DBA Lawyers director Daniel Butler had said that while the draft LCR confirms that a non-arm’s length expense (NALE) causes the income from that particular year to be NALI, this ATO view also leads to the conclusion that all future income (including net capital gains) on all assets held by the fund at that particular time would also be NALI.

In a recent technical update, SMSF Association technical manager Mary Simmons said many just presume that a non-arm’s length capital gain is intended to cause NALI, even if the gain relates to an asset supporting a retirement phase income stream. 

“This view is correct from 1 July 2021. However, due to a technical deficiency in the law, the law does not currently operate this way for SMSFs with segregated pension assets (i.e. where specific assets of the fund are set aside to fund one or more retirement phase income streams),” Ms Simmons said.

“The ordinary and statutory income an SMSF earns from assets held to support retirement phase income streams is exempt from income tax unless it is NALI.

“The technical deficiency is that NALI only applies to ordinary income or statutory income and a capital gain, per se, is neither ordinary income nor statutory income. However, a net capital gain is statutory income and so only a net capital gain can be NALI.”

However, before a capital gain can become a net capital gain, a number of provisions operate, according to Ms Simmons. One such provision is s118‑320 of the ITAA97, which states that if the gain is made from a segregated current pension asset, the gain is simply disregarded. 

“Therefore, if the gain is disregarded, it cannot become a net capital gain and it cannot become statutory income. Ultimately, it cannot become NALI,” she said.

On 17 December 2020, Treasury Laws Amendment (2020 Measures No. 6) Act 2020 (Cth) received royal assent to amend this defect in the law. Subsection 118-320(2) was introduced to ensure that non-arm’s length capital gains in relation to segregated current pension assets are no longer disregarded and are treated as NALI.

With this new introduction, Ms Simmons said not only did the technical issue become complex, but there was also confusion relating to the date of effect of the new provision. 

“If you are like many and rely on legislation websites such as Austlii or the Federal Register of Legislation website, the amendment is already showing as being operative, so you would think that a non-arm’s length capital gain made from a segregated current pension asset currently causes NALI,” she continued.

“On the other hand, if you refer to the relevant explanatory material, you would conclude that the new provision only has effect from 1 July 2021. So, which one is it?” 

In determining the date of effect, the SMSF Association sought clarification from the ATO and has received confirmation that s118-320(2) applies from the 2021–22 income year.

“Effectively, this means that if a non-arm’s length capital gain is made by a segregated current pension asset before 1 July 2021, it does not cause NALI,” Ms Simmons explained.

“If a non-arm’s length capital gain is made by a segregated current pension asset on or after 1 July 2021, it does cause NALI.”

Determining the date of effect 

In a case study provided, consider a number of years ago, an SMSF acquired an asset on non-arm’s length terms. More specifically, the asset’s market value was $500,000, but the SMSF only paid $300,000.

The SMSF is fully being used to pay an account-based pension and the asset is a segregated current pension asset. On 22 April 2021, the SMSF signs a contract to sell the asset. The capital gain is disregarded and is not NALI.

“However, if the SMSF signs a contract to sell the asset on or after 1 July 2021, the capital gain would not be disregarded and thus would cause NALI,” Ms Simmons explained.

“So, from 1 July 2021, where an asset has been impacted by the NALI provisions, any net capital gain will be taxed as part of the fund’s NALI component at the highest marginal rate. 

“This includes SMSFs that are paying a retirement phase income stream to one or more members, regardless of whether the fund is using the segregated or proportionate method to calculate their exempt income.”

Naturally, in addition to non-arm’s length income, Ms Simmons warned there are other issues that should still be considered, including general anti-avoidance provisions (i.e. Part IVA), deemed contributions and excess contributions tax along with promoter penalty laws and SIS regulatory issues (i.e. arm’s length rules etc).

“Understanding the interaction of the NALI, CGT and ECPI provisions is complex at the best of times,” she continued.

“Add a layer of uncertainty in relation to deficient law and it highlights the importance of seeking specialist advice to ensure other super and tax laws are not at risk of being breached.”