![\"\"](\"http:\/\/www.dbalawyers.com.au\/wp-content\/uploads\/2019\/12\/NALI-unit-trusts-and-draft-LCR-2019-D3.jpg\")
<\/p>\n<\/p>\n
Broadly, SMSF trustees may assume that, in any related party dealing, NALI will apply unless they can prove otherwise given the ATO may issue an assessment and place the burden on the SMSF trustee to prove that it is excessive.<\/p>\n
One key criticism of the draft Law Companion Ruling 2019\/D3 (the draft LCR<\/strong>) is the breadth of the ATO\u2019s view in relation to the \u2018nexus\u2019 required between the scheme and the loss, outgoing or expense (expense<\/strong>) that can constitute non-arm\u2019s length income (NALI<\/strong>) under s 295-550 of the Income Tax Assessment Act 1997<\/em> (Cth) (ITAA 1997<\/strong>).<\/p>\n The ATO\u2019s view is that, where an expense is incurred by a fund that is less than an arm\u2019s length amount, all of a fund\u2019s ordinary income and statutory income is NALI, which (after relevant expenses) is taxed at 45%.<\/p>\n Extrapolating this to a \u2018general expense\u2019 incurred by an SMSF, the ATO takes the view that where a direct nexus to a particular source\/asset is missing, there is instead a nexus to all income of the fund, regardless of the source of that income or whether any asset produces that income or gain.<\/p>\n While the draft LCR confirms that a non-arm\u2019s length expense (NALE<\/strong>) causes the income from that particular year to be NALI, this ATO view also leads to the conclusion that all future income (including net capital gains) on all assets held by the fund at that particular time would also be NALI.<\/p>\n For example, a $100 reduction in an accounting cost for a widely diversified mum and dad SMSF with an average fund balance of $1.3 million would expose all future income and all future capital gains on all assets then held by that fund to NALI.<\/p>\n On December 2019, The Tax Institute lodged a detailed submission on \u2018Non-arm\u2019s length income and expenses \u2013 LCR 2019\/D3 and PCG 2019\/D6\u2019 to the ATO adopting a different construction of the wording in s\u00a0295-550(1) ITAA97. The Tax Institute\u2019s view is examined below and contrasted to the ATO\u2019s view. (Note that PCG 2019\/D6 was finalised as PCG\u00a02020\/5 which is discussed below).<\/p>\n In preparing this article, we wish to acknowledge The Tax Institute\u2019s NALI submission for raising this \u2018nexus\u2019 issue.<\/p>\n All references are to the ITAA 1997 unless otherwise stated. Emphasis is added by bolding throughout.<\/p>\n Section 295-550(1) contains a nexus requirement in paragraphs (b) and (c) \u2013\u2013 that if, as a result of the scheme<\/strong> \u2026 the parties to which were not dealing with each other at arm\u2019s length in relation to the scheme, one or more of the following applies:<\/p>\n (a)\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u2026<\/p>\n (b)\u00a0\u00a0\u00a0\u00a0\u00a0 in gaining or producing the income,<\/strong> 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\u2019s length in relation to the scheme;<\/p>\n (c)\u00a0\u00a0\u00a0\u00a0\u00a0 in gaining or producing the income,<\/strong> 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\u2019s length in relation to the scheme.<\/p>\n Clause 2.38 of the Explanatory Memorandum (2019 EM<\/strong>) that introduced Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019<\/em> (Cth) (NALE Act<\/strong>) states:<\/p>\n [w]here there is a scheme that produced non-arm\u2019s length income by applying non arm\u2019s length expenses, there must also be a sufficient nexus between the expense\/s and the income, that is, the expenditure must have been incurred \u2018in\u2019 gaining or producing the relevant income. This reflects the analysis that must be undertaken in determining whether an expense is deductible under section\u00a08-1, or can be included in the entity\u2019s cost base for the transaction if the expense is of a capital nature (see below).<\/p>\n This nexus point is not critically examined in the draft LCR. Rather, the ATO readily accept that a nexus is easily established. For example, paragraph 17 of the draft LCR states:<\/p>\n Non-arm’s length expenditure incurred to acquire an asset (including associated financing costs) will have a sufficient nexus to all ordinary or statutory income derived by the complying superannuation fund in respect of that asset. This includes any capital gain derived on the disposal of the asset (see Example 1 of this Ruling).<\/p>\n Broadly, the draft LCR suggests that NALI will arise if there is a nexus between the acquisition of an asset and any eventual capital gain derived, when the fund incurs an expense less than the arm\u2019s length amount.<\/p>\n The introduction of the NALE Act was largely due to the growth of low interest loans in relation to limited recourse borrowing arrangements (LRBAs<\/strong>).