The rules state that where parties are not dealing at arm’s length, and the terms are more favourable to the SMSF, there will be no breach of s109 SIS. 

But what the SMSF wins on the merry-go-round gets lost on the roundabout as there can be income tax consequences. 

Why NALI is gnarly

The NALI provisions under s295 – 550 of the ITAA 21997 remove the tax concessions where the SMSF and other parties are not dealing at arm’s length concerning a scheme, and the SMSF’s ordinary or statutory income is more than if they were dealing at arm’s length. 

Where the SMSF inappropriately benefits, the NALI provisions seek to tax the fund at the highest marginal tax rate which will apply to:

1. Ordinary or statutory income derived from schemes
2. Dividends or amounts attributable to dividends
3. Entitlements to trust income (both fixed and non-fixed entitlements)

The other consideration is that from the 2018–19 income years on, NALI also includes the income derived from a scheme where a loss, outgoing or expenditure is less than the amount (including a nil amount) that the entity might have expected to incur in gaining or producing income. 

How do LRBAs fare?  

In real terms, this affects all aspects of the fund’s operations, including LRBAs and property development activities. 

The benchmark for an LRBA that is not on arm’s length terms will be a “hypothetical borrowing arrangement” that is at arm’s length. The factors, therefore, that give rise to NALI include:

1. Repayments and the ability to repay
2. Arrangements to provide security to a lender
3. Related party fees, especially where these are outside the ordinary course of commercial arrangements 

Arm’s length rule of thumb

The critical issue for SMSFs is to conduct all transactions on arm’s length terms and to record them as such. Applying this rule of thumb, even where the parties are not related, will ensure the integrity of each transaction and that all dealings are a result of real bargaining. 

SMSFRB 2020/1 outlines specific examples of transactions SMSF trustees should ensure are on an arm’s length basis:

1. The purchase of land or other assets
2. The terms (including the use of personal or related party guarantees) of any borrowing arrangements of the SMSF or other entities involved in the development
3. Where a related party is engaged to provide services in their professional capacity (such as building or construction works), and charge no fee for these services or paid less than an arm’s length rate
4. The return on investment and income or capital entitlements

Remember, too, that Part IVA may apply where the ATO concludes the sole purpose of the property development was to obtain a tax benefit. 

Conclusion

Where an SMSF trustee applies the golden rule of thumb of arm’s length transactions to property development, it will be easier to avoid NALI. Achieving this requires each activity to be reviewed holistically to ensure consistency and provide the assurance that the transaction is on commercial terms. 

It can be effortless to lose sight of what’s important and walk straight onto the SMSF property development path leading to NALI — which means the NALI legislation will catch out SMSF trustees who ignore non-arm’s length dealings at their peril. 

In the last part of our series, we will review joint ventures and the sole purpose test to see the circumstances where property development ventures are detrimental to SMSFs. 

Shelley Banton, head of education, ASF Audits