Section 8.1 provides that an expense can be deducted from assessable income if it is incurred:

• In gaining or producing assessable income; or

• In carrying on a business for the purpose of generating assessable income.

For an SMSF, expenses that meet this criterion must have a nexus to income generation. If an SMSF incurs non-arm’s length expenses (NALE) that directly or indirectly impact income production, the resultant income may be classified as NALI, attracting tax at 45%. Examples include:

• Expenditures related to acquiring specific assets at below-market rates.

• Services provided to the fund at discounted rates or free of charge.
• General expenses incurred at a level lower than commercial rates.

Relationship between NALE and NALI

The ATO’s ruling LCR 2021/2 clarifies that non-arm’s length expenditure can have a nexus to all the ordinary or statutory income of an SMSF, not just a particular asset. If the expenditure relates to income generation, it triggers NALI.

However, the ATO’s position also acknowledges that certain expenses, particularly those incurred under Section 25.5, do not have a sufficient nexus to income and therefore do not contribute to NALI (refer to paragraph 19 of the LCR).

Expenses under Section 25.5 – Managing tax affairs

Section 25.5 of the ITAA 1997 allows deductions for expenses incurred in:

• Managing the tax affairs of an entity.

• Complying with an obligation imposed under Commonwealth law in relation to tax affairs.

• General interest charges, shortfall interest charges, and certain penalties.

• Obtaining valuations for taxation purposes.

The key distinction is that expenses deductible under Section 25.5 do not have a direct nexus to income generation. As a result, such expenses do not trigger NALI provisions, even if they are incurred at non-arm’s length rates. Examples include:

• Fees for preparing and lodging the fund’s tax return.

• Costs associated with responding to ATO audits or investigations.

• Expenses for seeking tax rulings or advice on tax compliance.

Case study: When NALE does not apply

Consider an SMSF engaging an accounting firm (where a trustee is a partner) for its financial reporting. If the firm provides services beyond tax compliance (such as general accounting and administration) at a discounted rate, this could trigger NALE, leading to NALI. However, if the firm’s services only relate to tax compliance and are deductible under Section 25.5, then NALE rules do not apply, and no NALI arises.

Practical Implications

• Claiming expenses under Section 25.5 is advantageous because there is no need to apportion the deduction, even if the SMSF claims Exempt Current Pension Income (ECPI).

• Trustee capacity is irrelevant—if services are or would be deductible under section 25.5 ITAA 1997, that is, for managing the tax affairs of the SMSF, then there is no need to consider the capacity in which the service was performed as there is no nexus to income and consequently can be no NALI.

• NALE exposure arises when an expense is incurred below market rates and contributes to income generation. Managing tax affairs does not meet this condition, thus excluding it from NALE scrutiny.

• Focus will turn to substantiating that the service provided is that of managing the tax affairs of the SMSF and is or would be deductible under section 25.5 ITAA 1997. This may require apportionment of the expenditure under sections 25.5 and 8.1 ITAA 1997. For that amount that is or would be deductible under section 8.1 ITAA, consideration would need to be given to the capacity in which the service was performed and whether it gives rise to NALI.

Understanding the distinction between expenses under Sections 8.1 and 25.5 is critical in managing an SMSF’s tax obligations. While expenses tied to income generation can lead to NALI under Section 8.1, those incurred for managing tax affairs under Section 25.5 remain outside the scope of NALE rules, ensuring tax compliance without unintended penalties. Trustees and their advisors should assess the nature of their SMSF’s expenses carefully to maintain compliance with tax laws and optimise their fund’s tax position.