The question of how NALI interacts with the CGT provisions is discussed below, and, unfortunately, the answer is not nice; it’s rather nasty. The legislation urgently needs fixing!

Unless stated otherwise, all legislative references in this article are references to the ITAA 1997.

Overview

Broadly, s 295-550(1) defines NALI of a complying superannuation fund to include an amount of ordinary or statutory income obtained as a result of a scheme in which the parties were not dealing at arm’s length.

Naturally, the statutory income of a superannuation fund includes capital gains made by a fund, and this is calculated under the method statement in s 102-5(1).

When does the ATO consider that a capital gain is NALI?

The ATO states in paragraph 7 of TD 2024/5 that a capital gain resulting from a non-arm’s length (NAL) scheme is considered NALI under s 295-550(1) where either of the following applies:

• The amount of the capital gain is more than the amount the fund might have been expected to derive if the parties had been acting at arm’s length in relation to the scheme; or
• For SMSFs or small APRA funds – in gaining or producing the capital gain, non-arm’s length expenditure (NALE) is incurred (including nil expenditure) in respect of a CGT asset that is less than the amount of a loss, outgoing or expenditure that the fund might have been expected to incur if those parties were dealing with each other at arm’s length in relation to the scheme.

Importantly, the ATO notes in paragraph 9 of TD 2024/5 that the amount of statutory income from capital gains that is NALI cannot exceed the superannuation fund’s net capital gain calculated under the method statement in s 102-5(1) for the relevant income year. This means that where the amount of NALI capital gains exceeds the net capital gain (i.e., once losses and discounts are applied in accordance with the method statement), the amount of NALI from capital gains is equal to the net capital gain of the superannuation fund.

A NAL capital gain taints an arm’s length capital gain

Does the interaction between the NALI and CGT provisions lead to a NAL capital gain tainting an arm’s length capital gain?

Yes, the ATO confirms this position in TD 2024/5. Thus, technically, it is possible that a $100 NAL gain will taint a $1 million arm’s length gain if it is crystallised in the same income year. However, where a NAL gain exceeds the fund’s net capital gain, the amount of the NAL gain equals the fund’s net capital gain.

You might very well think that a $100 “tainted” gain should not taint an arm’s length capital gain as that would presumably be a shortcoming in the legislation. However, the ATO’s role is to administer tax legislation, and it’s the ATO’s construction of the legislation that gives rise to this outcome. Therefore, the legislation needs fixing as, otherwise, it will result in some disproportionate and unfair outcomes.

The tainting impact of a NAL gain: ATO example

A NAL gain tainting an arm’s length gain is highlighted in example 3 in TD 2024/5, which deals with an SMSF that receives inflated capital proceeds of $5 million for an asset worth $1.5 million. We have extracted this example below with some minor amendments.

Hakuho is one of the trustees of the SMSF which made the following in the 2022–23 income year:

• $1 million arm’s length capital gain.
• $5 million NAL gain as reported by the SMSF. However, this capital gain arose as a result of a CGT event where the SMSF received capital proceeds of $6 million for a CGT asset with a market value of $1.5 million (noting the arm’s length cost base for this CGT asset was $1 million). If the parties had dealt with each other at arm’s length in respect of the scheme, the gain would have been $500,000. As such, s 295-550(1)(a) applies as the relevant income under the scheme is more than what might have been expected to have been derived if the parties had been dealing with each other at arm’s length in relation to the scheme.
• There are no assessable contribution or contributions.

The SMSF had a current-year capital loss of $100,000 and no previous net capital losses. Both capital gains are discount capital gains.

The net capital gain as calculated under s 102-5(1) was $3,933,333.34. Section 116-30(2) generally applies to replace the capital proceeds with the market value of the CGT asset if the capital proceeds are more than the market value of the CGT asset if parties did not deal with each other at arm’s length. However, s 116- 30(2C) provides that the market value substitution rule in s 116-30(2) does not apply where the capital proceeds from the CGT event exceed the market value and assuming that those capital proceeds were statutory income, the proceeds would be NALI. The net capital gain is, therefore, calculated as:

$6,000,000 (capital gain consisting of $1,000,000 arm’s length component and $5,000,000 NAL component) – $100,000 (capital losses) – $1,966,666.66 (1/3 SMSF CGT discount)
= $3,933,333.34

The example then highlights how the tax payable is calculated pursuant to the method statement in s 295-10 (which deals with ‘How to work out the tax payable by superannuation entities’):

Step 1 – is not applicable.

