Non-Arm’s Length Income (NALI) for SMSFs
NALI legislation has been part of our Australian Taxation laws for some time. However, changes to expand NALI to include non-arm’s length expenses (NALE) has been in effect since 1 July 2018. The Federal Government recently passed amendments to the NALE legislation into law on 28th June 2024. The amendments are retroactive to 1 July 2018 and related to general expenses.
What is Non-Arm’s Length Income (NALI)?
NALI is income which is higher than expected when dealing with non-arm’s length parties, usually members or their related parties, as part of a scheme.
There are broadly four types of NALI
- all dividends from private companies
- transactions where the parties are not dealing with each other at arms length
- trust distributions from fixed unit trusts
- trust distributions generally from discretionary trusts
If income from the above is consistent with an arm’s length transaction it will not be NALI.
Example -Sandra’s self-managed superannuation fund acquires 250,000 units in a private unit trust for 50c each unit totaling $125,000 on 1 January 2023. It is a non-geared unit trust as the trust holds a property which is used in Sandra’s business which is a medical practice, and it doesn’t have any borrowings or invests into any other entities. Sandra’s brother Peter and father Bill have also acquired 100,000 units each for $1.00 totaling $100,000 for each unitholder on 1 January 2023.
The market value of the units at 1 January 2023 was $1 each.
On 20 June 2024 all of the unitholders are paid a distribution of 10c per unit which was $10,000 to Peter and Bill and $25,000 paid to Sandra’s SMSF.
The rate of distribution per units held was the same for all unitholders. However, Sandra’s SMSF paid 50% less to acquire the units than the other related unitholders. Sandra’s SMSF trustee is not dealing with Peter and Bill on an arm’s length basis. As a result Sandra’s SMSF received higher income than would be expected if all parties were dealing at arm’s length. The dividend of $25,000 is taxed at 45% as all of it is considered NALI.
What is Non-Arm’s Length Expenditure (NALE)?
NALE is an expense which was part of a scheme and either was not incurred or was incurred but was less than what it should have been if the parties had been dealing with each other on an arm’s length basis.
NALE is either a specific expense incurred or a general expense. It can apply to a revenue or a capital expense.
Specific expense relates directly to earning or producing income from a particular asset. An example of this type of expense would be rental expenses such as management fees, rates, repairs & maintenance. The expense has a direct nexus with the relevant income flowing from the rental property.
A general expense does not have a direct nexus with a specific asset used to gain or produce income but has sufficient nexus to all of the income derived by the SMSF. Generally, expenses which are tax deductible under the ordinary deductible tax rules such as accounting fees, investment adviser fees and other administrative costs are considered by the ATO to have a sufficient nexus to the income of the fund.
If the nexus is insufficient the NALE rules do not apply. An example includes fees paid to a tax agent to manage the fund’s tax affairs or an actuarial certificate used to claim exempt current pension income. These expenses have no nexus to the fund earning ordinary or statutory income.
Example taken from the ATO Law Companion Ruling 2021/2
Example 2 – non-arm’s length expenditure incurred has a nexus to all income of the fund – NALI
- 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 SMSF. The accounting services include services other than those relating to complying with, or managing, the SMSF’s income tax affairs and obligations. The accounting firm does not charge the SMSF for those services as a result of non-arm’s length dealings between the parties (and not as part of any discount policy referred to in paragraph 51 of this Ruling).
- 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.
- Subsection 295-550(1) would cease to apply if the arrangement changes for the 2021-22 income year so that the SMSF incurs expenditure for the accounting services provided by the accounting firm of an amount that would have been expected to be incurred where the parties were acting at arm’s length. In this situation, none of the SMSF’s income for the 2021-22 income year is NALI.
Example taken from the ATO Law Companion Ruling 2021/2
Example 4 – purchase financed through a limited recourse borrowing arrangement on non-arm’s length terms – NALI
- During the 2018-19 income year, Kellie (as trustee of her SMSF) entered into a non-commercial LRBA with herself in her individual capacity to purchase a commercial property valued at $2 million. Her SMSF borrowed 100% of the purchase price and the terms of the loan included interest being charged at a rate of 1.5% per annum and repayments only being made on an annual basis over a 25-year period. Kellie’s SMSF received a commercial rate of rent from the property of $12,000 per month.
- If Kellie’s SMSF had entered into an LRBA on arm’s length terms, it would be expected that repayments of principal and interest would have occurred on a monthly basis and interest would be charged on the LRBA at a commercial rate. The loan to market value ratio would have also not exceeded commercial levels.
- For the purposes of subsection 295-550(1), the scheme involves the SMSF entering into the LRBA with Kellie, complying with the terms of the LRBA, purchasing the commercial property, and deriving the rental income. The terms of the LRBA constitute a non-arm’s length dealing between the SMSF and Kellie, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The rental income derived from the commercial property by the SMSF for all income years is therefore NALI, regardless of whether the LRBA is subsequently refinanced on arm’s length terms.
- The non-arm’s length expenditure incurred under the LRBA will also result in any capital gain that might arise from a subsequent CGT event happening in relation to the property (such as disposal of the property) being NALI. This will be the case regardless of whether the LRBA is subsequently refinanced on arm’s length terms.
Example taken from the ATO Law Companion Ruling 2021/2
Example 9 – SMSF trustee carrying out duties – different capacities
- Trang is the trustee of her SMSF of which she is the sole member. She is also a plumber by trade and runs her own business as a sole trader in which she also employs an apprentice, Novee.
- Trang’s SMSF has two investment properties which are leased for a commercial rate of rent.
