After seeking advice from an independent advice panel, the ATO has released its finalised Law Companion Ruling setting out the ATO view on the non-arm’s length expenditure (NALE) amendments to section 295-550 of the Income Tax Assessment Act 1997 (ITAA97), LCR 2021/2. In addition, the ATO has amended its contribution tax ruling TR 2010/1. The final LCR and amendments to TR 2010/1 partially soften the ATO views on the application of NALE.

But first, some background on the draft version of this ruling, LCR 2019/D3.

The draft ruling – LCR 2019/D3

In mid-2018, the definition of non-arm’s length income (NALI) under the ITAA97 was amended to include NALE. The NALE provisions are designed to apply where, in gaining or producing the income, if there is any NALE that is less than what might have been expected if the parties were dealing at arm’s length, that income is NALI. NALE includes not just an expenditure, but also a loss or outgoing that is lower than an arm’s length amount, and also includes where there is a nil amount (ie, no expenditure).

Following the NALE amendments, the ATO issued Draft Law Companion Ruling 2019/D3 (LCR 2019/D3) indicating how they intended to apply the NALE provisions. LCR 2019/D3 caused widespread concern in the industry, as it appeared from LCR 2019/D3 that the ATO were proposing to administer the law such that a wide range of activities would be caught by the NALE provisions.

Of particular concern was a statement in LCR 2019/D3 that suggested that ‘in some instances, the non-arm’s length expenditure will have a sufficient nexus to all of the ordinary and/or statutory income derived by the fund.’ To illustrate where this might occur, the ATO gave the example of Mikasa, a trustee of an SMSF, who engaged an accounting firm where she is a partner to provide accounting services for her SMSF, and the accounting firm did not charge the SMSF for those services.

In LCR 2019/D3, the ATO stated that in this scenario, the NALE (being the nil amount incurred for the accounting services) had a sufficient nexus to all of the ordinary and statutory income derived by the SMSF for that income year, and therefore all of the SMSF’s income for that income year was NALI.

While LCR 2019/D3 remained in draft, the ATO issued Practical Compliance Guideline PCG 2020/5 (PCG 2020/5) which confirmed the ATO’s transitional compliance approach to the NALI/NALE provisions. In PCG 2020/5 the ATO recognized that fund trustees may not have realised that the NALE amendments will apply to NALE of a general nature to all ordinary and/or statutory income derived by the fund in an income year. Accordingly, under PCG 2020/5, the ATO noted they would not allocate compliance resources to determine whether the NALI provisions apply to a fund for the 2018-19, 2019-20 and 2020-2021 income years where the fund incurred NALE of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, NALE on accounting services provided to an SMSF for free or for an under market value fee).

Finalised ruling - LCR 2021/2

ATO seeks review of its position on NALE of a general nature

While the transitional compliance approach set out in PCG 2020/5 gave SMSF trustees some comfort over the transitional period, there was still widespread concern among industry that the ATO approach on NALE of a general nature would make it to the finalised version of LCR 2019/D3. Submissions were made from a number of key industry bodies, setting out their concerns regarding LCR 2019/D3. In response to this, the ATO took the unusual step of seeking advice from an independent advice panel on their view as set out in LCR 2019/D3.

First the bad news, the ATO’s general expenses view has been maintained

Having received that advice, the ATO has now released the finalised ruling, LCR 2021/2. Unfortunately, the ATO view on general expenses NALE as set out in LCR 2019/D3 and the example of Mikasa remains in the finalised ruling as follows:

Example 2 – non‑arm’s length expenditure incurred has a nexus to all income of the fund – NALI

24. For the 2020–21 income year, Mikasa as trustee of her SMSF engages an accounting firm, where she is a partner, to provide accounting services for the SMSF. The accounting services include services other than those relating to complying with, or managing, the SMSF’s income tax affairs and obligations. The accounting firm does not charge the SMSF for those services as a result of non‑arm’s length dealings between the parties (and not as part of any discount policy referred to in paragraph 51 of this Ruling).

