Importance of documenting arm’s length dealings with related parties
Importance of documenting arm’s length dealings with related parties
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Navigating the complexities of superannuation can be daunting, especially regarding rules like non-arm’s length income (NALI). If you’re a trustee of a self-managed superannuation fund (SMSF), you might be wondering what NALI actually means and why the Australian Taxation Office (ATO) is so focused on it.
In this article, we break down NALI in plain English. We explain how it could affect your fund, what red flags the ATO is watching for, and most importantly, how you can stay on the right side of the rules. We also provide a detailed example to help bring it to life.
Understanding NALI: What SMSF Trustees need to know
A SMSF may be an appropriate entity to hold investments across asset classes including real estate. Where real estate is leased to a related party, it is essential that terms are commercial, appropriate documentation is used (e.g. a standard lease agreement on arm’s length terms), and importantly, Trustees document and retain records of the basis of the terms, including any correspondence or reports from professional third parties.
For example, if your SMSF owns an asset, like a property, and leases it to someone you’re connected with, the lease terms must be just like they would be with a stranger. That means charging a fair market rent, having a proper lease agreement in place, and keeping good records to show how you came up with those terms. Ideally, you’d also have supporting documents like independent valuations or professional advice
The ATO expects that:
- The price your fund pays or receives for assets reflects the true market value
- Any income earned from these assets is at a market rate.
If the ATO decides that your fund has received more income than it should have, because the deal wasn’t at arm’s length, that income could be taxed at 45 per cent, instead of the usual 15 or 0 per cent.
This is known as NALI, and it can apply to all sorts of situations, not just rent. For example, if your fund gets a loan from a related party at a super low interest rate, or if someone provides services to the fund for free or at a discount, that could also trigger NALI rules. Our example below will use an inflated rental income.
Trustees need to report any NALI income in their SMSF’s annual return (Item U) each year. Specifically, you’ll need to disclose any assets or loans involving related parties. These disclosures may prompt the ATO to take a closer look and ensure dealings are at arm’s length.
Our advice
If you’re dealing with related parties, make sure everything is done on commercial terms and keep clear records to prove it. This is the best way to avoid unexpected tax bills and stay on the ATO’s good side.
The ATO may rely on their own valuation even if you’ve provided one
Trustees should not assume that the ATO will automatically accept a valuation they’ve provided. During a review, the ATO may obtain its own independent real estate and/or rental income valuation. If the ATO believes the Trustee’s valuation is inaccurate, they may challenge it, so it’s important to ensure all information is up to date and accurate.
For example, we’re aware of a case where the ATO believed the rental income reported by a fund was too high. They supported their position with their own valuation of what they considered arm’s length rental income. However, upon closer review, it was discovered that the ATO’s valuation was based on an incorrect floor plan, i.e. the lettable area was less than the actual floor area shown on the final plans.
Once the ATO valuation was recalculated using the correct floor area, it closely aligned with the Trustee’s original valuation. In this instance, both parties agreed that the Trustee’s valuation provided was the most appropriate under the circumstances.
This example highlights two key points:
- Always obtain a proper valuation, especially when dealing with related party transactions
- Double-check the details. Make sure the valuer has used the correct and final information.
Trustees should also maintain clear records of all valuations and supporting documents, as these may be critical in the event of an ATO review.
What could go wrong, even if you get the lease right at the start?
Example scenario:
- An SMSF leases commercial property to a related party
- The lease has an initial term of five years, with an option to extend for a further five years
- Initial rent is set at $50,000 per year
- Rent increases annually in line with the Consumer Price Index (CPI)
- A market rent review is scheduled to at the end of year five, if the option is exercised
- The tenant is responsible for paying outgoings.
In this case, the Trustees did everything right. They obtained advice from a real estate professional to determine appropriate lease terms and engaged a lawyer to draft the lease. The arrangement was considered to be on arm’s length terms.
What happened next
At the end of the third year, the Trustees sought updated professional advice on the property’s value for audit purposes. The valuation showed the property had increased in value, and the market rent was now estimated at $80,000 per year.
Although the lease only required CPI increases until year five, the Trustees decided to start charging the higher market rent in year four, believing it was the right thing to do for the fund and fair to the related party tenant.
The issue
Trustees unintentionally created a non-arm’s length arrangement by charging above the lease-agreed rent before the scheduled market review. The ATO determined that the rent in year four was more than what an unrelated tenant would have paid under the lease terms. As a result, that year’s rental income was treated as NALI and taxed at 45 per cent after deducting directly related expenses.
What happens when NALI applies?
Since the lease was on arm’s length terms for the first three years, and the issue only arose in year four, the NALI tax rate would only apply to income from the year, provided the rent in year five reverts to the lease terms.
Important, because the property was originally acquired on arm’s length terms, the NALI issue does not taint the asset itself. This means any future capital gains on the property sale would still be taxed at the concessional superannuation rates.
What should you do if this happens to you?
Every SMSF is different, and there’s no one-size fits all solution. If you find yourself in a similar situation, we strongly recommend you contact your BDO adviser for assistance.
The best outcome is always to avoid the issue in the first place by sticking closely to lease terms and documenting any changes carefully.
Final thoughts
In summary, it pays to be proactive. Before entering into or changing any arrangements involving related parties, take a moment to check in with your accountant or adviser. A quick call or email could avoid a costly mistake.
And remember, our dedicated superannuation team is here to support you. Whether you need help navigating NALI, reviewing lease terms, or preparing for an ATO review, please contact us.
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