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Non-arm’s length income: Rule changes pose difficulty

Nov 20, 2018, 16:18 PM

By Mark Ellem

Mark Ellem SuperConcepts SMSF expert

You might find yourself in a bit of a conundrum, owing to a proposal currently in front of the Senate. Let me explain.

SMSF trustees have several pieces of legislation to comply with, the two main ones being the Superannuation Industry (Supervision) Act & Regulations, known as ‘SIS’, and the Income Tax Assessment Act 1936 and 1997 (yes, we still have two tax acts!). When trustees are dealing with an event or transactions, not only must they ensure they don’t contravene SIS, but also must consider any tax ramifications.

The Senate is now deliberating a Bill which includes amendments to non-arm’s length income (NALI) rules. These amendments would effectively deem income earned by a fund as NALI where – despite the gross income being commercial – expenses associated with the income are not commercial, including where no expenses are charged.

Where NALI rules don’t apply …

The Explanatory Memorandum to the Bill (‘Memorandum’) states that the NALI rules do not apply in respect of a superannuation entity’s arrangements that are purely internal. This is because an entity’s internal functions are not undertaken with another party on any terms, non-arm’s length or otherwise.

The example provided in the Memorandum of an internal function is where an SMSF trustee undertakes book keeping activities for no charge in performing their trustee duties. The Memorandum explains that “Such internal arrangements are outside of the scope of the non-arm’s length income rules as they do not constitute a scheme between parties dealing with one another on a non-arm’s length basis”.

… and where they do

An example of where NALI rules apply, according to the Memorandum, is where the SMSF has a rental property and, rather than outsource the management of the rental property to a real estate agent, the SMSF trustee attends to it themselves. In this scenario, where the SMSF trustee charges a less-than-commercial fee for managing the rental property, including no fee at all, then the NALI rules are intended to apply. This would mean that that the net income from the rental property, including any capital gain on disposal, with be taxed at the top marginal rate, currently 45%.

New focus on the expense/income nexus

It appears that, rather than distinguishing between internal and external arrangements to see if the new NALI rules apply, there is a greater focus on whether expenses can be distinctly associated with a source of income. With the bookkeeping services, they could also be outsourced, however, the expenses themselves cannot be specifically associated with a source of income, rather, they relate to the fund as a whole. However, the property management costs (or lack of any cost), can be specifically linked to the income of that property.

Tension between new NALI rules and SIS requirements 

Now, keep in mind that these proposed new NALI rules reside in the Tax Act, the 1997 one. However, an SMSF must also comply with SIS and this is noted in the Memorandum:

“As a general rule, the trustee of an SMSF is prevented from charging for the services or functions that it undertakes in its capacity as trustee by paragraph 17A(1)(f) of the SIS Act”.

It is further noted, in the Memorandum, that section 17B of the SIS Act:

“permits a trustee to charge up to an arm’s length amount for duties or services performed other than in the capacity as trustee”.

Yes, this is correct, but not the whole story. For a trustee to charge for management of the fund’s property, it must comply with all of s.17B. That is:

  1. the trustee is appropriately qualified, and holds all necessary licences, to perform the duties or services; and
  2. the trustee performs the duties or services in the ordinary course of a business, carried on by the trustee, of performing similar duties or services for the public; and
  3. the remuneration is no more favourable to the trustee than that which it is reasonable to expect would apply if the trustee were dealing with the relevant other party at arm's length in the same circumstances.

If the SMSF trustee cannot show that they are appropriately qualified, hold the necessary licenses to be a property manager and are carrying on a business of property management, then they do not comply with s.17B. How many SMSF trustee will comply with all of the requirements of 17B?

Let’s change the asset from property to listed securities. Costs associated with managing a listed stock portfolio can be associated with the income from that same portfolio. The management of that portfolio can also be outsourced. If the SMSF trustee manages the portfolio themselves and charges a commercial fee to do so (in order not to have NALI), will they comply with 17B? That is, are they a licensed financial adviser (appropriately qualified and holding the necessary licenses) and do they operate a business providing such a service to the public?

So, is it a case of “have NALI and don’t breach 17B” or “have no NALI but breach 17B”? Quite the conundrum.