26 August 2021
By Shaun Backhaus, Senior Associate and Daniel Butler, Director, DBA Lawyers
Non-arm’s length income (NALI) has recently become one of the hottest and most contentious topics in the superannuation industry that impacts both large APRA and self managed superannuation funds (SMSFs).
This is largely due to the finalisation of the ATO’s Law Companion Ruling LCR 2021/2, which outlines the ATO’s view of the application of the new non-arm’s length expenditure (NALE) provisions. The ATO’s interpretation regarding NALE, especially its view that a general fund expense has a sufficient nexus to all of a fund’s ordinary and statutory income (including capital gains and concessional contributions), has given rise to a refocus on NALI and how NALE is linked to NALI.
While NALE is currently in the spotlight advisers also need to be on top of the different heads of possible exposure under the NALI provisions. This technically speaking bulletin goes back to the basics of the NALI provisions and provides an overview of these provisions. Given the ATO’s views reflected in LCR 2021/2 every SMSF adviser should have a good understanding of NALI and NALE as these provisions can readily apply in many SMSF contexts. Failure to properly consider these aspects may result in an SMSF being taxed at 45% and leave advisers exposed to liability.
Current law and types of NALI
Broadly, there are four different types of NALI covered in s 295-550 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). We will refer to these as:
- General NALI (includes NALE) found in s 295-550(1);
- Dividend NALI found in s 295-550(2) and (3);
- Non-fixed trust entitlement NALI found in s 295-550(4); and
- Fixed trust entitlement NALI found in s 295-550(5).
Section 295-545 provides that the taxable income of an SMSF is split into a non-arm’s length component and a low tax component. While the low tax component of a superannuation fund is subject to a 15% rate of tax (or zero on assets in pension or retirement phase) the non-arm’s length component is subject to a 45% tax rate (Income Tax Rates Act 1986 (Cth), s26).
Background to NALI
Section 273 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) was initially introduced to counter higher than arm’s length dividends in private companies being paid to superannuation funds and to counter certain other non-arm’s length transactions.
On 25 November 1997 the ITAA 1936 was expressly amended so that NALI caught certain trust distributions to superannuation funds. Insight into what strategies were developing in practice at the time were noted in Allen (Trustee), in the matter of Allen’s Asphalt Staff Superannuation Fund v FCT [2011] FCAFC 118 (Allen’s) at [60] where the following extracts from the explanatory memorandum to the Superannuation Legislation Amendment Bill (No 2) 1999 (Cth) appear:
2.14 The ATO has become aware of arrangements which circumvent section 273. Under the arrangements, pre-tax income of a trust (usually a discretionary trust) is distributed to a complying superannuation fund set up for the benefit of the beneficiaries of that trust rather than to the beneficiaries themselves. The effect of the arrangements is that the income is taxed at only 15% as income of the superannuation fund rather than at the marginal rate of tax applicable to other beneficiaries.
2.15 It is doubtful whether subsection 273(4) of the ITAA 1936, which seeks to tax income derived by a superannuation entity from a non-arm’s length transaction at the non-concessional rate of 47%, would catch these discretionary trust distributions.
Note that the rate applicable to NALI in late 1999 was 47%.
Section 273 from 25 November 1997 largely remained unchanged until mid-2007 when it was replaced by s 295-550, which took effect on 1 July 2007. The mid-2007 superannuation reforms broadly resulted in pt. IX of the ITAA 1936 being replaced by pt. 3-30 of the ITAA 1997 and s 295 550 was largely a restatement of s 273 of the ITAA 1936 in more modern language. As set out in TR 2006/7, to the extent that s 295-550 expresses the same ideas as s 273 of the ITAA 1936, the ruling is also taken apply to s 295-550.
