1. The income is taxed at the top marginal rate
2. Any eventual capital gain on disposal of the asset being treated as non-arm’s length income (NALI)

Market value substitution rules

Where the scheme involves the acquisition of an asset at less than market value, the cost base of the asset will be modified by the market value substitution rule in s112-20 SIS.

As a result, the amount of any capital gain will be affected, as the cost base must be treated by the SMSF as having acquired the asset at market value. It is irrelevant whether the asset was purchased directly or is accounted for through an in-specie contribution.

NALI rules

The golden rules are that all fund activities must be undertaken on commercial terms and all assets purchased at market value. Additionally, each situation is assessed on their own merit as to whether NALI applies to the income of a particular asset, or to all of the income of the fund.

Remember, too, that all the NALI principles will apply regardless of whether the asset or activity has been acquired in line with s66 SIS – acquisition of assets from a related party.

Generally, where no such link can be found between the activity undertaken and a particular asset, NALI will apply to all income of the fund in that financial year.

The ATO has published LCR 2019/D3 which provides examples of how the new legislation applies with the following situations giving rise to NALI.

Asset purchased less than market value
A property is purchased for $200,000 while the market value is $800,000. This provides sufficient connection between the NALE incurred in acquiring the property such that all rental income is NALI and any capital gain from the disposal of the property is also NALI.

Trustee uses their professional services firm (non-asset related)
The partner of an accounting firm who is the trustee of their SMSF uses the firm to provide accounting services to the fund, but no fee is charged. In this case, the trustee is not acting as a trustee but has provided services that are undertaken by a third party.

The SMSF has acquired the services under a non-arm’s length agreement, providing a connection between the NALE and fund income that classifies all of the SMSF’s income for the financial year as NALI.

Trustee uses their professional services firm (asset related)
The trustee of a fund is a licensed real estate agent and provides property management services to the SMSF as a licensed real estate agent. The fund is charged 50 per cent of the fee than would be otherwise charged to a non-related party.

There is sufficient nexus between the NALE and rental income derived from the residential property such that all rental income will be NALI as long as the non-arm’s length deal remains in place.

Related-party LRBA financed on non-arm’s length terms
A related-party LRBA involved a 25-year term and a 1.5 per cent interest rate. The terms of the LRBA constitute a non-arm’s length dealing between the fund and the lender. All rental income derived from the property is NALI, and any capital gain that might arise from a subsequent CGT event happening is also NALI.

Acquisition of fixed entitlement in unit trust
The trustee of a fund entered into a non-commercial related-party LRBA to acquire units in a listed unit trust. There was no interest being charged to the loan and repayments were not required until the end of the 25-year term. The units provide the fund with a fixed entitlement to the income of the unit trust.

The terms of the LRBA constitute a non-arm’s length dealing between the trustee as the lender and the fund, which results in the fund incurring NALE that would otherwise be expected if they were dealing on commercial terms. All distributions from the units in the unit trust and any future distributions is NALI.

What is an arm’s length dealing?
It can be challenging to determine the exact price of an arm’s length price, as this may fall within a range of commercial prices. One common example is that a loan may able to accept a market interest rate within a band of rates available to it on an arm’s length basis.

Most importantly, parties may enter into arrangements that result in discounted prices or favourable terms. The justification could be that a party operates on a simple cost-recovery basis for particular services on commercial terms because of the economies of scale it achieves within its business by providing other services.

Audit implications
There can be significant tax implications for SMSFs that result in fund income being taxed at the highest marginal rate and applies regardless of whether the fund is in pension mode. 

From an audit perspective, NALI is not a compliance breach but a tax issue. It will result in a management letter comment in most cases notifying trustees that the tax calculation has been misstated. Where it has been materially misstated, Part A of the audit report will be qualified, which must now be reported on the fund’s income tax return.

Conclusion
There is a new addition to the NALI rules that consider fund expenditure. Where the fund incurs a loss, outgoing or expenditure that 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, the NALI provisions will apply.

The legislation applies to all fund activities and assets that are not undertaken on commercial terms from the 2019 financial year onwards, regardless of whether the scheme was entered into before 1 July 2018.

When you think about the ATO’s high-level data-matching capabilities, there is no doubt that the new NALE legislation will catch out those SMSF trustees who ignore non-arm’s length dealings at their peril.

Shelley Banton, head of technical, ASF Audits