Non-arm’s length income – the impracticality of the Commissioner’s new policy

Accountants lodging your SMSF’s tax return – unless you lodge by paper, your actions may already be exposing your fund to a 45% tax rate, even if it is in pension phase!

I arrived at this conclusion after reading the Commissioner’s draft law companion ruling, LCR 2019/D3. This ruling outlines the Commissioner’s position regarding the recent expansion to the non-arm’s length income (NALI) provisions, which can apply to tax some or all of a superannuation fund’s income at 45% instead of the usual 15% or 0%.  The draft ruling follows changes to the existing law such that some or all of a super fund’s taxable income will now be ‘NALI’ where there is a non-arm’s length dealing regarding expenses incurred by the fund.  These changes came into effect from 1 July 2018 and apply irrespective of when the relevant arrangement commenced (i.e. there are no grandfathering provisions).

Based on the explanatory memorandum accompanying the amending legislation, it seems the law change occurred due to concerns that SMSFs were entering into arrangements to underpay (or not pay at all) for goods or services, potentially resulting in the SMSF making a higher profit than would arise under a completely commercial arm’s length situation.  Given the policy behind contribution caps is to restrict the flow of funds into super, I assume that there was some concern that such underpayments were being used to subvert the integrity of these caps.

However, these amendments seem to have been introduced with no consideration to the existing governance rules in the Superannuation Industry (Supervision) Act (SIS Act).  For example, section 109 of the ‘SIS’ Act requires a trustee of a fund to deal with other parties on an arm’s length basis in relation to investments of the fund.  The possible consequences of breaching this requirement include both civil and criminal penalties against the trustees rather than potentially large negative impacts on members retirement balances. Given the ATO is the Regulator for SMSFs, it already had the power to penalise such breaches.

Despite the pre-existing mechanisms (including the example above) which arguably should already deal with the perceived or real problem, we now have additional new laws to comply with.

Going back to the draft ruling, while the Commissioner indicates that the draft ruling is intended to clarify the operation of the law, there are a number of examples which have raised more questions than answers regarding the extent to which the Commissioner intends to enforce the rules.

Two particular contrasting examples from the draft ruling illustrate this.

Example 2 considers an accountant whose accounting firm provides accounting services to her SMSF without charging the fund for those services.  The conclusion drawn by the Commissioner is that this is a non-arm’s length arrangement (presumably the reason that the accounting firm is not charging for their time is due to its relationship with the individual trustee) and so all of the fund’s net income is NALI and taxed at 45% (as the expenditure does not relate to any single asset or income stream, but to the fund as a whole).

Example 6 provides a contrasting set of facts that is intended to confirm that a trustee of a fund can provide services in their trustee capacity without remuneration. In this example, the accountant uses their personal skills to do their SMSF’s return without use of the equipment or assets of her firm, and without lodging the return using her tax agent registration. In this instance, the Commissioner says that the NALI tax rate would not apply on the basis the accountant is acting in their trustee capacity.

To illustrate the effect of these examples, assume that the SMSF has $1 million of member funds, on which it derives a 5% return, i.e. $50,000 in the relevant year. Ignoring the NALI rules, and assuming the fund is in accumulation phase and that the accounting firm usually charges a $2,000 fee for the work, the SMSF’s tax liability would be $7,200 (i.e. ($50,000 – $2,000) x 15%). Simply due to the accountant’s firm not charging their normal fee, the Commissioner will now treat the fund’s entire income as NALI, resulting in the SMSF’s tax bill jumping from $7,200 to $22,500(being $50,000 x 45%).  If the fund was in pension phase then the tax bill goes from $nil to $22,500.  On these numbers the penalty appears harsh!

Clearly there would be other examples, such as a builder using their skills to maintain a fund’s rental property, a real estate agent managing their SMSF’s rental properties, or a solicitor’s firm assisting via discount conveyancing.

So how far will the Commissioner go with this? What if the accountant does the work herself using her firm’s accounting software (for no fee), but lodges in her trustee capacity (i.e. without using her firm’s tax agent licence)? Or she does nothing more than use her accounting firm’s photocopier?  Maybe the builder uses his work tools, or the solicitor uses the office electronic conveyancing system.  Is there a level where the ATO will concede no breach has occurred?  Looking at paragraph 39 of the ruling does not give much hope that he will, as these sorts of things appear to be ones where he would apply the NALI tax rate.

The changed rules also potentially conflict with another part of the SIS Act.  The definition of a SMSF requires that trustees do not receive any remuneration from the fund for any duties or services performed in their capacity as trustee.  If this rule is breached, the fund may cease to be a SMSF, so there is a strong incentive for trustees not to breach this rule.  There is an exception where duties or services are provided other than in the capacity as trustee where they are duties which the trustee performs as part of the services they provide to the public, and where the remuneration is no more favourable than an arm’s length dealing would have.  I note this exception requires remuneration to be charged for it to be available.

So the situation seems to be that if an accountant prepares the accounts and tax return through their firm’s software or other resources, and:

  • charges a fee, they must prove that the fee is at a market rate and that the services being provided are ones that the accountant otherwise provides (so if you are an auditor, an insolvency advisor or even an accountant who doesn’t have any super fund clients this might not be possible). There is a whole lot of minutes, letters back and forth and market price testing documentation that the ATO could expect you to have in this situation, and any flaws could cause the fund to breach the SIS Act such that the fund will cease to qualify as an SMSF; or
  • doesn’t charge a fee, then while the fund does not breach the SIS Act and is still a SMSF, all its income is NALI.

For those still wondering why I think more accountants may move to paper returns – if your SMSF has low expenses for a year and you lodge the return electronically through your firm’s tax agent registration, there is a far greater risk that the Commissioner will form the opinion that you provided a non-arm’s length service (lodgement for a below market or nil fee) has been provided and that they should apply the ruling to tax the fund at 45%. The electronic lodgement itself could be all the evidence the Commissioner needs to start a review or audit.

The trustees still have to lodge a tax return each year – if an electronic lodgement will cost thousands in NALI tax, then we all might be reaching for a ballpoint pen!

This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.

This article provides a general summary of the subject covered as at the date it is published. It cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.

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