Section 295-550 taxes trust distributions as NALI by reliance on much the same wording as in s 273(6) and (7) which are now reflected in s 295-550(4) and (5). However, s 295-550(1) from 1 July 2007 expressly covers statutory income (eg, assessable capital gains and franking offsets) as well as ordinary income. It is interesting to note that s 295-550(4) and (5) still refer to ‘income’ rather than ‘ordinary income’ and ‘statutory income’. (It is not clear if this was an oversight by the draftsperson or an intended outcome given that the Allen’s decision broadly held that ‘income’ in s 273, being an anti-avoidance provision, included an assessable capital gain (ie, statutory income). Note that the decision in Allen’s case was decided after the High Court’s decision in F C of T v Bamford & Ors; Bamford & Anor v F C of T [2010] HCA 10 which confirmed, broadly, that the term ‘the income of the trust estate’ has ‘a content found in general law of trusts’ (broadly, that ‘income’ means ‘ordinary income’ and not ‘statutory income’).
In 2018, Treasury carried out a consultation process regarding changes to the NALI rules as part of the Superannuation Taxation Integrity Measures Consultation Paper. Treasury considered that the rules in place did not take into account fund expenditure incurred that would normally apply in a commercial transaction. The 2018 consultation paper and exposure draft legislation was aimed at assessing non-arm’s length related party limited recourse borrowing arrangements (LRBAs).
After an initial bill lapsed in 2018, the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2019 (2019 Bill) received royal assent on 2 October 2019. The 2019 Bill re-cast ss 295-550(1) and (5) to expressly provide for arrangements where a Super Fund trustee incurred no expenses or lower expenses than might have been expected had they been dealing at arm’s length.
General NALI
Section 295-550(1) provides:
(1) An amount of ordinary income or statutory income is non-arm’s length income of a complying superannuation entity if, as a result of a scheme the parties to which were not dealing with each other at arm’s length in relation to the scheme, one or more of the following applies:
(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme;
(b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme;
(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.
This subsection does not apply to an amount to which subsection (2) applies or an amount * derived by the entity in the capacity of beneficiary of a trust.
The General NALI provisions are very broad and importantly, are not concerned with the actual amount of the benefit obtained by an SMSF above what would have occurred had the parties been dealing at arm’s length but rather that the amount of income is higher (or expense lower). That is, the provisions do not take a proportional approach to the amount but rather deem all income from the arrangement to be NALI.
The first step for the General NALI provisions to be applied is to determine whether a ‘scheme’ exists.
The definition of scheme in s 995-1 of the ITAA 1997 is so broad as to provide little assistance. It provides:
“scheme” means:
(a) any arrangement; or
(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.
Based on this definition, in practice it can usually be assumed that the SMSF trustee is a party to a scheme. At times, identifying what steps or actions form the relevant scheme and the parties to the scheme can be contentious.
The second step is to determine whether the parties to the scheme were dealing at arm’s length. Section 995-1 of the ITAA 1997 provides the following as a definition of arm’s length:
“arm’s length”: in determining whether parties deal at arm’s length consider any connection between them and any other relevant circumstance.
It has been said that this definition contains a direction about how to determine whether parties are dealing at arm’s length rather than a definition or explanation of the expression (The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation [2012] AATA 527 (Ghali), [48]).
A useful explanation of ‘arm’s length’ is APRA v Derstepanian (2005) 60 ATR 518, [18]):
… a dealing that is carried out on commercial terms. … a useful test to apply is whether a prudent person, acting with due regard to his or her own commercial interests, would have made such an investment
Another explanation was provided in Granby Pty Ltd v FCT [1995] FCA 259 as follows:
… the term “at arm’s length” means, at least, that the parties to a transaction have acted severally and independently in forming their bargain.
As noted above, in LCR 2021/2, the ATO view is that NALE that is a lower general fund expense taints all of a fund’s ordinary and statutory income as NALI (see para 19). In contrast, the ATO’s view is that where NALE is incurred to acquire an asset (including associated financing costs) it will have a sufficient nexus to all ordinary or statutory income derived by the fund in respect of that asset (see para 18).
The ATO’s PCG 2020/5 states that:
The ATO will not allocate compliance resources to determine whether the NALI provisions apply to a complying superannuation fund for the 2018-19, 2019-20, 2020-21 and 2021-22 income years where the fund incurred non-arm’s length expenditure (as described in paragraphs 9 to 12 of LCR 2019/D3) of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, non-arm’s length expenditure on accounting services).
