SMSF non-arm’s length expenses – will you be caught out by the ATO’s recent ruling?

If you are in a qualified profession or trade, it is important that you are aware of the ATO’s recent self-managed super fund (SMSF) ruling that may impact you.

You may already be aware that SMSF dealings which result in more income than would be expected in an arm’s length transaction is deemed as non-arm’s length income (NALI) and incur 45 per cent tax. What you may not be aware of is back in 2019, the Government amended the Income Tax Assessment Act 1997 (the Act) to ensure that an SMSF’s expenses are also taken into account in determining if an SMSF’s income is to be taxed as NALI.

The Act states an amount of income will be NALI of a superannuation fund where:

• there is a scheme in which the parties were not dealing with each other at arm's length; and
• 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.

Furthermore, the income is also NALI if the fund does not incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.

Breaching these NALI rules may result in some or all SMSF income being taxed at 45 per cent.

There was much confusion (and angst) in regards to this change so the ATO released the ruling LCR 2021/2 recently, which confirms their position in relation to non-arm’s-length expenses (NALE) and provides examples where SMSF trustees may or may not breach these rules.

An example

A real estate agent who provides rental property management services for free to their own SMSF’s rental property will be caught under these new rules. The real estate agent is considered to be providing services “less than expected if those parties were dealing with each other at arm's length”.

The result: A nexus between the non-arm's length expenditure (free rental property management services) and the rental income received from the rental property, resulting in NALI and tax at 45 per cent for each income year the non-arm's length dealing remains in place. A significant cost for what appears to be a nominal service performed by the trustee.

Similar scenarios would also apply to accountants, lawyers, finance professionals, tradespeople or any SMSF trustee who may involve related parties for services on a non-arm’s length basis.

Auditors will now need to consider the impact of the NALI provisions on fund expenses when conducting the annual audit on the super fund. Where applicable, it is important trustees seek advice now to ensure they do not innocently breach the rules and be subject to significant tax penalties.

If you are unsure or concerned your SMSF may breach these new rules, please contact us to discuss further. We can also help you with all facets of superannuation, SMSF and associated tax laws to help you protect and grow your wealth.