25. For the purposes of subsection 295‑550(1), the scheme involves the SMSF acquiring the accounting services under a non‑arm’s length arrangement. The non‑arm’s length expenditure (being the nil amount incurred for the services) has a sufficient nexus with all of the ordinary and statutory income derived by the SMSF for the 2020–21 income year. As such, all of the SMSF’s income for the 2020–21 income year is NALI.

26. Subsection 295‑550(1) would cease to apply if the arrangement changes for the 2021–22 income year so that the SMSF incurs expenditure for the accounting services provided by the accounting firm of an amount that would have been expected to be incurred where the parties were acting at arm’s length. In this situation, none of the SMSF’s income for the 2021–22 income year is NALI.

The only changes in this example from the same example contained in LCR 2019/D3 are:

The ATO clarifies that the accounting services include services other than those relating to complying with, or managing, the SMSF’s income tax affairs and obligations;
The accounting firm does not charge the SMSF for those services as a result of non-arm’s length dealings between the parties (and not as a result of any discount policy which is a discount arrangement consistent with normal commercial practices);
The NALE provisions would cease to apply if the arrangement changes for the 2021-22 year so that the SMSF incurs arm’s length expenditure for the accounting services. In that situation, none of the SMSF’s income for the 2021-2022 income year is NALI.

The finalised ruling also expands on what the ATO consider to be expenditure that may have a sufficient nexus to all income derived by the fund, including:

actuarial costs (except those incurred in complying with or managing the fund’s income tax affairs and obligations which are ordinary deductible under section 25-5);
accountancy fees (except those incurred in complying with, or managing the fund’s income tax affairs which are ordinarily deductible under section 25-5);
audit fees;
costs in connection with the calculation and payment of benefits to members (eg, interest on money borrowed to secure temporary finance for payment of benefits and medical costs in assessing invalidity benefit claims);
investment adviser fees; and
other administrative costs incurred in managing the fund.

Tension with section 17A of the SIS Act

The approach set out in LCR 2019/D3 created a tension between the NALE provisions and section 17A of the Superannuation Industry (Supervision) Act 1993 (SIS Act). Section 17A of the SIS Act provides that a trustee/director must not receive any remuneration for services performed by the trustee/director in relation to the SMSF (subject to limited exceptions set out in section 17B of the SIS Act). LCR 2019/D3 suggested that where a trustee/director performed work for a business conducted by the SMSF but didn’t charge for their work to avoid breaching section 17A, they would be caught by the NALE provisions.

This tension has been addressed in the finalised ruling, including at paragraph 42 and paragraph 43 as follows:

42 Given the statutory restrictions that prevent a trustee or director of a corporate trustee from receiving remuneration, paragraphs 295-550(1)(b) and (c) will not be enlivened due to the trustee or director not charging for the services performed in relation to the fund when acting in a trustee capacity. For example, the non-arm’s length expenditure provision will not apply where a trustee, acting in that capacity, performs bookkeeping or accounting services for the fund for no remuneration.

43 However, when the trustee or director of a corporate trustee operates in another capacity and either does not receive remuneration for those services or receives remuneration in accordance with the exceptions in section 17B of the SISA, paragraphs 295-550(1)(b) or (c) may apply where the fund incurs non-arm’s length expenditure.

The key therefore is that the individual must be carrying out those duties in their capacity as a trustee, rather than in any other capacity. This is illustrated by example 7 of LCR 2021/2:

Example 7 – SMSF trustee carrying out duties – trustee capacity

27. Levi is the trustee of his SMSF of which he is the sole member. He is also a financial advisor and director of Levi and Co Financial Services Pty Ltd. Levi operates the business of Levi and Co Financial Services Pty Ltd from a commercial office and on regular occasions from his home. At home, Levi uses the computer and office equipment supplied by and paid for by the business.

28. When at home, but not while working or billing clients, Levi undertakes the bookwork and occasionally makes online investments for his SMSF using the computer and office equipment supplied by the business.

