The net widens for non-arm’s length income

27 October 2020

Mark Wilkinson , Partner, Private Wealth |

When you invest in a superannuation fund, one of the benefits you expect to receive as a member is that fund income will be taxed at a concessional tax rate of 15% (10% for capital gains where the asset is held for longer than 12 months) or 0% after the retirement phase pension commences.

Although this is a common expectation, it is not always the case. Some fund trustees could be tempted to funnel income that would normally be derived by other entities into the superannuation fund, where it is taxed at concessional tax rates.

To prevent this from occurring, Section 295-550 of the Income Tax Assessment Act 1997 treats fund income as non-arm’s length income and taxes it at 45%. Specifically, when:

  • Parties were not dealing with each other at arm’s length in relation to the scheme and derived ordinary or statutory income is more than what might have been expected if those parties had been dealing with each other at arm’s length
  • Parties were not dealing with each other at arm’s length in relation to the scheme and they derived income as a beneficiary of a trust by holding a fixed entitlement to the income of the trust. Also, the fund acquired the entitlement under a scheme, or the income was derived under a scheme, and the amount of income is more than what might have been expected to have been derived in those parties had been dealing with each other at arm’s length.

While the above measures address the derivation of non-arm’s length income, they do little to address excessive income in a fund where it was derived because of reduced or non-charging of expenses.

Non-charging of expenses

The non-charging of expenses or the purchase of assets at less than market value is addressed in amending legislation that became operative on 1 July 2018. As a result of these amendments, ordinary or statutory income will be subject to tax as non-arm’s length income, where:

  • There is a scheme in which the parties were not dealing with each other at arm’s length
  • The fund incurs a loss, outgoing or expending of an amount in gaining or producing the income
  • The amount of the loss, outgoing or expenditure is less than the amount 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.

These changes will have a significant impact on trustees where the fund has not charged an arm’s length fee for services provided or charged a fee at all.

For the legislation to apply, a scheme must first exist. The Australian Taxation Office (ATO) defines a scheme as “any arrangement or any scheme plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.”

Given the breadth of the definition, any arrangement under which a fund and a related party agreed to provide services to each other would likely fall into the definition of a scheme, if in doing so they agreed the fee charged for the service would be less than an arm’s length value.

The final step in determining the application of Section 295-550 with respect to expenses, is to see whether there is a sufficient nexus between the expenditure incurred at less than an arm’s length amount and the income derived by the fund. To see how easy it is for a nexus to be established, it is worth reviewing one of the examples contained in Law Companion Ruling 2019/D3.

“Non-Arm’s Length Income (NALI) expenditure incurred has a nexus to all income of the fund.

For the 2020-2021 income year, Mikasa as trustee of her Self-Managed Superannuation Fund (SMSF) engages an accounting firm, where she is a Partner, to provide accounting services for the fund. The accounting firm does not charge the fund for those services.

For the purpose of Subsection 295-550(1) the scheme involves the SMSF acquiring the accounting services under a non-arm’s length expenditure (being the nil amount incurred for the services). All the SMSF income for the 2021-2022 income year is NALI.

To use the above as an example, had Mikasa not charged her fund an arm’s length amount, her assets of $3 million earning a net return of 5% (equivalent to $15,000), would have resulted in the income being taxed at 45% instead of the ordinary income rate of 15%. This would result in an additional tax liability of $45,000.

In the above example, the ATO is of the view the discounted expense has sufficient nexus to the entire fund income. The example below demonstrates how the situation can be almost as bad if the expense is linked to a single income stream.

Sharon is a trustee of an SMSF of which she is the sole member. She is a licensed 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 of her business (including the business website) in performing these services. Her actions are covered by the 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 fund obtaining the services from Sharon and deriving the rental income. The price Sharon charges the SMSF constitutes a non-arm’s length dealing between the SMSF and Sharon, which results 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 from the residential property. The rental income will therefore be NALI for each income year the non-arm’s length arrangement remains in place.

The ATO has announced that a transitional arrangement will be put in place, so that if the NALI expense does not relate to a specific income stream, the ATO will not take any action to enforce the legislation until after 30 June 2021. However, if the expense nexus applies to a specific income stream, like the rental income stream above, the provisions apply from 1 July 2018.

Great care is required to ensure an arm’s length fee is charged for services provided by members or associates of SMSF trustees, where it is possible to do so.

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