The bill containing the amendments to the non-arms’s-length income rules covering the treatment of certain expenses was not passed by parliament before the federal election was called. Nicholas Ali believes it will, however, be passed in the future and lays out the confusion surrounding the proposed treatment of certain SMSF expenses.
With the announcement of the federal election, the bill containing the changes to the non-arm’s-length income (NALI) provisions officially lapsed.
Does that mean the proposed amendments will never see the light of day?
While the original bill contained an item that meant it languished in the Senate (the Superannuation Guarantee Amnesty to employers), it did contain several important SMSF integrity measures designed to ensure the rules worked the way they were intended. So regardless of who wins the election, we are likely to see this measure reintroduced into the new parliament. The original start date for the NALI amendments was 1 July 2018, which may still be the case.
By way of background, in May 2018, the government introduced a bill to restructure section 295-550 of the Income Tax Assessment Act (ITAA) 1997 to capture as NALI situations where a superannuation fund incurs a loss or expenditure when deriving income that is less than what might have been expected had the parties been dealing with each other at arm’s length (among other changes to the NALI provisions).
Under current law, if a fund receives income on an investment that is higher than what one would expect from a dealing on arm’s-length terms, then all the income the fund receives from that investment would be considered NALI and taxed at the highest marginal tax rate. What the changes propose is even though the income might be on arm’s-length terms, if the fund has incurred expenses that are less than the amount expected from an arm’s-length dealing (including where the fund incurs no expense), the income received from the investment will also be treated as NALI and taxed at the top marginal rate.
If the trustee undertakes a service on a non-arm’s-length basis, whether the proposed NALI rules apply depends on the capacity in which the trustee undertakes that service or activity.
However, the explanatory memorandum (EM) to the bill states the NALI rules do not apply with respect to a superannuation entity’s arrangements that are purely internal. This is because an entity’s internal functions are not undertaken with another party on any terms, non-arm’s-length or otherwise.
Let’s have a look at an example to illustrate the point.
Sandy is a member and trustee of the Lucky Super Fund, an SMSF. She is a chartered accountant and runs a small accounting business. In her capacity as trustee of the Lucky Super Fund she prepares the accounts and annual return. She does not charge the fund for this work. The question then becomes, given Sandy is dealing with the fund where no arm’s-length expenditure is being charged, does such an arrangement give rise to NALI?
In short, the answer is no. The EM explains that: “Such internal arrangements are outside the scope of the non-arm’s-length income rules as they do not constitute a scheme between parties dealing with one another on an arm’s-length basis.”
Where a trustee undertakes activities in performing its duties, or outsourcing those functions to third parties, NALI may apply regarding expenditure however. Here the EM muddies the waters somewhat; it states trustees performing services at less than market rates may mean the NALI provisions are triggered. If the trustee undertakes a service on a non-arm’s-length basis, whether the proposed NALI rules apply depends on the capacity in which the trustee undertakes that service or activity.
Again, it is worthwhile using an example to illustrate this point.
Carol and Ken have a substantial investment portfolio in the Astina Super Fund, an SMSF. Carol is a practising financial planner and will manage the fund’s portfolio. She will not charge a fee for this service and will manage the portfolio in her own time, but will occasionally use the company’s computers and printers. Does this mean the management expense fee saving leads to dividend income and distributions (and future capital gain from the portfolio) being NALI?
In response to the confusion the ATO issued a draft guideline on how the proposed changes to the NALI rules would apply to superannuation funds, particularly SMSFs.
The answer to this question is not entirely clear. There is an example in the EM where an SMSF has a rental property and rather than outsource the management of the rental property to a real estate agent, the SMSF trustee attends to the service themselves. In this scenario, where a less-than-commercial fee is charged for managing the property, including no fee at all, it could be construed the NALI rules are intended to apply.
It appears that rather than simply distinguishing between internal and external arrangements to see if the new NALI rules apply, there is a greater focus in the EM on whether expenses can be distinctly associated with a source of income. With the bookkeeping services, they could also be outsourced, however, the expenses themselves cannot be specifically associated with a source of income; rather, they relate to the fund. The portfolio management costs (or lack thereof), on the other hand, can be specifically linked to the income of that portfolio.
Now keep in mind these proposed new NALI rules reside in the ITAA. Superannuation funds must also comply with the Superannuation Industry (Supervision) (SIS) Act and this is noted in the EM: “As a general rule, the trustee of an SMSF is prevented from charging for the services or functions that it undertakes in its capacity as trustee by paragraph 17A(1)(f) of the SIS Act.”
