Non-arm’s length income

As most SMSF practitioners are aware, the NALI provisions are an anti-avoidance measure designed to prevent income that would otherwise be taxed at personal marginal tax rates being diverted to a super fund.

The non-arm’s length component of taxable income is a super fund’s NALI less allowable deductions. NALI is taxed at the top personal marginal tax rate (MTR) which is currently 47 percent.

NALI is excluded from exempt current pension income for assets that are supporting income streams.
Non-arm’s length income definition

The definition of NALI is contained in section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) and involves four classes of income:

1.    Income from non-arm’s length transactions.
2.    Private company dividends.
3.    Trust distributions where there is no fixed entitlement.
4.    Trust distributions where there is a fixed entitlement.

Income from non-arm’s length transactions

Income derived from non-arm’s length transactions has three components to the definition:

1.    The income is derived from a scheme.
2.    The parties were not dealing on arm’s length terms.
3.    The income is more than the super fund would be expected to derive if the parties had been dealing at arm’s length.

A scheme is defined as:

•    Any arrangement
•    Any scheme, plan, proposal, action, course of action or course of conduct.

An arrangement is defined as:

Any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

As such, the definition of a scheme is very broad.

Definition of arm’s length:

In determining whether parties deal at arm’s length, it is necessary to consider any connection between them and any other relevant circumstance.

The definition of arm’s length is therefore also very broad.

Case law

The Darrelen case considered the issues of private company shares and arm’s length transactions.

Darrelen Pty Ltd was the SMSF trustee. The SMSF acquired four of the 100 shares on issue in a private company. The SMSF paid $51,218 for the four shares in October 1995. The private company was a passive holding company which simply held 25,609,320 shares in an ASX listed company. The SMSF had effectively acquired four per cent of the private company’s 25,609,320 shareholding in the ASX listed company, being 1,024,373 shares. In October 1995, the ASX listed company’s share price was $0.58, valuing the SMSF’s indirect holding at $594,136 (1,024,373 * $0.58).

Over the eight financial years from 1995/96 to 2002/03, the SMSF received dividends totaling $950,136.
The dividends were determined to be NALI, with the key consideration being that the purchase price of the shares was so far below market value (the SMSF paid $51,218 for $594,136 worth of shares). The dividend income derived occurred from a non-arm’s length transaction, despite all dividends being paid at arm’s length rates.

Limited recourse borrowing arrangements

The ATO holds the view that non-commercial terms in LRBAs lead to NALI. The ATO released two interpretive decisions, ATO ID 2014/39 and ATO ID 2014/40 which cover these issues. The interpretive decisions follow a number of previous private binding rulings on the topic where there has not always been obvious consistency.

The ATO’s view is that non-commercial terms lead to NALI because without the loan there would be no investment in the asset. Without the investment in the asset there would be no income, including capital gains. Therefore all income is NALI.

Arm’s length borrowing arrangement

The ATO will look for consistency with arm’s length dealings covering a number of factors including:

•    the nature of the acquirable asset
•    the amount borrowed
•    the term of the loan
•    the loan to valuation ratio
•    the interest rate
•    principal repayments
•    any personal guarantees
•    the actual operation of the arrangement.

Safe harbour provisions

The ATO recently issued guidelines entitled ‘Practical Compliance Guideline 2016/5’ on safe harbour provisions regarding NALI in respect of related party LRBAs. Clients who have their LRBAs on terms within the safe harbour provisions can have comfort that this aspect of their LRBAs will not result in the application of NALI.

Importantly, clients intending to rely on the safe harbour provisions must ensure that their LRBA terms comply with the provisions by 31 January 2017 for the whole of the 2015/16 financial year.  
Alternatively, trustees can benchmark their arrangement against commercially available terms and conditions and ensure that they document and retain appropriate evidence to demonstrate that their LRBA has been established and maintained on terms that are consistent with an arm’s length dealing.  

The safe harbour provisions cover LRBAs over real property (including residential, commercial and primary production) and a collection of stock exchange listed shares in a company or units in a unit trust, which cover the majority of LRBAs. Where trustees have LRBAs over other assets, they will need to ensure that benchmarking is undertaken.

Conclusion

As with all private investment arrangements, it is important to ensure that the investment provisions of relevant superannuation law are complied with. SMSF trustees must thoroughly review all income received from non-arm’s length arrangements including related party limited recourse borrowing arrangements to ensure it is not taxed at the top marginal tax rate.

Julie Steed, Senior Technical Services Manager, IOOF