Step 2 – work out the entity’s assessable income and deductions, taking into account the special rules in Division 295.

The assessable income is $3,933,333.34. The deductions are nil.

Step 3 – work out the entity’s taxable income.

Assessable income of $3,933,333.34 less deductions of nil, equals $3,933,333.34 taxable income.

Step 4 – calculate the non-arm’s length component.

The NAL component is $3,933,333.34.

This amount is calculated as the lesser of:

$3,933,333.34 (the NALI amount) – $0 (deductions) = $3,933,333.34

The taxable income of $3,933,333.34 less assessable contributions of $0 plus deductions of $0 attributable to those contributions.

While the capital gain reported under the scheme was $5 million, the NAL gain cannot exceed the SMSF’s net capital gain.

Capital loss and discount percentage are not deductions.

The low tax component of the taxable income is nil.

Step 5 – apply the applicable rates as set out in the Income Tax Rates Act 1986

The NAL component of $3,933,333.34 is taxed at the highest marginal rate (45 per cent) and the low tax component of $0 is taxed at 15 per cent

Step 6 – is not applicable.

The above example demonstrates that, where a NAL gain is crystallised in the same income year as an arm’s length gain, the entire net capital gain will be tainted and taxed at the NALI tax rate of 45 per cent. In this example, the $1 million arm’s length capital gain was tainted and taxed at 45 per cent. Thus, a NAL gain effectively taints any other capital gain in the same income year.

Market value substitution rule – cost base

Paragraph 8 of TD 2024/5 highlights that a NAL gain is subject to the CGT market value substitution rules contained in s 112-20. For example, where an asset is purchased by a fund for less than its market value and the parties are not dealing at arm’s length, the market value of the asset is deemed to be the cost base of the asset for the purposes of calculating a future capital gain.

Section 116-30 usually results in the market value of an asset being substituted where the capital proceeds exceed the market value of the asset and the parties are not dealing at arm’s length. However, as noted in the example above, this rule has been modified in the case of superannuation funds under s 116-30(2C), meaning there is no substitution of the market value of the asset and, therefore, no reduction in the capital proceeds. Thus, in the example, the inflated capital proceeds were taxed as NALI.

Rejection of alternative views

TD 2024/5 also explains the commissioner’s position on several alternative views to the interpretation of the NALI and CGT provisions.

Notably, the commissioner expressly rejects the view that the amount of NALI in relation to a NAL gain can be calculated by reference to the tainted gain alone but must be considered in relation to an amount that takes into account both arm’s length and NAL gains.

Capital losses

TD 2024/5 also discusses the treatment of capital losses. Broadly, capital losses reduce the amount of net capital gain under the method statement in s 102-5. Thus, one strategy that you might consider if you have a tainted capital gain in an income year is whether any capital loss can be realised to offset the capital gain to produce a lower net capital gain. However, before doing so, you should consider, among other things, the following:

• The ATO’s view in the “wash sales” ruling TR 2008/1 (i.e., Income tax: application of Part IVA of the Income Tax Assessment Act 1936 to “wash sale” arrangements).
• The Federal Court’s decision in Merchant v Commissioner of Taxation [2024] FCA 498 that, among other things, the family trust’s $56+ million capital loss realised on the sale of Billabong Limited shares to the Gordon Merchant Superannuation Fund was part of a Part IVA tax scheme to offset the $85 million capital gain on the sale of Plantic Technologies shares held by the family trust.
• Obtaining expert tax and SMSF advice. Naturally, DBA Lawyers is well qualified and would be pleased to assist.

Conclusions

SMSF trustees and advisers must be aware of the nuances of how the CGT provisions interact with the NALI provisions. As some commentators say, “What’s logic got to do with tax law?” Naturally, expert advice should be obtained if there is any doubt.

TD 2024/5 also highlights the need for an urgent legislative fix to the above situation where disproportionate and unfair outcomes can result, e.g., a $100 NAL gain tainting a $1 million arm’s length gain.