided services to their SMSFs using the skills of their trades and professions at no charge. If there is no evidence that the services are part of the trustee functions, NALI is intended to apply.
Since passing of the amendment legislation, the ATO has issued for consultation draft LCR 2019/D3 and draft PCG 2019/D6 to clarify the application of the new rules. The time frame for comment on these draft instruments has expired.
Several aspects of the draft LCR are under intense lobbying from the industry. These include questions as to the nexus between general expenses NALE (e.g. accounting expenses) to all the income of the fund; the tests for “gaining or producing” income under NALI and the criteria for determining separate capacities.
In particular, there is a controversy in relation to the application of general expenses NALE. The legislation requires the attribution of NALE to an “amount” of ordinary or statutory income that is NALI under the nexus test. On the other hand, specific expenses NALE refers to NALE that can be attributed to specific income amounts of the fund. For example, NALE property management services can be attributed to income and capital gains from the properties.
The general expenses NALE situation is more complex. Due to the general nature of these expenses (e.g. bookkeeping services or accounting services), the ATO is of the preliminary view that general expenses NALE have sufficient nexus to all the ordinary and statutory income of the fund, rendering all income of the fund to be NALI for the income year. The consequence is harsh should the fund inadvertently breach the general expenses NALE. The ATO is allowing two years for funds to reorganise.
It is therefore very important that SMSFs ensure they won’t be caught under the new provisions.
For NALI to be applicable, all of the following conditions have to be met.
• Existence of a scheme as defined under Section 995-1(1) of the Tax Act
Basically “any arrangement” whether formal or informal constitutes a scheme in relation to this Section.
• Dealings between at least two parties
The SMSF trustee acting in more than one capacity will meet the two parties situation and can become part of a scheme.
• The non-arm’s length requirement
The dealing is on a non-arm’s length basis if it results in inflated income and or any non-arm’s length expenditure (or nil expenditure) incurred would be less than what the fund might have been expected to incur under normal arm’s length circumstances.
• The nexus test
If NALE is involved, the expenditure (or nil expenditure) must be incurred in gaining or producing the relevant income. The expenditure may be of a revenue or capital nature.
In the EM, indications that the nexus exists include instances where revenue expenditure is deductible under the Tax Act or capital expenditure is included in the fund’s cost base for capital gain or loss assessment. The ATO in draft LCR 2019/D3 considers that NALE can be both deductible and non-deductible.
Where the nexus exists, the legislation requires identification or attribution of the NALE to a specific amount of ordinary or statutory income that is NALI.
The strategy options for NALE
The important points are:
- If the SMSF trustee provides services to the fund internally as part of the trustee’s normal duties for no charge, this will not give rise to NALI.
- If the trustee is acting in the capacity of an outsourced party providing services to the SMSF, this will have NALI implications only if NALE is involved. If the transactions or dealings are undertaken on arm’s length terms and basis, NALI will not apply.
The distinction in relation to capacities and the prerequisites to be met for each scenario is important. SMSF trustees should consider these options carefully. Any decision will have to be supported by trust deed provisions, strong documentation and protocols to be adhered to vigilantly.
Individual acting in trustee capacity
A trustee discharging its trustee duties or functions internally will not have NALI implications. The functions are not undertaken with another party and no scheme is constituted.
Therefore, subject to proper structuring, documentation and implementation, the trustee will be able to discharge its trustee functions for example in the management of the fund’s real estate portfolio or investment portfolio or in preparing the accounts and bookkeeping of the fund without attracting NALI.
In this regard, it is important that no fee is charged by the trustee for any of the duties performed. Section 17A(1)(f) of the SIS Act provides that no trustee of the fund may receive any remuneration from the fund or from any other person for any duties or services performed by the trustee in relation to the fund.
In addition, the trustee must not use any of the resources from their business practice to discharge or perform any of the trustee duties. To do so would raise the question as to the capacities with potential NALI implication. For example, a trustee using their tax agent portal to lodge the fund’s returns may contravene this aspect if the ATO adheres to its strict approach.
Trustee individual acting in contractor capacity
In some circumstances, it may be advantageous to outsource where the fund will get the benefits of specialised services, business platforms, team support and deductions for the fund.
If the trustee is providing services to the fund in a separate capacity i.e. as a contractor, it should be structured accordingly. There will be no NALI if separate capacity can be established and all the transactions are conducted on an arm’s length basis, supported by appropriate documentation and practices. Any undercharge or no charge or non-arm’s length terms will result in NALI.
An important factor for the contractor scenario is the existence of engagement documentation specifying the terms and conditions of the arm’s length remuneration and services, in addition to fund documentation.
Section 17B of the SIS Act specifically permits a trustee performing duties or services other than as trustee to receive remuneration subject to:
- the trustee being appropriately qualified and holding all necessary licences to perform the duties or services, and
- the trustee performing the duties or services in the ordinary course of a business, and
- the remuneration is no more favourable to the trustee than that which it is reasonable to expect would apply if the trustee were dealing with the relevant other party at arm’s length in the same circumstance.
The ATO considers that the determination of capacities is fact-dependent involving the terms of the trust deed and the manner in which the activities are performed. The above Section 17B conditions are important indicators of the contractor and separate capacity arrangement. An additional factor to consider is insurance.
Where “the activity is covered by an insurance policy of the business or profession e.g. indemnity insurance” this denotes that the activity is undertaken by the business (not trustee) and would be taken into consideration. However, exclusion of the activity from the insurance policy does not necessarily mean that the trustee individual is not acting separately as a contractor. All the facts and circumstances have to be considered.
Whether to take the trustee path or the contractor path depends on the objectives and circumstances of each SMSF.
Other NALI situations include for example such things as inflated income due to non-arm’s length rent and other lease arrangements, in specie contributions at less than market value and NAL capital expenditures and would need to be addressed and re-structured.