It is further noted in the EM that section 17B of the SIS Act “permits a trustee to charge up to an arm’s-length amount for duties or services performed other than in the capacity as trustee”.
While this is correct, it is not the whole story. For a trustee to charge for management of the fund’s investment portfolio it must comply with all of section 17B. That is:
- the trustee is appropriately qualified, and holds all necessary licences, to perform the duties or services, and
- the trustee performs the duties or services in the ordinary course of a business, carried on by the trustee, of performing similar duties or services for the public, 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 circumstances.
If the SMSF trustee cannot show they are appropriately qualified, hold the necessary qualifications and are carrying on a business of investment management, then they do not comply with section 17B. How many SMSF trustees will comply with all the requirements of 17B?
In response to the confusion the ATO issued a draft guideline on how the proposed changes to the NALI rules would apply to superannuation funds, particularly SMSFs. Draft Law Companion Ruling 2018/D10 was released for comment on 19 December 2018 and appeared to provide a much narrower application of NALI expense rules than was initially thought after the release of the bill and EM that contained the proposed amendments.
What the draft ruling appeared to be saying is if the trustee provided a service to their fund and was unable to charge because they were not licensed to provide that service, the non-charging of that fee won’t invoke the new NALI rules. It would appear this is due to the trustee providing the service in their capacity as trustee and consequently, per section 17A of the SIS Act, being prohibited from charging the SMSF for the service.
The draft ruling states: “The NALI provisions are not intended to apply to services provided by a trustee (or a director of a corporate trustee) of a complying superannuation fund in their capacity as trustee (or director of a corporate trustee).”
It goes on to say: “Where an entity performs services in their capacity as a trustee (or a director of a corporate trustee) of a complying superannuation fund and does not charge for those services, this is not a non-arm’s-length arrangement for the purposes of the NALI provisions. Services of this kind do not form part of a non-arm’s-length scheme between the parties as they relate to the trustee’s obligation in respect of the fund. For example, the NALI provision will not apply where a trustee performs bookkeeping or accounting services for the fund for no remuneration.”
Another example, in our view, would be where the SMSF owns a rental property and the trustee manages the property rather than outsources management to a real estate agent. The trustee collects the rent, arranges repairs (they may even do some of the repairs themselves) and attends to paying the rental property bills. Here the trustee is performing duties in their capacity as trustee – attending to maintaining the assets of the fund and maximising member retirement benefits.
But importantly, as the draft ruling further explains: “If, however, the trustee outsources its functions to third parties and the outsourcing arrangement is not on arm’s-length terms, the NALI provisions apply.”
So, would this occur in our scenario with Carol and Ken?
The draft ruling provides an example of an SMSF trustee, Sharon, who is also a licensed real estate agent and runs a real estate business that includes property management services. The SMSF holds a residential property, which is leased. Sharon provides property management services in her personal capacity to her SMSF, that is, not in her capacity as trustee. She only charges her SMSF 50 per cent of the normal fee she would charge her real estate property management clients.
The proposed new NALI rules would only apply where a service is provided to an SMSF by the trustee or a related party and the trustee or related party is:
- qualified and holds the necessary licence to provide the service, and
- provides the services as part of a business they conduct, and
a fee less than what would be considered commercial is charged to the SMSF.
- If the trustee provides a service to their SMSF and they are unable to charge their SMSF because they are not licensed to provide that service, it appears the non-charging of that fee won’t invoke the new NALI rules.
In the EM example, the conclusion reached was that the arrangement would be caught by the proposed changes to the NALI rules, resulting in the rental income from the rental property (and any future capital gains) being treated as NALI and taxed at 45 per cent.
However, we believe this example requires further clarification. The example refers to Sharon providing the service in her personal capacity. So could it not be argued she has provided this service in her capacity as a trustee and therefore is not permitted to charge her fund for this service under section 17B of the SIS Act? Perhaps the example could be amended to refer to Sharon providing the service using the resources of her real estate business. In our view this would make it clearer when the proposed NALI provisions would apply as the service has been outsourced to a third party on non-commercial terms.
The scenario with Carol and Ken could also be construed as a service being provided in a personal capacity (that is, as trustee) rather than a professional one, but it’s difficult to reach that conclusion reading the draft ruling and the EM. In Carol and Ken’s case, the conundrum regarding non-arm’s-length expenses persists.