The ATO proposes further administrative relief from 1 July 2022 in the Appendix to LCR 2021/2. Paragraph 92 states that in context of general expenses, the ATO’s compliance resources will only be directed:
for an SMSF – toward ascertaining whether the parties have made a reasonable attempt to determine an arm’s length expenditure amount for services provided to the fund, other than services provided by an individual either acting in the capacity as trustee of the SMSF or as a director of a body corporate that is a trustee of the fund
Clearly the General NALI provisions are exceedingly broad and provide the ATO a wide opportunity to apply these provisions in a general anti-avoidance way.
Dividend NALI
Sections 295-550(2) and (3) provide:
(2) An amount of ordinary income or statutory income is also non-arm’s length income of the entity if it is:
(a) a dividend paid to the entity by a private company; or
(b) ordinary income or statutory income that is reasonably attributable to such a dividend;
unless the amount is consistent with an arm’s length dealing.
(3) In deciding whether an amount is consistent with an arm’s length dealing under subsection (2), have regard to:
(a) the value of shares in the company that are assets of the entity; and
(b) the cost to the entity of the shares on which the dividend was paid; and
(c) the rate of that dividend; and
(d) whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and
(e) whether the company has issued any shares to the entity in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue; and
(f) any other relevant matters.
The ATO’s position in relation to private company dividends and NALI is outlined in some detail in TR 2006/7. In TR 2006/7, the ATO explains what amounts are to be considered as ‘special income’ under the former s 273 of the ITAA 1936. (As set out in TR 2006/7, to the extent that s 295-550 expresses the same ideas as s 273 of the ITAA 1936, the ruling is also taken to apply to s 295-550.)
Two notable cases where NALI was applied to dividends derived by an SMSF from private companies include Darrelen Pty Ltd v Commissioner of Taxation [2010] FCAFC 35 (Darrelen) and GYNW and Commissioner of Taxation [2019] AATA 4262 (GYNW).
Darrelen involved a case where an SMSF acquired shares in a private company at less than 10% of the market value of those shares. The dividends in each of the relevant years of income were far in excess of the purchase price which the trustee of the Fund had paid for the shares. In this regard, against an acquisition cost of $51,218 (paid in October 1995), the trustee of the fund received dividends as follows: in the year ended 30 June 1996 – $26,400; in 1997 – $208,136; in 1998 – $140,000; in 1999 – $125,200; in 2000 – $143,720; in 2001 – $143,720; in 2002 – $86,320 and in 2003 – $76,640. The full Federal Court confirmed the Tribunal’s decision that the dividends were to be taxed as NALI.
GYNW involved a case where an employee whose SMSF was provided with favourable terms to acquire shares in the employer’s company. The employee’s SMSF acquired shares at a nominal value of $200 which produced substantial dividends (eg, a dividend of $672,900 with a $288,283.71 franking credit for FY2013, a dividend of $1,050,000 with a $450,000 franking credit for FY2014 and a dividend of $70,000 with a $30,000 franking credit for FY2015; being a total of $1,792,900 in dividends and $768,283.71 in franking credits over three financial years). The Tribunal held that s 290-550 did apply and relied on the analysis of the Full Federal Court in Darrelen. In particular, the Tribunal confirmed that:
- s 295-550(2) is not limited to an enquiry about the circumstances surrounding the payment of the dividend, but can extend the circumstances surrounding the acquisition of shares;
- it is not sufficient to merely show that dividends are paid on all shares in the company, including those owned by the SMSF, on an equal basis without preference;
- regard must be had to all of the factors in s 290-550(3)(a) to (f); not just some of them; and
- the reference to ‘value’ in s 290-550(3)(a) is a reference to market value.
Broadly, in each of Darrelen and GYNW a careful analysis of each of the factors in s 290-550(3)(a) to (f) was undertaken to determine whether NALI applied to dividends received from the SMSF’s acquisition of shares in a private company. In each case the analysis concluded that the shares had been acquired for less than market value.
Thus, the application of the Dividend NALI provisions provides a relatively structured analysis compared to the General NALI provisions.
Fixed and Non-fixed trust entitlement NALI
Section 295-550(4) provides:
(4) Income derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm’s length income of the entity.
