There has been uncertainty as to how the following two provisions interact:
(1) the non-arm’s length income (NALI) provisions in s 295‑550 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997); and
(2) the Capital Gains Tax (CGT) provisions in s 102‑5 of the ITAA 1997.
The ATO has recently released Draft Taxation Determination TD 2023/D1. It provides greater clarity and a practical approach to the ATO’s view on this important topic.
A full version of TD 2023/D1 is available at https://www.ato.gov.au/law/view/document?DocID=DXT/TD2023D1/NAT/ATO/00001
In this article, we summarise our understanding of TD 2023/D1 and provide detailed calculations of how we understand TD 2023/D1 would apply in practice.
Background: uncertainty
At the risk of oversimplifying the NALI provisions, they can be — at a very high level — summarised as follows:
An amount of ordinary income or statutory income is NALI if it is greater than what it would have been if parties had been dealing on an arm’s length basis.
Although the above is an oversimplification, one part of it is actually verbatim from the legislation, namely, ‘[a]n amount of ordinary income or statutory income is [NALI] if….’
This is interesting when it comes to the CGT regime. Naturally, a ‘capital gain’, by itself, is neither ordinary income nor statutory income. However, a ‘net capital gain’ is statutory income pursuant to the method statement in s 102‑5(1) and s 6-10.
Of course, under the method statement in s 102-5, ‘net capital gain’ is broadly calculated by (again, at a very high level and in a simplified way):
- Adding up all capital gains for that financial year.
- Then, subtracting capital losses (present year and then any prior year losses carried forward).
- Then, reducing by the discount percentage each amount of a discount capital gain remaining.
The remaining amount is then the net capital gain.
Accordingly, consider a very simple example.
An SMSF has:
- A $1 capital gain due to dealings not conducted on an arm’s length basis.
- A $1 million capital gain due to dealings conducted on an arm’s length basis.
Assume for simplicity there are no losses and neither of the gains are eligible for the discount percentage (eg, the relevant acquisitions and disposals occurred within 12 months of each other).
Accordingly, applying the method statement in s 102‑5, the net capital gain would be $1,000,001 (ie, $1 ‘non-arm’s length capital gain’ + $1 million ‘arm’s length capital gain’).
On a very strict view, the amount of statutory income could be seen as being the entire net capital gain (ie, $1,000,001). Thus — because of a $1 ‘non-arm’s length capital gain’ — the other $1 million constitutes NALI. Naturally, NALI less relevant deductions is broadly taxed at 45%. Assume there are no relevant deductions. Therefore, the $1 of ‘non-arm’s length capital gain’ could cause a CGT-related income tax liability of $450,000.45 (ie, $1,000,001 x 45%). Again, though, this is on a very strict view.
This is not a practical, nor fair, outcome. To its credit, the ATO in TD 2023/D1 consider but end up rejecting this strict view. See paragraphs 57–60 of TD 2023/D1.
The ATO’s view
The ATO, in TD 2023/D1 instead choose the following more practical and sensible approach:
The phrase ‘an amount’ can, as a matter of ordinary usage, apply to an amount which is part of a larger amount.
| SUMMARY OF TD 2023/D1
Accordingly, we understand that in TD 2023/D1 the ATO essentially state that NALI is the lesser of the:
|
Accordingly, in the prior example, under TD 2023/D1, instead of resulting in a $450,000.45 CGT-related income tax liability, there would be a CGT-related income tax liability of $150,000.45 (ie, $1 x 45% + $1 million x 15%).
The ATO provide three examples.
We have adapted these three examples into the first three scenarios in the accompanying spreadsheet/table. We have also added certain facts. (In example 1, in TD 2023/D1, the ATO state that there is a ‘$500,000 arm’s length capital gain’, but we have added that the capital proceeds were $800,000 and the cost base was $300,000.)
We feel that tax practitioners who wish to gain a very strong understanding of the ATO’s approach in TD 2023/D1 simply need to:
- remember our summary of TD 2023/D1 above; and
- work through the calculations in the spreadsheet.
A warning — a ‘non-arm’s length capital gain’ can still taint an ‘arm’s length capital gain’
Even under TD 2023/D1, a ‘non-arm’s length capital gain’ can still taint an ‘arm’s length capital gain’!
To illustrate, we have added in the accompanying spreadsheet/table a scenario 4. Scenario 4 is based on scenario 3 but without the arm’s length capital gain. That is, scenario 4 just has a ‘non-arm’s length capital gain’. As shown in the accompanying spreadsheet/table, the resulting income tax liability is $1.47 million.
The difference between scenario 4 and scenario 3 is simply that scenario 3 has an ‘arm’s length capital gain’ of $1 million, which is a discount capital gain. Everyone knows that such a $1 million discount capital gain in an SMSF should typically cause a tax liability of $100,000 (ie, $1 million x 15% x (2/3)).
However, applying our summary of TD 2023/D1, the difference between income tax payable in scenario 4 ($1.47 million) and in scenario 3 ($1.77 million) is not $100,000. Rather, the difference is $300,000 (ie, $1.77 million – $1.47 million). Accordingly, in a practical sense, because of the presence of a ‘non-arm’s length capital gain’, the ‘arm’s length capital gain’ is still tainted … it just is not fully tainted.
A final warning — this is still only draft
We stress that the draft determination is just that: a draft! Accordingly, heed must be paid to the ATO’s reminder at the start of TD 2023/D1:
“This publication is a draft for public comment. It represents the Commissioner’s preliminary view on how a relevant provision could apply.”
The Tax Institute has lodged a submission in relation to the draft Determination and it is hoped the draft is varied before being finalised. Indeed, The Tax Institute has recommended the legislation be revised. Until this position is clarified, taxpayers that rely on the draft Determination reasonably and in good faith, should be protected from interest and penalties; but not on primary tax. Once the draft is finalised as a tax determination it should become a public ruling binding on the Commissioner. Given the uncertainty surrounding this topic, expert advice is recommended as there are likely to be changes given draft NALI legislation relating to non-arm’s length expenses is expected to issue soon.
Click this link to view the detailed calculations.
Related information
For related information and articles:
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional. The above does not constitute financial product advice. Financial product advice can only be obtained from a licenced financial adviser under the Corporations Act 2001 (Cth).
Note: DBA Lawyers presents monthly online SMSF training. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.
For more information regarding how DBA Lawyers can assist in your SMSF practice, visit www.dbalawyers.com.au.
By Bryce Figot ([email protected]) Special Counsel and Daniel Butler ([email protected]) Director, DBA Lawyers
DBA LAWYERS
25 August 2023
