Understanding the difference between the services offered to the fund in a trustee capacity versus an individual capacity is the key. LCR 2021/2 (“the LCR”) lists specific professions, such as accounting and auditing, which makes it clear that the general expenses for those services at non-arm’s length will always give rise to NALI

The problem is that “Other Administrative Costs” encompasses every other operating expense and throws up a massive smokescreen. 

Under s17A SIS, trustees cannot receive remuneration for any duties performed in their capacity as either an individual trustee or as a director of a corporate trustee.

But s17B SIS says that a trustee can receive remuneration if they:

1. are qualified and hold the necessary licence/s,
2. perform the duties or service in the ordinary course of a business, and
3. receive remuneration that is no more favourable than if they were dealing with the relevant party at arm’s length in the same circumstances.

Suppose the trustee is qualified, holds a licence in their professional capacity, has the necessary insurances and runs the service through their business. In that case, the trustee acts as an individual and has no choice but to invoice the fund at arm’s length.

But it is the facts and circumstances that determine whether the trustee is working in a trustee capacity or an individual capacity.

While the ruling allows for minor, infrequent or irregular use of business equipment, this fact on its own does not indicate that the trustee is acting in an individual capacity.

Whether the service or activity can only be provided by an individual or business holding the relevant qualification or license is relevant.

And when no fee, or a lesser fee, is charged, it demonstrates a connection between the service expenses listed in the ruling and the fund’s income.

The grey area of capacity

The grey area is where a trustee provides a service in an individual capacity at home on the weekend. Under these circumstances, there is no requirement to invoice the fund.

One example is a financial adviser and trustee of their fund, who uses their professional skills to formulate its investment strategy. While they have the skills and knowledge as a licensed adviser, they can also utilise them to decide the fund’s investment strategy because this forms part of the trustee’s duties under r4.09 SIS.

A trustee, however, could not produce a statement of advice for the members as this requires a professional qualification, licence, insurance and experience. It is a service that only a qualified financial adviser can provide – not a trustee.

As a result, preparing a statement of advice would mean invoicing the fund on arm’s length terms to avoid NALI.

Example 6 in the ruling further demonstrates this point. Leonie is a trustee and sole member of her fund. She is a CA and registered tax agent employed as an accountant.

As the trustee of her fund, she prepares the accounts and return for the fund but does not use her employer’s equipment, assets or lodge the return using her tax agent registration.

She performs that service in her capacity as a trustee and not as an individual, so there is no NALE and NALI is not triggered.

To take this example one step further, if Leonie prepared all financial statements and tax return in her capacity as a trustee and her accounting firm lodged the return, the fund would have to be invoiced at arm’s length for that service to avoid NALI. Once again, the firm’s discount policy is critical.

Is there any good news?

NALE does not necessarily taint all fund income permanently.

In Mikasa’s situation as a partner of her accounting firm, if the fund were charged an arm’s length fee in the following income year, the fund would no longer have NALI in that year.

Another example is Sharon, a trustee of her fund and a licensed real estate agent, managing a property owned by the fund through her business.

In the 2021 financial year, Sharon charged the fund half the commercial fee in her capacity as the real estate agent. A sufficient nexus connects the NALE charged to the property, which means that the rental income from the property is NALI and taxed at 45 per cent in the 2021 income year.

If Sharon continued with this arrangement, the income from the property would be NALI for each year the fee reduction was in place. But if Sharon stopped this practice at the end of 2021 and then charged the fund the total commercial rate her business charged all other clients, then the NALI would not apply to the rental income in 2022.

Most importantly, because Sharon ceased this non-arm’s length expenditure, there is no longer a nexus to the property. Any future capital gain on the disposal of the property is not treated as NALI.

What happens at audit?

How will an SMSF auditor know whether a trustee has provided a service in an individual or a trustee capacity?

What happens if a trustee who is a licensed plumber by trade changes a tap in the fund’s property without invoicing the fund? Is the income from the property then NALI?

Based on the facts and circumstances, probably not simply because a trustee could perform that job in a trustee capacity without being licensed, qualified and insured.

In this case, the use of plumber’s tools is considered minor, infrequent or irregular because a trustee would also use the same equipment for the job.

Remember, too, that the trustee’s powers under the trust deed typically allow them to do whatever they consider necessary for the fund’s administration, maintenance, and preservation.

But if the water meter required moving, this is not a job the trustee could do without being a licensed plumber requiring specialist equipment, skills and qualifications. The trustee would need to charge the fund on arm’s length terms in an individual capacity.

Uncorrected NALI may result in a material misstatement of the fund’s tax expense resulting in a Part A qualification of the audit report.

From an audit perspective, that is the extent of modifying the audit report because NALI is a tax issue, not a compliance issue.

NALI litigation

Ignoring the impact of NALI may have future consequences for SMSF professionals.

Problems can arise when an SMSF professional fails to identify NALI, and the fund incurs a significant tax bill for NALI in later years. The trustees or their beneficiaries may look to recoup this expense from the PI insurance of those involved.

Implementing procedures and processes that minimise future litigation risk will be critical in fending off a potential court case.

Will benchmarking become more popular to ensure that expenses incurred within an SMSF are reasonable? The ATO is using this and data matching capabilities to ensure that fund expenses align with industry expectations.

Consider where members get divorced, and the remaining member in the fund is hit with a heavy tax bill several years later. If the members were aware of their tax obligations at the time of the divorce, the settlement would have been different to allow for payment of the tax bill.

Conclusion 

The ATO has allowed for the transitional compliance treatment of NALE of a general nature and will not be applying compliance resources to determine whether fund expenses have a nexus to all fund income incurred on or before 30 June 2022.

While SMSF auditors can ignore this aspect of general NALE applying to all fund income until then, it does not apply to any arm’s length expenses that directly relate to specific assets of the fund that will result in NALI of those assets.

The SMSF industry will be working through the maze of practical implications of this ruling to ensure that any fund activities do not result in non-arm’s length expenses, outgoing or losses.

In the meantime, start getting NALI.