Section 295-550(5) provides:
(5) Other income derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm’s length income of the entity if, as a result of a scheme the parties to which were not dealing with each other at arm’s length in relation to the scheme, one or more of the following applies:
(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme;
(b) in acquiring the entitlement or in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme;
(c) in acquiring the entitlement or in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.
As can be seen, where the relevant trust provides a ‘fixed entitlement’, there must be greater income derived or a lower (or no) expense incurred before the NALI provisions will be enlivened.
However, where the relevant trust does not provide a fixed entitlement, eg, a distribution from a family discretionary trust, the income received will be NALI. It is generally accepted that distributions from ‘discretionary trusts’ will result in that income being NALI. However, in other types of trusts such as unit trusts, this aspect is not always clear and a careful review of the trust deed is required as there may be units that have some discretion attached.
The High Court in CPT Custodian Pty Ltd v Commissioner of State Revenue (2005) 224 CLR 98 confirmed at [15] that:
However, “unit trust”, like “discretionary trust”, in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning …
The Federal Court in Colonial First State Investments Limited v Commissioner of Taxation [2011] FCA 16 confirmed that a managed investment trust that allowed a 75% vote to amend the constitution of the trust did not qualify as a fixed trust as there was the possibility, although it was unlikely to be exercised, for the majority to dilute the 25% minority’s interests in the trust.
An important practical aspect of TR 2006/7 is the ATO’s view on what is required for a ‘fixed entitlement’. TR 2006/7 provides:
208. Having regard to the statutory context, it is considered that the composite expression ‘income derived … by virtue of a fixed entitlement to the income’ is designed to test whether an amount of trust income … was included because the entity had an interest in the income of the trust that was, at the very least, vested in interest, if not in possession, immediately before the amount was derived by the trustee.
209. To have an interest in the income of a trust estate, a person must have a right with respect to the income of the trust that is susceptible to measurement; … An interest in the income of a trust estate will be vested in interest if it is bound to take effect in possession at some time and is not contingent upon any event occurring that may or may not take place. …
However, ‘fixed entitlement; is defined in s 995-1 of the ITAA 1997 as:
an entity has a fixed entitlement to a share of the income or capital of a company, partnership or trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F to the Income Tax Assessment Act 1936.
It is generally accepted that the definition of fixed entitlement in s 272-5 of Schedule 2F of the ITAA 1936 would provide a stricter measure of fixed entitlement compared to the ATO’s view in TR 2006/7. The application of the definition of fixed entitlement provided in Schedule 2F of the ITAA 1936 to the NALI provisions was endorsed by the AAT Senior Member in Ghali. In the ATO’s Decision Impact Statement after Ghali, the Commissioner proposed to adhere to his view that the Schedule 2F definition is inapplicable for the purposes of the NALI provisions.
Notably, in PCG 2016/16 at [4] the Commissioner states that his view of fixed entitlement in respect of s 273 of the ITAA 1936 and s 295-550 of the ITAA 1997 is explained in TR 2006/7.
In view of this analysis, we recommend that a fixed unit trust should be used where an SMSF invests in a unit trust as many unit trusts include some form of hybrid or discretion that may not qualify as a fixed entitlement especially if the Commissioner’s current administrative view changes.
Conclusions
The NALI provisions have broad application which has been extended considerably further with the ATO’s interpretation of the NALE amendments. In recent years there has been an increased focus on NALI and where these provisions apply and it can prove costly, time consuming and challenging to respond to an ATO assessment raising NALI.
Advisers should view every SMSF transaction involving a related party carefully and through the lens of a potential application of the NALI provisions. In this way, advisers will provide an important first barrier to obvious non-arm’s length transactions going ahead that may save their clients plenty of distress and money.
Disclaimer and legal notice
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional. Note the law is subject to constant change, and accordingly, expert advice should be obtained if there is any doubt in relation to this document. Unless specifically instructed by you in writing, and subject to you entering into an ongoing client agreement and payment of our required yearly fee, there is no obligation whatsoever on DBA Lawyers to notify you in respect of any changes to the law, ATO policies, etc and how any such changes might impact upon the above information. Copyright belongs to DBA Lawyers and DBA Lawyers are not licensed to provide financial product advice under the Corporations Act 2001 (Cth).
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