I’ve been discussing the ATO’s ruling on non-arm’s length expenditure with colleagues of late and have concluded, the ATO are basically saying the legislation needs a re-write. Their stance, whilst clarifying some aspects of the previous draft ruling (LCR 2019/D3), shows the ATO have believed all along the legislation is not fit for purpose. Either that, or the ATO are wringing their hands about a problem that doesn’t exist.
How could I sound so condescending about “Our ATO”? Well, if the latter applies and one examines the chronology of events that have led to this point, one might think the whole thing a bit of a debacle.
From what I can gather, it all started way back in 2010, when the ATO released their Interpretive Decision (ID) 2010/162. In it, they stated an SMSF would not breach s109 of the Superannuation Industry (Supervision) Act (1993) if it borrowed money from a related party of the SMSF under a Limited Recourse Borrowing Arrangement (LRBA) on terms favourable to the SMSF. They then went through an example where an SMSF borrowed at an interest rate lower than an arm’s length arrangement. The conclusion of the ATO is succinctly stated in the last paragraph of ATO ID 2010/162:
Subsection 109(1A) of the SISA applies to dealings with parties that are not at arm's length, during the term of the investment to ensure that the investments are maintained on an arm's length basis. Subsection 109(1A) of the SISA applies after an investment to which paragraph 109(1)(b) applies has commenced and is interpreted in that context. As a result provided the dealing is not more favourable to the other party than would be expected had the parties been at arm's length then the provision will not be contravened.1
None of the above is in any way controversial or remarkable. The ATO also made remarks in a National Tax Liaison Group(NTLG) meeting 2
about interest not being a crucial element of a loan as well as the lack of an interest rate not being a contribution (both which again are true and largely benign statements).
However, the White Shoe Brigade interpreted this as the ATO giving its imprimatur for SMSFs to borrow from related parties at 100%+ Loan to Valuation Ratios (LVR) and zero percent interest rates. This was not the ATO’s stance and such a strategy never sat well with most in the industry. Unfortunately, no clarification came from the ATO in the form of guidelines as to what would constitute satisfactory LRBA terms and conditions.
Some more history
We now transport ourselves forward several years, by which time the industry saw this laissez-faire situation as potentially causing problems for SMSFs with related party LRBAs. Enter Private Binding Rulings (PBR) 1012414213139 and 1012396819768; where the ATO was asked if a related party loan with less than market and/or zero interest rate would give rise to non-arms length income. There response was, for various reasons, no. This, as well as the ATO’s stance that such loans will not give rise to a contribution, caused the lunatic fringe to go apoplectic. Notwithstanding the fact PBRs are only specific to the taxpayer involved, some saw it as a sign the ATO had finally nailed its colours to the mast.
Whist I personally believe the position is these PBRs to be correct, the higher-ups at the ATO (and possibly bureaucrats in other departments) seemingly had conniptions about the Kraken they thought had just unleashed causing a plethora of related party LRBAs with low or zero interest loans.
So then followed a flurry of PBRs that contradicted those mentioned above and referred to zero interest loan being breaches of the non-arms length provisions in the Income Tax Assessment Act (ITAA) of 1997 (s295-550). Hot on the heels of these were ATO ID 2014/39 and 2014/40, which reinforced the ATO’s newfound zeal to put the genie they had released back into the bottle.
Still more history....
Finally, more than half a decade after ATO ID 2010/162, the ATO finally released their guidance on what would constitute a related party LRBA that would not trigger the non-arms length income provisions (Practical Compliance Guidelines 2016/5). In it, the ATO issued safe harbour guidelines for related party LRBAs that, if adhered to, would not invoke the NALI provisions.
Many believed this would resolve the mischief that was zero interest LRBA loans, with ridiculously high LVRs and repayment schedules. Alas, that was not the end of the saga. The NALI provisions contained in section 295-550 of the ITAA (1997), were essentially a re-write of the former provisions in section 273 of the ITAA (1936), the purpose of which was stated in the Explanatory Memorandum (EM) to the Superannuation Legislation Amendment Bill (SLAB) (No. 2) 1999:
“…to prevent income from being unduly diverted into superannuation entities as a means of sheltering that income from the normal rates of tax applying to other entities, particularly the marginal rates applying to individual taxpayers.” 3
Post 1 July 2017 legislative amendments
The changes introduced by the Treasury Laws Amendment (Fair and Sustainable Superannuation) Act 2016, were seen by Treasury as further inducing SMSF trustees to engage in NALI arrangements that circumvent the restrictions to monies being held in the concessionally-taxed superannuation environment.
