Q: The Government has passed a bill that cracks down on the use of super fund income strategies involving non-arm’s length income. I am a self-managed fund trustee and thought there were already rules in place to stop this sort of activity. What has changed?
A: You are right. There are already provisions covering this, but last month they were tightened up. The purpose of the non-arm’s length income (NALI) provisions is to prevent super fund earnings being inflated by non-arm’s length dealings, such as schemes involving non-commercial arrangements that stream income to the fund.
A non-arm’s length transaction occurs where individuals or entities are not dealing with each other on commercial terms. This could involve private company dividends, income from a managed investment scheme or trust distributions.
Strategies involving NALI can be used to increase superannuation fund savings in a way that is not caught by the contribution caps.
Under the NALI rules in place before last month’s amendment went through, any part of a super fund’s income (including a self-managed fund) that comes from a non-arm’s length arrangement is taxed at the top marginal rate, rather than the normal concessional rates, where the income is higher than if the trustee had been dealing at arm’s length.
It was not clear whether non-arm’s length expenses incurred by the superannuation entity in gaining or producing assessable income result in such income being included in the entity’s non-arm’s length component.
The effect of the amendment is that the definition of NALI has been expended, so that expenses incurred by a superannuation entity in gaining or producing assessable income result in such income being included in the non-arm’s length component.
The income of a super fund will be NALI and taxed at the top marginal rate where is a scheme in which the parties are not dealing with each other at arm’s length and one of two things occur:
- there is a loss, outgoing or expenditure in gaining or producing the income, which is less that what would be expected had the parties dealt with each other on an arm’s length basis; or
- a loss, outgoing or expenditure to acquire a fixed entitlement to the income of a trust or in gaining or producing income from a fixed entitlement that is less than would be expected had the parties dealt with each other at arm’s length.
For example, an SMSF acquires a commercial property from a third party at a commercial value. The SMSF derives rental income from the property. The SMSF financed the purchase under a limited recourse borrowing arrangement from a related party on terms that included 100 per cent gearing, no interest and no repayments for 25 years.
The SMSF has not incurred expenses that it might have been expected to incur in an arm’s length transaction. As such, the income derived from the scheme is non-arm’s length income.
In an example involving a fixed entitlement, a super fund trustee acquires units in a trust as a beneficiary with a fixed entitlement but pays a substantially lower amount for the units than stated in the promotional material for the trust.
In acquiring the units, the trustee did not incur expenditure it might have been expected to incur if dealing at arm’s length. The income derived is non-arm’s length income, as are any capital gains upon disposal.
Even though the Bill was passed last month it has an effective date of July 1, 2018 and covers the 2018/19 tax year. The reason is that Government announced it ages ago but only just got around to getting the bill passed.
The Australian Taxation Office website has updated 2019 SMSF annual return instructions to help trustees work out how to report any NALI amounts.
The ATO says: “If you’ve already lodged your 2019 SMSF annual return and are affected by these new measures, you may need to amend your return.”