29. Levi performs these activities as trustee of his SMSF and does not charge the SMSF for this work. Levi’s use of the computer and office equipment at home is minor and incidental in nature and will not, of itself, indicate that he is undertaking these services in any capacity other than as trustee for his SMSF.

Some good news - employer discounts not NALE

The ATO has confirmed that if an SMSF is eligible for an employer discount as a result of a member being employed with the employer, then NALE will not apply provided that discount is available to all employees, partners, shareholders or office holders.

This is shown in example 8 of LCR 2021/1 which provides that the discounted accounting services provided to Sasha, as a result of Sacha’s employment at the accounting firm, is not NALE as the staff discount rate is available to all staff of the firm.

More good news, ATO’s softened administrative approach to NALE of a general nature

The other main difference between LCR 2019/D3 and LCR 2021/2 is the inclusion of an Appendix setting out the ATO’s proposed practical compliance approach. Broadly, the practical compliance approach set out in the Appendix appears to soften the paragraphs of LCR 2021/2 on NALE of a general nature.

Paragraph 92 of the Appendix notes that from 1 July 2022, where the ATO applies any compliance resources to SMSFs for such general fund expenses, they will only be directed towards ascertaining whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the fund, other than services provided by an individual either acting in the capacity as trustee of the SMSF or as a director of a body corporate that is a trustee of the fund.

The ATO does not give any guidance as to what a “reasonable attempt” to determine an arm’s length expenditure is. It is expected that it will be similar to the ATO’s existing view in relation to providing arm’s length dealings. For example, supporting expenditure with benchmarking evidence.

It is hoped that the practical compliance approach set out in the Appendix will help to avoid the potential draconian application of the NALE provisions that were contemplated following the release of LCR 2019/D3.

Draft Taxation Ruling TR 2010/1

The ATO has also released draft proposed changes to Taxation Ruling 2010/1 Income Tax: Superannuation Contributions (Draft Changes). The current version of TR 2010/1 sets out the Commissioner’s view as to the ordinary meaning of the word ‘contribution’ in relation to superannuation funds and the ITAA97.

The current version of TR 2010/1 has been under review since the removal of the maximum earnings test for the purpose of deducting personal contributions, which commenced from 1 July 2017. The Draft Changes proposes to address these changes, as well as explaining the interaction between the NALI provisions and the rules concerning superannuation contributions.

In paragraph 25A of the Draft Changes, the ATO confirm that:

Where a superannuation provider (ie, a trustee) acquires an asset by purchasing that asset under a sale contract, that acquisition is not a contribution;
However, an in specie contribution may be made in conjunction with the purchase of an asset.
For example, 50% of the asset can be purchased and the remaining 50% of the asset can be treated as an in specie contribution.

The ATO also confirmed in the Draft Changes that they will not apply both the contribution and NALE rules in the same transaction. For example, in paragraph 25C the ATO give the example where a trustee purchases an asset under a contract for less than market value. In this scenario, the ATO consider that the trustee has incurred NALE under a non-arm’s length dealing, and the NALI provisions are triggered. The ATO will not treat the difference between the consideration paid (if any) and the market value as an in specie contribution, as the asset has been acquired under the terms of the contractual arrangement.

Overall, the Draft Changes highlight the importance of ensuring assets are acquired by an SMSF (either by way of in specie contribution or under the terms of a contractual arrangement) at market value to ensure that NALI does not arise.

This in turn links back to the view set out in paragraph 27-30 of LCR 2021/2. Importantly, paragraph 30 of LCR 2021/2 reiterates that ‘a consequence of the non‑arm’s length expenditure provisions applying to the purchase of either all, or a part, of the asset is that all of the income derived from that asset will be NALI, including any capital gains from the disposal of the asset.’

For further information please contact:

Phil Broderick
Principal
M +61 419 512 801 | T +61 3 9611 0163
E: pbroderick@sladen.com.au

Philippa Briglia
Senior Associate
T +61 3 9611 0173
E pbriglia@sladen.com.au