Self-managed superannuation funds generally provide their members with greater control and flexibility over the types of investments that are selected to fund investments.
As a result, you see a significant minority of these funds make investments such as purchasing real property or investing in unlisted companies and unit trusts, which are associated with members of the funds.
Naturally, the fact that these investments are unlisted, and therefore not subject to the normal scrutiny that ASX listed shares may be subjected to, can mean that ordinary income or capital gains that are derived from these sources could be inflated. The temptation to inflate the income or capital gains comes from the face that the income may be taxed at lower income tax rates inside the fund than it would be if received and taxed in the hands of an individual or company.
A scheme that was relatively common up until 2016 involved a fund that would borrow to purchase an asset. While there were strict rules regarding the way in which the borrowing was structured, there was nothing in the legislation that said the fund could not borrow from a related party or a member.
The scheme that developed, involved the fund borrowing from say a member of the fund at zero interest, to acquire an asset that would produce an arm’s length income. Therefore, the fund derived an income, which was taxed at concessional tax rates, but the fund did not incur the expenses that would normally be incurred in deriving this income, resulting in inflated income.
Unsurprisingly, the Australian Taxation Office considered this a loophole in the legislation and it has been amended from 1 July 2018. So what do fund trustees need to consider now that the law has changed?
The amended legislation
Fundamentally, there are three aspects of the amended legislation that are likely to impact on SMSFs when they are dealing with related parties (i.e. members of the fund and their associates), on a non-arm’s length basis.
The amended provision applies where an SMSF derives income under a scheme entered into between the fund and the other party, and:
- The amount of the income is more than the amount of income that SMSF might have derived, had the parties been dealing with each other at arm’s length in relation to the scheme; or
- In the process of deriving the income the SMSF incurs a loss, outgoing or expenditure that is less than what would be expected to be incurred had the parties being dealing with each other at arm’s length in relation to the scheme; or
- In the process of deriving the income, the SMSF does not incur a loss, outgoing or expenditure that it would normally expect to incur if the parties were dealing with each other at arm’s length in relation to the scheme.
To simplify the provision, income is at risk of being non-arm’s length income where it is derived under a scheme where the parties are not dealing with each other at arm’s length, in three circumstances:
- The income is greater than would be expected had the parties been dealing with each other at arm’s length
- An expense attributed to the derivation of income is less than expected, or not incurred at all, in non-arm’s length situation
- An expenditure or outgoing attributed to the derivation of income (such as the purchase price of an asset) is less than expected or not incurred at all under a non-arm’s length scheme.
The change is going to have wide ramification for many parties dealing with an SMSF. Fortunately, the ATO has provided BDO with some guidance on how the legislation is likely to apply in draft ruling LCR 2019/D3, which contains a large number of examples on how the legislation is likely to apply.
Case study one
During the 2018 -19 year Fred owns a commercial property valued at $800,000. The property is transferred from himself to his SMSF for a purchase price of $300,000. The fund then leases it to a related party.
The ATO view of this transaction is that the scheme involves the transfer of the property from Fred to the SMSF at less than an arm’s length price. There is a sufficient nexus between the non-arm’s length expenditure incurred in acquiring that property and the rental income the SMSF derives from leasing the property for the rental income to be non-arm’s length income. Further, there will be a sufficient nexus between the non-arm’s length expenditure and any capital gain derived on the disposal of the property for the capital gain to be non-arm’s length income.
Case study two
Sharon is a trustee of an SMSF of which she is the sole member and trustee. She is a licenced real estate agent and runs a real estate business, which includes property management services for rental properties. The SMSF holds a residential property, which it leases for a commercial rate of rent. Sharon provides property management services to the SMSF as a licenced real estate agent. She utilises the equipment and assets for her business in performing these services. Her actions are covered by applicable insurance policies in respect of the business. Accordingly, Sharon provides property management services in her individual capacity to the SMSF with respect to the residential property. She charges the SMSF 50% of the price for her services that she would otherwise charge a non-related party.
For the purpose of subsection 295-550(1), the scheme involves the SMSF obtaining the services from Sharon and deriving rental income. The price Sharon charges the SMSF constitutes a non-arm’s length arrangement between Sharon and the SMSF, which result 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 residential property. The rental income will therefore be NALI for each year the non-arm’s length dealing remains in place.
If you have any questions around non-arms length income and your SMSF, contact a BDO Private Wealth Adviser.
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