- After finishing work for the day, Trang stops by one of the SMSF’s investment properties to connect a stand-alone water filter provided (and to be taken away at lease end) by the tenant. She uses some of her tools of trade to complete the installation.
- Trang performs this activity as trustee of her SMSF and does not charge the SMSF for this work. Trang’s use of the tools of her trade in respect of this property is minor, infrequent or irregular in nature and will not, of itself, indicate that she is undertaking these services in any other capacity other than as trustee for her SMSF. Accordingly, the non-arm’s length expenditure provisions will not apply.
- In respect of the second SMSF rental property, Trang undertakes a complete renovation of the bathroom and kitchen. She schedules time in her work calendar to undertake the work and uses the tools of her trade to undertake all plumbing work on the renovations. She also engages Novee in all works.
- Trang does not charge the SMSF for the work undertaken in respect of the second SMSF rental property.
- In this instance, Trang’s use of the tools of her trade will not be considered minor, infrequent or irregular in nature. Considering all her activities, she will be considered to be undertaking these services in her individual capacity, rather than as trustee for her SMSF.
- For the purposes of subsection 295-550(1), the scheme involves the SMSF obtaining the services from Trang and deriving the rental income. Trang not charging the SMSF for the services provided constitutes a non-arm’s length dealing between the SMSF and Trang, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme.
- As such, there is sufficient nexus between the non-arm’s length expenditure and the rental income derived from the second SMSF rental property. The rental income will therefore be NALI. The non-arm’s length expenditure will also result in any capital gain that might arise from the subsequent disposal of the second SMSF rental property being NALI.
Tax Implications of NALI
NALI is taxed at 45% being the highest marginal tax rate for an individual. Specific expenses which are caught under NALI may taint the asset for life. All income in relation to that asset as well as future capital gain will potentially be taxed at 45%. There is no fix. Unlike general expenses which capped NALI by a multiplier of 2. Any NALI forms part of the non-arm’s length component (NALC) of the fund’s assessable income. The total NALC cannot exceed the SMSF’s assessable income minus deductions and excluding assessable contributions and deductions against them. Furthermore, in the year in which the general expense is paid on a commercial basis the income is no longer tainted.
NALI is still taxed at 45% regardless of the fund being in pension mode. Exempt current pension income excludes NALI.
Example – Andrew’s is a partner is an accounting firm and his SMSF was not charged for accounting services to prepare the annual accounts. The fees would have been $4,500. The tax is calculated as follows:
$4,500 x 2 = $9,000 (multiplier)
45% x $9,000 = $4,050 (NALI tax)
There is a further cap being the fund’s actual taxable income. If it was $4,000 the above multiplier would be capped at $4,000.
ATO Guidelines for NALE
NALE is retroactive legislation which reaches back to 1st July 2018. From an administrative approach the ATO are not allocating any resources to determine if a SMSF has breached the general NALE rules in relation to the period 1 July 2018 to 30 June 2023. Essentially there was an amnesty in place which ceased on 1 July 2023.
However, the ATO will reach back to 1 July 2018 in relation to specific expenses which they consider to be NALE which are directly related to income derived by the fund.
Avoiding NALI and NALE in SMSFs
Leasing property to a member of the fund
- prepare and execute a formal lease agreement with commercial terms and conditions
- ensure rent is collected in accordance with the lease
- obtain a formal rent valuation to support the lease terms
Loan to a related company (within the 5% in-house asset threshold)
- prepare and execute a loan agreement to reflect commercial terms and conditions
- obtain supporting evidence of the terms used in the agreement
- ensure the loan is repaid in accordance with the loan agreement
- consider security over the loan
Building services acquired from a fund member
- ensure there is a formal contract with commercial terms and conditions
- pay commercial rates to the member
- obtain supporting evidence of the fees paid to the member
- pay the member from the fund’s bank account
Common Questions in relation to NALI and NALE
I am a licensed real estate agent and run my own real estate business. My super fund owns a residential property which is leased to an unrelated party, but I want to ensure I maximise the profit to support my retirement, and I do not charge my SMSF for managing the property. Is this NALE?
Yes, it potentially is caught as no expense was incurred by the fund. If an unrelated party used your services a fee would have been charged. Any rental income earned, and the future capital gain is tainted and may be taxed at 45%. Unfortunately, the current legislation does not allow any other resolution.
My SMSF owns a rental property. I have my own building business. I repaired the screen door for the tenant but didn’t charge a fee. Is this NALE?
It is unlikely to be NALE as the service was minor and incidental.
My SMSF owns a farm which is used in a primary production business which I run. I repair the fences. Are there any NALE issues I should be aware of?
Review the lease agreement to determine who is responsible to maintain the fences. If the tenant is then that is ok there is no NALE issue. If you undertake the repairs in your capacity as trustee then this should not impose any NALE issues as repairs and maintenance of fund assets would fall under a normal trustee duty and as you do not offer that service to the public.
Key Takeaways
- NALI is income which is higher than expected if the SMSF was dealing with an arm’s length party
- NALE is an expense which was not incurred or lower than expected if the parties were dealing on an arm’s length basis
- general expenses have a nexus to all of the fund’s assets
- specific expenses have a direct nexus with a specific asset of the fund
- NALI is taxed at the highest marginal tax rate of 45%
- tax on general expense NALE is capped by a multiplier of 2 and the total NALC cannot exceed the fund’s actual assessable income of the fund adjusted for assessable contributions and deductions
- the Australian Taxation Office were not taking compliance action in relation to general NALE but the amnesty ceased on 1 July 2023
- income is not deemed to be NALI or NALE provided all transactions are undertaken on an arm’s length basis
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