SMSF – Non-arm’s length income and expenses on ATO’s radar

SMSFs must transact on an arm’s length basis. The purchase and sale price of fund assets should always reflect the true market value of the asset, and the income from assets held by a fund should always reflect the true market rate of return. Any non-arm’s length income (NALI) is taxed at the highest marginal rate.

What is Non-Arm’s Length Income?

Broadly, income is considered non-arm’s length for a complying SMSF if it is:

  • derived from a scheme in which the parties weren’t dealing with each other at arm’s length, or
  • more than the SMSF might have been expected to derive if the parties had been dealing with each other at arm’s length.

Income derived by an SMSF as a beneficiary of a discretionary trust is also non-arm’s length income, as are dividends paid to an SMSF by a private company (unless the dividend is consistent with arm’s length dealing).

In addition, income from investments that have non-commercial conditions – for example, limited recourse borrowing arrangements with zero interest loans – may also be considered non-arm’s length income.

What is a Non-Arm’s Length Expense?

Like non-arm’s length income, non-arm’s length expenditure (NALE) is expenditure from an SMSF that is not at arm’s length.

Broadly, expense is non-arm’s length for a complying SMSF if:

  • the SMSF has purchased an investment at less than its market value, or
  • the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm’s length in relation to the scheme.
  • NALE also occurs when there is no expenditure. for example, if an SMSF borrows from a related party to buy an asset and no interest is payable, then all the income from that asset will be taxable in the SMSF at the top marginal tax rate.

Key considerations

Any income derived by a SMSF that is NALI or as a result of NALE will be taxed at the top marginal tax rate, rather than the concessional rates that apply to most income in an SMSF. Whilst the NALI rules have been around for many years, the NALE rules applied from 1 July 2018. Application of these rules are straightforward in some situations, but the ATO has caused concerns in the LCR 2021/2 which is now finalised.

The final view of the ATO provides SMSFs with some certainty regarding how these rules will be applied, the potential penalties for breaching these rules will be substantial. This highlights the importance of SMSFs understanding the ATO’s new position and the NALI and NALE rules more broadly.

Key actions

The ATO has previously advised it will not allocate compliance resources to determine whether the NALE changes will apply to SMSFs for the 2019, 2020 and 2021 financial years where the SMSF incurs expenditure of a general nature.

However from 1 July 2022, the fund auditors will scrutinize the related party transactions more aggressively and the Trustees of the SMSFs will risk paying the top marginal tax on the NALI or NALE. A common example is where a Business Real Property owned by an SMSF is leased to the related business and rent is not charged per market or the arrangement is not on an arms-length basis.

SMSF trustees must be aware of NALI and NALE and take appropriate action. Particular traps include:

  • making sure contributions of assets are properly and clearly documented
  • identifying related party transactions and the evidence required to substantiate the dealings
  • identifying services provided by trustees, and differentiating the capacity in which they are provided
  • checking the currency of rulings previously obtained about SMSF expenses at less than market value.

We strongly suggest that you see your SMSF advisor/accountant in relation to both NALI and NALE and in particular where you have related party lease, loans & other arrangements in place.

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