“Would you tell me, please, which way I ought to go from here?”

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“That depends on where you want to get to,” said the Cat.

The non-arm’s length income (NALI) dilemma centres on two types of trustee.

First, we have trustees that use their skills to benefit their SMSF in a laudable way. Then we have trustees who improperly introduce value into their SMSF by reducing fund expenditure though non-arm’s length dealing. Where there is sufficient nexus between cost savings and SMSF ordinary or statutory income, the fund incurs NALI.

It is not clear where the line between these groups should be drawn. It is also not clear how SMSF auditors are to act as gatekeepers in this space.

Is the auditor expected to assess the suitability of fee benchmarks?

How far is the auditor responsible to detect ‘missing’ or discounted expenses?

Is it possible to exit the debate by relying on trustee representations?

In terms of drawing the line, LCR 2021/2 attempts to dispel the uncertainty with examples. But one foresees difficulty.

First of all…it’s a matter of hats

An SMSF trustee is a person who wears two hats.

As trustee, they must act in the fund’s best financial interest. This involves the free use of time and skill. In fact, SISA section 17A prohibits an SMSF’s remuneration of trustees, unless (as per section 17B) the trustee is appropriately qualified and performs a fund service in the ordinary course of business. And the remuneration must not exceed an amount the fund would pay if dealing with an arm’s length party.

As an individual, this same person must also have an eye to ITAA97 section 295-550 and take care that ‘free’ value is not introduced to the SMSF outside the trustee mantle. The borrowing of funds to an SMSF at below market rates is an obvious example. Such benefits flow to the SMSF without any connection to a trustee’s administrative duties. It was a loophole in the legislation that had to be closed.

As a rule of thumb: when the trustee hat comes off, beware NALI.

But it’s not always simple. When does the hat come off? LCR 2021/2 indicates that a person’s use of professional, business or employment resources signals the trustee hat is off and the person is acting as an individual, who should be charging the fund a market rate for services performed.

But this leads to some strange outcomes.

The busy accountant

Levi is an accountant and registered tax agent. Each year, he prepares his SMSF financials and annual return while at work using office equipment because it’s convenient. In the annual rush, Levi always lodges the fund’s return under his tax agent registration to avoid late penalties and complications. He thought this was the responsible thing to do.

He has never charged the SMSF for these services.

This is a common situation.

It’s an unlikely tax avoidance scheme.

The value added by Levi’s services is directly linked to his management of the fund as trustee. Yet a close reading of LCR 2021/2 examples 6 and 7 suggests that Levi’s regular use of business equipment and his lodgement of the fund’s annual return under his agent registration may give rise to non-arm’s length expenditure, which in turn will have sufficient nexus to all fund income for any year Levi provides the service. For each relevant year, total fund income (including any capital gains) will be taxed at the top marginal tax rate.

This is anti-avoidance on steroids.

In Levi’s case, the absence of accounting fees is a clear flag to the SMSF auditor, and the effect of NALI should be identified.

But auditors may also need to detect reduced or missing expenses with little guidance.

The unsuspecting electrician

Jean is a licensed electrician and performs work on his SMSF’s investment property that should only be undertaken by someone with his qualifications. It never occurred to Jean to charge his own fund, and the accounts are prepared without any suggestion that the work was done. Several years later, Jean remarks happily to his SMSF auditor that the fund has never paid a cent in electrical services.

LCR 2021/2 example 10 makes it clear that Jean’s trustee hat comes off when he’s undertaking work for the SMSF as individual with specialist skills.

Depending on the nature of Jean’s work, cost savings may have a nexus to property income in a specific year. Or, if capital expenditure, it may irreversibly taint the whole property and its capital gain when sold, possibly years into the future.

There is nothing anyone can do to fix this.

Unless the SMSF auditor asks very specific questions, they will have no idea this NALI time bomb is ticking. And once a problem is identified, the auditor must unravel a very tangled snarl to assess what kind of NALI issue exists.

Yet a trustee’s provision of free expert skill is not uncommon. It could be argued that Jean’s use of skill falls within a trustee’s duty to manage and maintain SMSF investments in the fund’s best financial interest. As a professional, he may charge the fund an arm’s length rate under section 17B – but should he be obliged to do so?

On the basis of law, it is unclear why the use of professional skills or license must signal that the trustee hat is off.

What about audit engagement documents?

The ATO’s interpretation of section 295-550 is challenging for SMSF auditors.

The auditor must form an opinion regarding the tax provision as part of the financial statements audit. The application of NALI is often material.

It is not possible to scope NALI considerations outside the audit in the engagement letter. Nor is it possible to place total reliance upon trustee written representations that confirm NALI does not apply. ASA 580 paragraph 4 states:

Although written representations provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the matters with which they deal.

If section 295-550 applies to everyday expenditure, the hunt is on not only for those items that appear in the financials, but also for every outgoing that does not.

In terms of expenses that do appear, the SMSF auditor will need to assess whether the amount charged is appropriate. This will involve evaluating fee benchmarks against the service provided. Will the auditor need to evaluate trustee service quality against the benchmark presented? Not all service quality is alike, and neither are fees. Low-balling of fees may still occur when using a benchmark. What level of assessment is required?

Then there are cost savings that don’t appear at all. How far in this search for the absent is the auditor required to go? Without a point of comparison, reduced or missing expenditure will be hard to identify. Let’s face it, if Handyman Jim spends a few Saturdays with his truck at Grandma’s SMSF investment property, the auditor is unlikely to hear about it.

Maybe Grandma has baked him a chocolate cake. Or maybe she hasn’t.

Is it important?

If the NALI provisions are intended to prevent Grandma increasing the value in her SMSF through Jim’s pro bono professional skills, then it certainly is.

But is this where we wanted to go?

Naomi Kewley, Specialist SMSF Auditor, Peak Super Audits