However, buried among small business aids, such as the $20,000 instant asset write‑off and the Small Business Energy Incentive, are changes to the non-arm’s length expense (NALE) provisions.

Below we bring you, in its entirety, an explainer of the changes written by Daniel Butler, director at DBA Lawyers.

NALE changes explained

On 13 September 2023, Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Bill 2023 was introduced into the House of Representatives (NALE Bill).

The NALE Bill provide guidance on changes to the non-arm’s length expense (NALE) provisions introduced in s 295-550(1)(b) and (c) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) with effect from 1 July 2018. References in this article will be to the ITAA 1997 unless stated otherwise.

What were the NALE changes in mid 2018?

Broadly, under the current NALE provisions (see paragraphs (b) and (c) of s 295-550(1)) where the parties are not dealing at arm’s length and a lower or nil expense is incurred, all the ordinary and statutory income of a superannuation fund for a financial year (FY) including assessable contributions will be taxed at 45%. In other words, NALE results in substantial non-arm’s length income (NALI) exposure.

Moreover, NALE currently applies to all superannuation funds, both APRA funds and SMSFs. Note however the ATO provided an administrative solution by way of its Practical Compliance Guideline PCG 2020/5 where it did not apply its compliance resources for the 2019 to 2023 FYs to enforce a general expense NALE.

A specific NALE exposure was however not covered by PCG 2020/5 and therefore can result in NALI from 1 July 2018.

NALE changes under the NALI Bill to apply from 1 July 2018

The NALE Bill proposes a cap on the amount of income that will constitute NALI from a non-arm’s length scheme involving a lower or nil general fund expense. This cap is in the form of a two times (i.e., 2 x) multiple of the amount of the lower general expense for an SMSF or a small APRA fund. The example below outlines how this cap is to apply.

The proposed changes do not apply in relation to expenses relating to ‘gaining or producing income in relation to any particular asset or assets of the fund’ (i.e., a specific expense).

The difference between a specific and a general expense is discussed further below.

Example applying a 2 x multiple:

If an SMSF trustee uses a member’s brother’s accounting firm’s services, which would usually cost $5,000 under an arm’s length relationship but is not charged any fee, this is considered NALE as the parties were not dealing at arm’s length. Therefore, the tax payable would be calculated as follows:

• 2 x $5,000 = $10,000 NALE
• $10,000 x 45% = $4,500 tax payable by the fund.

Note that where the product of 2 x the NALE is greater than the fund’s actual taxable income, an “upper cap” will be the SMSF’s taxable income for the FY (not including any assessable contributions or any deductions against those assessable contributions).

Referring to the above example of the SMSF member’s brother’s firm providing accounting services valued at $5,000 for free, where the amount of NALI under a 2 x is $10,000 but the fund’s actual taxable income is say only $6,000, the upper cap would result in total NALI being only $6,000.

Other proposed changes

Clarification on non-arm’s length and internal arrangements

The explanatory memorandum (EM) to the NALE Bill discusses the capacity that an SMSF trustee/member acts and whether those actions will give rise to non-arm’s length risks or would be an internal arrangement not giving rise to NALI-E risks. Broadly, this distinction depends on the capacity in which the trustee undertakes those activities based on the particular facts and circumstances.

The EM notes that if a trustee is not acting as a trustee but is instead providing services that are procured as a third party, the NALI rules are intended to apply. The EM also recognises that in such cases, an SMSF trustee may be prevented from charging any more than the arm's length price because of s 17B of the Superannuation Industry (Supervision) Act 1993 (Cth), which permits a trustee to charge in limited circumstances.

The EM uses different language to that used by the ATO in LCR 2021/2 and further clarification by the ATO on the NALE Bill in this regard would be welcome.

Capital expenses

Note that Treasury released Exposure Draft ‘Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s Length Expense Rules for Superannuation Funds’ on 19 June 2023. That Exposure Draft did not apply the two times multiple cap to general expenses of a capital nature. Fortunately, the Bill has not proceeded with a distinction between a revenue versus capital general expense and any general expense will be subject to the two times multiple cap. (Otherwise, there was a fear that an SMSF deed update for less than market value may have resulted in all of a fund’s income being NALI, apart from assessable contributions.)

Specific v general expense

The EM states:

7.5 Any [NALE] will be either a specific expense or a general expense. A general expense will be an expense that is not related to gaining or producing income from a particular asset … of the fund. A specific expense will be any other expense. …

7.6 For specific expenses the previous treatment continues to apply, and the amount of income that will be taxed as [NALI] is the amount of income derived from the scheme in which the parties were not dealing at arm’s length.

Example 7.4 of the NALE EM is relevant to SMSFs utilising the services of related members and party parties as the example, among other matters, states:

[Sam is a related party of an SMSF, whose assets include a rental property.]

… Sam is a licensed builder and blocks time out of their work calendar to conduct renovations on the rental property worth $3,000 for which they charge nothing.

The renovations were an expense incurred in deriving income from a particular asset, the asset being the rental property. The renovations are a specific [NALE] …

Thus, given the lower $3,000 specific expense, the net rental income from the SMSF’s rental property in example 7.4 is taxed at 45 per cent. The example gives no guidance on whether the property is tainted for life or just in relation to that particular FY. However, the ATO’s Law Companion Ruling LCR 2021/2 suggests that Sam’s work taints the property for the remainder of its life.

Example 9 in LCR 2021/2 where Trang, a plumber, renovated the kitchen and bathroom of her SMSF’s second rental property, exposing the net rental income and future capital gain forever to NALI.

Note there is no express discretion for the Commissioner to disregard honest or inadvertent oversights.

Contributions to be excluded

The NALI Bill proposes to exclude contributions assessable under sub-division 295-C from NALI. Note that under current legislation, general expenditure NALE results in assessable contributions being taxed as NALI at 45 per cent.

Pre-1 July 2018 expenditure to be excluded

The NALE Bill proposes that expenditure incurred prior to 1 July 2018 will be exempt from NALI. Note that under current legislation, NALE can apply retroactively.

Large APRA funds exempt from NALE

Large APRA funds will be exempted from NALE in relation to both general and specific expenses.

Conclusions

Many SMSF trustees are not aware of the breadth of these provisions and advisers should ensure there is ongoing education and monitoring for NALI/E risks in their client base.

In particular, specific NALI remains a risk given it exposes all future ordinary and statutory income (less deductions) from a particular asset to a 45 per cent tax rate including a future net capital gain on disposal of the asset.

A number of professional bodies representing both the large APRA fund and SMSF industry requested a more proportionate treatment for NALI and the ability to rectify honest and inadvertent oversights.