By Mark Ellem
The ATO has issued a draft guideline on how the proposed changes to the non-arm’s length income (NALI) rules will apply to superannuation funds, particularly SMSFs, and appears to provide a much narrower application than was initially thought after the release of the Bill and Explanatory Memorandum (EM) that contains the proposed amendments.
We have previously highlighted in our article, Non-arm’s length income: Rule changes pose difficulty, a potential conflict between the proposed new NALI rules which sit in the Tax Act, and the rules concerning SMSF trustees charging for services which sit in the SIS Act.
Whilst the proposed changes to NALI are currently before the Senate, the ATO has now provided guidance on how they’ll administer the changes.
It is worthwhile noting that if the Bill is not passed prior to the federal election being called, it would lapse and consequently the proposed changes will not apply unless they are re-introduced post-election and passed into law. From this perspective, it is interesting that the ATO has issued a guide on changes that are not law yet (and may never become law).
The proposed change to the NALI rules 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.
When the Bill and EM were first released, there was a concern that NALI changes may have a much broader application and would capture virtually all services that a trustee provides to their own fund on a non-arm’s length basis, aside from a small number of services a trustee performs in their capacity of trustee of the fund.
However, what the ATO’s draft ruling appears to be saying is that if the trustee provides a service to their fund and they are not able to charge their fund because they are not licensed to provide that service, the non-charging of that fee won’t invoke the new NALI rules. Here, the ATO seems to have considered that the trustee has provided the service in their capacity as trustee and consequently, per section 17A of the SIS Act, is prohibited from charging for the service.
The draft ruling states:
“The NALI provisions are not intended to apply to services provided by a trustee (or a director of a corporate trustee) of a complying superannuation fund in their capacity as trustee (or director of a corporate trustee)…Where an entity performs services in their capacity as a trustee (or a director of a corporate trustee) of a complying superannuation fund and does not charge for those services, this is not a non-arm's length arrangement for the purposes of the NALI provisions. Services of this kind do not form part of a non-arm's length scheme between the parties as they relate to the trustee's obligation in respect of the fund. For example, the NALI provision will not apply where a trustee performs book keeping or accounting services for the fund for no remuneration.”
Another example, in our view, would be where the SMSF owns a rental property and the trustee manages the property, rather than outsource to a real estate agent. The trustee collects the rent, arranges repairs (may even do some of the repairs themselves) and attends to paying the rental property bills. Here, the trustee is performing duties in their capacity as trustee – attending to the maintenance of fund assets in order to maximise member benefits.
However, as the draft ruling further explains:
“If, however, the trustee outsources its functions to third parties and the outsourcing arrangement is not on arm's length terms, the NALI provisions apply.”
So, when might this occur?
The draft ruling provides an example of an SMSF trustee, Sharon, who is also a licensed real estate agent and runs a real estate business, which includes property management services. The SMSF holds a residential property, which is leased. Sharon provides property management services in her personal capacity to her SMSF, that is, not in her capacity as trustee. Sharon only charges her SMSF 50% of the normal fee she would charge her real estate property management clients.
It would appear that the proposed new NALI rules would only apply where a service is provided to an SMSF, by the trustee or a related party and the trustee or related party is:
If the trustee provides a service to their SMSF and they are not able to charge their SMSF, because they are not licensed to provide that service, the non-charging of that fee won’t invoke the new NALI rules.
In the above Sharon example, the conclusion reached in the draft ruling was that the arrangement would be caught by the proposed changes to the NALI rules, resulting in the rental income from the rental property being treated as NALI and taxed at 45%.
However, we believe this example requires further clarification. The example refers to Sharon providing the service in her personal capacity so could it not be argued that Sharon has provided this service in her capacity as trustee and therefore is not permitted to charge her fund anything for this service under section 17B of the SIS Act?
Perhaps this example could be amended by removing the word ‘personal’ and referring to Sharon providing this service utilising the services and resources of her real estate business. In our view, it would then be clearer that the proposed new NALI provisions would apply as the service has been outsourced to a third party on non-commercial terms.
Whilst the draft ruling does allay concerns regarding the application of the proposed rules, in our view there needs to be more focus in the ruling on what constitutes a service a trustee performs in their capacity of trustee of the SMSF. For example, if a financial adviser provides investment advice to their own SMSF and doesn’t charge their fund for that advice, will that invoke the new NALI rules?
That type of service should constitute a service a trustee performs in their capacity of a trustee and, therefore, shouldn’t invoke the new NALI rules. But it’s difficult to reach that conclusion reading the ATO’s draft ruling and the Explanatory Memorandum. Further clarification would be welcome in the final version of the ruling (assuming the Bill is passed before the election is called).