By Mark Ellem

When an SMSF is made non-complying, its tax rate increases from 15% to 47%. However, whilst the higher tax rate of 47% applies to a non-complying superannuation fund, a higher rate can also apply to certain income of a complying superannuation fund. Fund income which is deemed “non-arm’s length” will be taxed at 47% (45% pre 1/7/2014).

Generally, non-arm’s length income (NALI) arises when the fund receives income, usually from a related party, and the income so derived is greater than what would have been derived if the parties were acting on a commercial basis. The NALI rules, formerly known as special income, are found in section 295-500 ITAA 1997 and include:

1. All income from discretionary & non-fixed trusts;
2. Private company dividends, unless they satisfy requirements in s.295-550(3) ITAA 1997;
3. Scheme where parties are not at arm’s length & income is greater than arm’s length;
4. Income from fixed trusts, where parties are not at arm’s length & income is greater than arm’s length.

For an SMSF with an investment in a private company, in addition to complying with the relevant ‘in-house asset’ rules, under the SIS Act, to ensure that the income (being dividends and any capital gain on disposal) is not treated as NALI, under the Tax Act, the amounts received by the fund must be consistent with an arm’s length dealing. In deciding whether an amount received by an SMSF, from shares in a private company, is consistent with an arm’s length dealing, the following factors are taken into consideration (s.295-550(3) ITAA 97):

• the value of shares in the company that are assets of the SMSF. This is the market value of the shares and not the paid up or par value;
• the cost to the SMSF of the shares on which the dividend was paid. Effectively, did the SMSF pay market value for the acquisition of the shares?
• the rate of that dividend. However, this is not necessarily the rate of return on the SMSF’s investment, that is, the yield may be higher than what is considered arm’s length, but this alone is not the deciding factor. It would be important for the SMSF to have acquired the shares at market value and for the rate of dividend to be the same for all shareholders of that class of share;
• whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend. The ATO will be reviewing whether there has been any streaming of dividends to the tax favoured SMSF by way of different classes of shares and whether those other classes of shares have different rights;
• whether the company has issued any shares to the SMSF in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue; and
• any other relevant matters.

These factors are further discussed in TR 2006/7, which whilst deals with the provision under the 1936 Tax Act, previously known as ‘special income’ (former section 273 ITAA 1936), it does provide guidance on how the ATO will consider the factors for consideration in 295-550 ITAA 1997.

Further, once income from a source is deemed to be NALI, then all of the income from that source is NALI, not just the amount which has been determined as excessive.

For example, Big Money Superannuation Fund owns commercial property which is leased to Big Money Finance Pty Ltd, a related party of the fund. The market rent for the property has been determined as $60,000 per annum, however, the amount of rent actually paid is $80,000. Consequently, the whole of the $80,000 of rental income, not just the $20,000 (being the amount above the market rate) is treated as NALI and taxed at 47%.

As a side note, the fact that the SMSF is receiving rent at greater than market value is not a SIS issue. Some may consider that it would be a contravention of section 109 of the SIS Act, commonly referred to as the “arm’s length rule”, however, section 109 merely ensures that where the SMSF and the other party are not at arm’s length, that the SMSF is in no worse of a position than had the other party been an arm’s length party. In the above example, Big Money Superannuation Fund is in a better position, as it is receiving $20,000 above market rent. If the rent paid was below market rent, say only $40,000, then there would be a contravention of section 109 (but no NALI issue).

NALI & LRBAs

NALI is also a topical issue in relation to Limited Recourse Borrowing Arrangements (LRBAs). NALI will generally be of concern where a fund has acquired an asset under an LRBA, the loan is from a related party and the loan’s terms are not commercial, for example the applicable interest rate is less than market rate.

The ATO has issued interpretative decisions 2014/39 and 2014/40 in relation to a superannuation fund that enters into an LRBA with related party loans. It appears that the ATO is not simply focussing on the loan interest rate, but on the overall loan arrangement and whether that arrangement, as a whole, would be obtainable from a commercial lender. If not, then treating the income from that arrangement as NALI. Consequently, care should be taken when structuring an LRBA with a related party loan, as it seems that unless all loan terms and conditions, not just interest rate, are commercial, that the ATO will treat the income from that arrangement as NALI. (Also refer to a previous blog article “Deadline set for Related Party Loans”).

It is noted that with the passing of the “Look through” legislation, to treat income from an LRBA as derived directly by the fund, that both of these ATO IDs may no longer have application. However, my understanding is that they will be revised and the conclusion will be the same, albeit by a different legislative path.

Pensions are no safe haven from NALI

It should also be noted that for a fund paying a pension, that NALI cannot be claimed as exempt current pension income (ECPI). So for example, if Big Money Superannuation Fund only had members with pensions, the $80,000 of above market rent would still be taxed at 47%, a tax liability increase of $37,600 – now that’s NALI dude!

(Apologies to all the surfers and an acknowledgment that the saying “It’s gnarly dude!” usually has a good outcome).