However, there was a perceived ‘deficiency’ in the NALI provisions; where expenses incurred by a superannuation entity, in respect of an asset, were not on arm’s length terms, but the amount of ordinary or statutory income from the arrangement was the same as might be expected had the dealing been at arm’s length. This included the situation where no expenses were charged. This would appear to cover situations where an SMSF has a related party loan with interest rates at less than market (or zero), but the income was at market rates and thus not triggering NALI.
Plugging the leak
So, a new bill was introduced - Tax Laws Amendment (2018 Superannuation Measures No. 1) Bill 2018, with the Explanatory Memorandum providing examples of how the new legislative instrument would work. In essence, a less than market expense must have been incurred in producing the income in order to trigger the NALI provisions. I have no problem with this rationale, as the nexus between the non-commercial expense and the asset makes it clear that asset’s ordinary and statutory income will be subject to NALI and taxed at the top marginal tax rate.
If we look at a simple example, the Cousins SMSF enters into a related party LRBA to buy a residential property in Cowes, on Philip Island, at zero interest rate, with a loan term of 50 years and no repayments made until the very end of the loan term. Clearly this is not on arms-length terms, so any rental income received by the fund from the property will be taxed at the top marginal tax rate, as well as any future capital gain. The nexus between the specific expense (or lack thereof) and the relevant income from the asset is clear and unambiguous.
Using a sledgehammer to crack a walnut
However, the legislative change went beyond addressing the mischief of related party loans not on commercial terms. The NALI provisions now encompass expenses of a general nature, where there is no nexus between the expense (or lack thereof) and specific income of the fund. Rather, the nexus is between the general expense and ALL the ordinary and statutory income of the fund.
While this seemed a little beyond what the legislative amendment was trying to mitigate, the ATO’s draft ruling on the matter (Draft Law Companion Ruling LCR 2019/D3) surprisingly clarified this view.
Let’s have a look at an example from the ruling
LCR 2019/D3 – example 2
For the 2020–21 income year, Mikasa as trustee of her SMSF, engages an accounting firm, where she is a partner, to provide accounting services for the fund. The accounting firm does not charge the fund for those services.
For the purposes of subsection 295-550(1), the scheme involves the SMSF acquiring the accounting services under a non-arm’s length arrangement. The non-arm’s length expenditure (being the nil amount incurred for the services) has a sufficient nexus with all of the ordinary and statutory income derived by the SMSF for the 2020–21 income year. As such, all of the SMSF’s income for the 2020-21 income year is NALI.
What if the fund had a property acquired at market rates say, 16 years ago and makes a significant capital gain in the relevant income year? In the draft ruling, the ATO is saying all the capital gain will be subject to NALI if sold in the financial year, because a trivial general expense that was not on arm’s length terms has tainted ALL the income of the fund. This should not be the case. The 16 years of capital gains should not be taxed at the top marginal rate due to the breach. The breach is not commensurate with the penalty and such an outcome is manifestly unfair.
The industry was hoping the final ruling would get back to why the amendment was proposed in the first place – it was low or no interest LRBAs – not discounted admin expenses - that needed to be penalised with the legislative amendment.
The final ruling – LCR 2021/2
Disappointingly, the ATO view on general non-arm length expenses (NALE), as set out in LCR 2019/D3 and the example of Mikasa referred to above, remains in the finalised ruling. Pleasingly, there were some common-sense changes made in the final ruling; one of which is the NALE provisions would cease to apply if the arrangement changes for the 2021/22 year, so that the SMSF incurs arm’s length expenditure for the accounting services. In that situation, none of Mikasa’s SMSF income for the 2021/22 income year is NALI.
The finalised ruling also expands on what the ATO considers expenditure with potentially sufficient nexus to all income derived by the fund, including:
• actuarial costs
• accountancy fees
• audit fees
• costs in connection with the calculation and payment of benefits to members (eg, interest on money borrowed to secure temporary finance for payment of benefits and medical costs in assessing invalidity benefit claims)
• investment adviser fees
• other administrative costs incurred in managing the fund
LRBAs must be prefect from inception
LRBAs must be prefect from inception
Of some real concern is the situation outlined in example 4 of the ruling where an SMSF acquires an asset using a related party LRBA that is not on an arms-length basis. In this situation, all the rental income and any future capital gain will be considered NALI, even if the LRBA is subsequently refinanced on arm’s length terms. This seems a very harsh penalty, as there is no solution to rectify a non-arms-length LRBA, other than to wind it up, or incur 45% tax on ordinary and statutory income.
Once again, the legislative instrument was not designed for this purpose and the punishment does not fit the crime. Surely a better solution would be to levy NALI for the years the LRBA is not on commercial terms (or the safe harbour guidelines) and then allow the fund to be taxed at superannuation concession rates once the LRBA in on arms-length terms?
