SMSF NALI rules to be strengthened

Legislation has been tabled into parliament which will strengthen the rules in which self-managed superannuation funds (SMSF) are being taxed for non-arm's length income (NALI) purposes.

In particular, the amendments to the current NALI provisions make it clearer that schemes as a whole are included in the Act. This includes schemes from both an income and expenditure perspective. If passed, the legislation is due to be applicable for the 2018/19 income year, and will include schemes that were entered into before 1 July 2018.

Current NALI rules

Currently, ITAA 1997 s 295-550 states that NALI applies if:

·         it is derived from a scheme where the parties involved in the transaction are not dealing with each other at arm's length

·         the amount received by the SMSF is more than what could have been earned if the parties were dealing at arm's length.

Where this section is clear in situations of overpaid income amounts into an SMSF, it creates a practical ambiguity with instances of underpaid expenses from the SMSF. In particular, situations may exist when an SMSF holds commercial property assets leased to a related party.

Currently, there are no legislative rules surrounding the in-house asset treatment for related party commercial properties under a limited recourse borrowing arrangement (LRBA). The ATO has previously released guidance surrounding "safe harbour" terms of an arm's length LRBA. However, this is the Commissioner's interpretation of arm's length and is not supported by legislative or judicial concurrence.

Also, an SMSF auditor cannot bring any NALI issues to the regulator due to wordings around SIS Act s 109. Specifically, s 109, which is a reportable contravention, relates only to the investment transaction, or whether the trustee was "required to deal" with another party during the financial year. Therefore, it is arguable that arrangements which are not on "safe harbour" terms are not a SIS breach. Only s 82 may be a breach if the under-reported interest (or accrued liability) is greater than 5% of the total value of assets.

Alternatively, an auditor could qualify the financial audit in the instance where the "Provision for Income Tax" is materially misstated. However, this qualification is also based on whether there was a specific breach of NALI rules. At any rate a financial audit qualification is not a reportable breach, either via contravention report or by the SMSF annual return.

Proposed strengthening of rules

The above pitfalls relating to NALI are proposed to be strengthened by specifically including a provision for NALI where expenses of the fund are understated. Also, NALI will exist where the fund does not incur an expense at all when it should have under normal circumstances.

Risk mitigation steps

Any SMSF currently operating outside the "safe harbour" guidelines based on their arguable position should be advised that new legislation is pending. If the proposed legislation passes through the parliamentary process, it is advised that any non-arm's length dealings are re-worked to be compliant with the Act.

SMSF internal arrangements

Despite the legislation, there are specific carve-outs where the new NALI rules will not apply in situations where SMSF "reduced expense" arrangements are purely internal. A couple of examples of this are listed in the explanatory memorandum are where an SMSF trustee:

·         undertakes bookkeeping activities for the SMSF in lieu of engaging a licensed bookkeeper

·         provides property management services for the SMSF in lieu of contracting a real estate agent.

 Information sourced using CCH iknow