The government has recently passed legislation to reduce the ambiguity surrounding the effect of non-arm’s length expenditure (NALE) on SMSFs.
To accompany the new legislation, the ATO has published LCR 2019/D3 to clarify their view of how the recently enacted law applies within situations giving rise to non-arm’s length income (NALI). The following examples are situations giving rise to NALI:
Trustee Uses Their Professional Services Firm (Non-Asset Related)
The partner of an accounting firm who is the trustee of their SMSF uses the firm to provide accounting services to the fund, but no fee is charged. In this case, the trustee is not acting as a trustee but has provided services that are undertaken by a third party.
The SMSF has acquired the services under a non-arm’s length agreement providing a connection between the NALE and fund income that classifies all of the SMSF’s income for the financial year as NALI.
Trustee Uses Their Professional Services Firm (Asset Related)
The trustee of a fund is a licensed real estate agent and provides property management services to the SMSF as a licensed real estate agent. The fund is charged 50% of the fee than would be otherwise charged to a non-related party.
There is sufficient nexus between the NALE and rental income derived from the residential property such that all rental income will be NALI as long as the non-arm’s length deal remains in place.
ATO has said that SMSFs will not be investigated for NALI where the fund incurred NALE of a general nature, such as NALE on accounting services. Please note this transitional compliance approach does not apply where the fund incurred NALE directly relating to the fund deriving particular ordinary or statutory income during these years.
The legislation applies to all other fund activities and assets that are not undertaken on commercial terms from the 2019 financial year onwards, regardless of whether the scheme was entered into before 1 July 2018.
This can create significant tax implications for SMSFs. The fund’s income will be taxed at the highest marginal rate and applies regardless of whether the fund is in pension mode.
Note that NALI is not a compliance breach but a tax issue. The auditor will only need to include details in the management letter relating to the issue and that the tax calculation has been misstated. If the amount is material then Part A of the audit report will be qualified and is now reportable on the fund’s income tax return.
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