A conundrum clarified
A conundrum clarified
LCR 2019/D3 created conflict between the NALE provisions and s17A of the SIS Act. Section 17A of the SIS Act provides that a trustee must not receive any remuneration for services performed by the trustee in relation to the SMSF, other than those exempted under s17B (basically where the trustee is qualified to perform those services and does so in the ordinary course of their business). However, the ATO’s draft ruling LCR 2019/D3 stated the NALE provisions would apply where the SMSF trustee provided services to the SMSF in an individual capacity (say through their business thus potentially invoking s17B) but did not charge for those services due to the constraints of s17A.
The final ruling resolves the conflict by stating the NALE provisions will not apply where the trustee is performing those services in the capacity as trustee. The example provided is where a trustee, acting in that capacity, performs bookkeeping or accounting services for the fund for no remuneration.
The ruling goes on to say when the trustee [is
in another capacity, and either does not receive remuneration for those services or receives remuneration in accordance with the exceptions in section 17B of the SIS Act, NALE may apply where the fund incurs non-arm’s length expenditure.
The key therefore is that the individual must be carrying out those duties in their capacity as a trustee, rather than in any other capacity. This is illustrated succinctly in example 7 of LCR 2021/2:
LCR 2021/2 Example 7 – SMSF trustee carrying out duties – trustee capacity
Levi is the trustee of his SMSF of which he is the sole member. He is also a financial advisor and director of Levi and Co Financial Services Pty Ltd. Levi operates the business of Levi and Co Financial Services Pty Ltd from a commercial office and on regular occasions from his home. At home, Levi uses the computer and office equipment supplied by and paid for by the business.
When at home, but not while working or billing clients, Levi undertakes the bookwork and occasionally makes online investments for his SMSF using the computer and office equipment supplied by the business.
Levi performs these activities as trustee of his SMSF and does not charge the SMSF for this work. Levi’s use of the computer and office equipment at home is minor and incidental in nature and will not, of itself, indicate that he is undertaking these services in any capacity other than as trustee for his SMSF. 4
Employer discounts clarified (sort of)
The final ruling confirms if an SMSF is eligible for an employer discount, then NALE will not apply provided that discount is available to all employees, partners, shareholders or office holders.
This is shown in example 8 of LCR 2021/2, which provides that the discounted accounting services provided to Sasha, as a result of Sasha’s employment at the accounting firm, is not NALE as the staff discount rate is available to all staff of the firm. What is still unclear is where, say, different groups of employees are entitled to different discounts (for example, senior employees may be eligible for a higher discount than junior employees, or an older employee is on a different discount rate than new employees).
The general expense nexus remains – with a caveat
Perhaps due to the heavy-handed approach the ATO feels it must take with general expense NALE, it has included an Appendix in the final ruling full of conciliatory statements. The ATO even acknowledges its approach would lead to penalty tax being punitive:
Nevertheless, the Commissioner is alive to concerns that a finding that general fund expenses are non-arm's length is likely to have a very significant tax impact on the complying superannuation fund, even where the relevant expenses are immaterial.5
For this reason, from 1 July 2022, where the ATO applies any compliance resources for such general fund expenses, they will only be directed:
• for an SMSF - toward ascertaining whether the parties have made a reasonable attempt to determine an arm's length expenditure amount for services provided to the fund, other than services provided by an individual either acting in the capacity as trustee of the SMSF or as a director of a body corporate that is a trustee of the fund, and
• for a large APRA-regulated superannuation fund - toward reviewing supporting documentation that evidences that appropriate internal controls and processes are in place and that reasonable steps were taken to determine an arm's length expenditure amount.
The definition of what is a ‘reasonable attempt’ to determine arms-length expenditure is not clarified, but it may be similar to other aspects of non-arms-length dealings, such as benchmarking evidence.
Conclusion – the law needs to be changed
Given the ATO’s stance on the use of compliance resources (or lack thereof) to police the application of the general expense NALE provisions, it is clear to me the legislation needs to be re-written. They have taken the approach that a ‘general expense’ taints a fund’s entire income, both ordinary income and statutory income. They even acknowledge the absurd and brutal outcomes of their application of the law. It is important to note the ATO does not make the law, it only administers (and interprets) it. It therefore appears time the law in this area is changed so it is fair, sustainable and reflects a common-sense approach to these important issues that fundamentally impact the retirement savings of ordinary Australians.
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2 See item 7.4 in the June 2012 Superannuation Technical minutes of the NTLG.
3 Explanatory Memorandum (EM) to the Superannuation Legislation Amendment Bill (SLAB) (No. 2) 1999 paragraph 2.13.
4 Law Companion Ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement (paragraphs 55-57).
5 Law Companion Ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement (paragraph 91).
6 Law Companion Ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement (paragraph 92).