The ATO has clarified how a contribution can trigger non-arm’s-length income (NALI) in its latest draft taxation ruling (TR) on contributions, TR 2010/1DC2, and the draft law companion ruling (LCR) on NALI, LCR 2021/2DC.
Where non-arm’s-length expenditure (NALE) is involved, these documents work hand in hand to explain how, depending on the circumstances, a part in-specie contribution is not a contribution and can trigger NALI.
What is NALE?
Where an SMSF is involved in a scheme where the parties are not dealing with each other at arm’s length and the amount of the loss, outgoing or expenditure, is less than the amount 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, it will trigger the NALI provisions.
The term ‘scheme’ is very loosely defined and casts an extensive net.
While a scheme traditionally has sinister overtones, it can mean any arrangement, agreement, understanding, promise or undertaking regardless of whether it is express or implied and whether or not it is enforceable. It can also include a plan, proposal, action and course of action or conduct.
NALE can relate to either a specific expense concerning a particular asset, or assets, or be of a general nature.
The penalties
Where the SMSF more than benefits, the NALI provisions tax the fund at the highest marginal tax rate, which applies to:
- ordinary or statutory income derived from schemes,
- dividends or amounts attributable to dividends, and
- entitlements to trust income (both fixed and non-fixed entitlements).
Where the ATO deems the income to come from a specific NALE, all income generated from that asset will be classified as NALI and taxed at the top marginal tax rate of 45 per cent, even if the member is in the pension phase.
Where the income is deemed to come from general NALE, it is also classified as NALI but calculated in line with the ‘twice the difference’ approach.
The maximum amount of NALI payable is restricted to twice the shortfall between the actual expense incurred and the expected market rate of the expense capped at the fund’s taxable income.
Where NALI is less than the fund’s taxable income, the non-arm’s-length component is taxed at the top marginal tax rate and the remainder is the low-tax component taxed at 15 per cent.
The materiality level SMSF auditors set will affect whether or not NALE is an issue. To this end, general NALE may not be identified during the audit.
The contribution NALI issue
Firstly, TR 2010/1DC2 sets out how a person’s purpose is determined, how a fund’s capital is increased and when a contribution is made.
The draft ruling states a person’s purpose will not benefit a member if “they are simply fulfilling the terms of a contract or arrangement entered into on a commercial or arm’s-length basis”.
It is the first clue as to why an SMSF may not accept a contribution even though “paying an amount to a third party for the benefit of the superannuation provider” can increase the capital of the fund.
The ATO has determined when an SMSF enters into a sale contract explicitly stating the fund is acquiring the asset, any difference between the consideration paid by the fund and the market value of the asset cannot be considered an in-specie contribution by the other party.
While both rulings state a member can make a part in-specie contribution to purchase an asset, it will not count as a contribution where a contract specifies the fund as the purchaser.
How a contribution can trigger NALI
The ATO is saying the in-specie contribution results in the fund paying less than the market value of the asset because the acquisition is not a contribution where the legal right is purchased under a sale contract.
By way of example, a contract stipulates the purchase price is $500,000, but the fund has physically paid $450,000.
The other $50,000 paid by the member personally cannot represent an in-specie contribution because the fund acquired the property through a sales contract and not an in-specie contribution.
Under these circumstances the fund has incurred NALE due to a non-arm’s-length dealing for the purposes of applying NALI.
Furthermore, the NALE is a specific expense associated with the property so all income derived from the asset will be NALI, including any capital gains from the disposal of the asset effective from 1 July 2018.
The solution
A fund can accept an in-specie contribution when purchasing an asset under a sale contract where the fund only acquires part of the asset.
The solution is to have the contract identify the fund’s interest in the asset and the in-specie contribution associated with the remaining interest.
However, this solution may not be practical if the vendor does not agree to modify the contract.
Luckily, example 5 of LCR 2021/2DC, detailed below, provides an alternative ‘get-out-of-jail-free card’ for SMSFs.
Nadia wants to transfer business real property into her fund worth $500,000, but the fund only has $400,000 in cash.
The fund purchases 50 per cent of the premises for $250,000 and she makes an in-specie non-concessional contribution of the remaining 50 per cent of $250,000.
Nadia accepts the in-specie contribution as trustee of the SMSF and records it in writing with the market value of the item reported in the fund accounts. The fund subsequently reports the non-concessional contribution to the ATO.
Documenting the transaction in a separate minute, resolution or other format should be sufficient to stop triggering the NALI provisions.
Conclusion
The ATO’s new approach of not recognising a part in-specie contribution where a sales contract is in place does not align with the previous industry practice of categorising the difference paid by a member personally as a contribution.
It is an important distinction of which SMSF professionals must be aware because not only can it trigger NALI, they may face litigation if their advice does not align with ATO requirements.
Effective 1 July 2018, the retrospective application of the new draft ruling will significantly impact the SMSF industry. All we can do is wait.
Shelley Banton is head of technical at ASF Audits.