<\/p>\n The Superannuation Taxation Integrity Measures Consultation Paper was issued on 11 January 2018 (the consultation paper<\/strong>) together with exposure draft legislation and an exposure draft EM. It stated:<\/p>\n Examples 2 and 3 in the consultation paper involve low interest LRBAs. There is no reference to, or example of, a general expense or lower professional fee giving rise to NALI.<\/p>\n The following paragraphs are extracted from the exposure draft EM of January 2018:<\/p>\n 1.16\u00a0\u00a0\u00a0\u00a0\u00a0 The legislation requires the indentification of a specific amount<\/strong> of ordinary or statutory income that is NALI. That is, the existence of an amount of NALI does not necessarily \u2018taint\u2019 all of a superannuation entity\u2019s income; it is necessary to specify the scheme in relation to which the NALI weas derived.<\/p>\n 1.23\u00a0\u00a0\u00a0\u00a0\u00a0 The framework or the ordinary and stautory NALI rules remain the same:<\/p>\n Example 1.1 of the exposure draft EM of January 2018 also relates to an LRBA. The circumstances in this example involves an LRBA with no interest, no repayments, 100% gearing and repayment of principal required at the end of the 25 year loan term.<\/p>\n Broadly, the SMSF industry had not contemplated that the proposed NALI changes would result in a general expense tainting all (of an SMSF\u2019s) ordinary and statutory income. As noted, for a considerable period it was envisaged that an expense such as a lower interest rate in respect of rental income related to an LRBA could give rise to NALI. This was on the basis that a superannuation fund is permitted under s\u00a067A of the Superannuation Industry (Supervision) Act 1993<\/em> (Cth) (SISA<\/strong>) to borrow to acquire a single acquirable asset. Thus, there is a sufficient nexus with the lower expense and the specific asset producing that income.<\/p>\n The ATO\u2019s Practical Compliance Guideline (PCG<\/strong>) 2020\/5 (dated 1 June 2020) confirmed the ATO\u2019s position that a general expense would taint all ordinary and statutory income. The following paragraphs from PCG 2020\/5 best explain the background to the ATO\u2019s revised view:<\/p>\n Thus, the SMSF industry was not expecting NALE to taint all ordinary and statutory income when the 2018 consultation paper was issued in January 2018 with exposure draft legislation and the exposure draft EM. The SMSF industry was put on notice of this broad view when the draft LCR issued on 2 October 2019.<\/p>\n As noted above in paragraphs 6 to 9 of PCG 2020\/5, the ATO\u2019s broader view resulted in considerable controversy from certain sectors of the SMSF industry. The ATO confirmed in the PCG 2020\/5 that the ATO decided that no compliance resources would be applied for the period of 1 July 2018 to 30 June 2021. However, as noted below, this period was extended on 24 March 2021 to cover the 2021-22 financial year.<\/p>\n The NALE Act was, upon receiving royal assent, finalised as law on 2 October 2019 with retroactive powers from 1 July 2018. Moreover, the changes are expressed to apply to schemes regardless of when they were entered into. For example, an SMSF that acquired an asset for less than market value in 2000 could be exposed today to NALI.<\/p>\n We will now examine the impact of NALE where an asset is acquired below market value and, secondly, where an asset is acquired at market value.<\/p>\n Example 1 of the draft LCR involves Armin selling commercial property with a market value of $800,000 for $200,000 to his SMSF. According to the draft LCR, all of the income and capital gains from that property is NALI.<\/p>\n However, what is not taken into consideration in this example is the application of the CGT market substitution rule and the ATO\u2019s long-established practice of treating a transfer of an asset below market value as a contribution in accordance with TR 2010\/1 (the ATO\u2019s tax ruling on superannuation contributions).<\/p>\n Where the CGT market value substitution rule in s 112-20 ITTA 1997 applies, the member transferring the asset to the fund below market value is deemed to have received the market value of the asset that exceeds any consideration received as capital proceeds in accordance with s 116-30 ITAA 1997. Therefore, Armin would typically be treated by the ATO as having made a non-concessional contribution (NCC<\/strong>) equal to the difference between the sale price ($200,000) and the asset\u2019s market value ($800,000); ie, a $600,000 contribution. This approach is consistent with the ATO view reflected in TR 2010\/1.<\/p>\n Note that if a member exceeds their NCC cap, then they will be subject to the excess contribution system which may potentially expose them to tax at a rate of 47% unless they elect to release the excess amount of NCCs, plus 85% of the associated earnings on the excess NCC amount, in which case the member will then pay tax on 100% of their associated earnings.<\/p>\n There is no guidance in the draft LCR about what takes precedence \u2013\u2013 the contributions regime or NALI \u2013\u2013 to avoid any potential \u2018double jeopardy\u2019. Indeed, the recognition of an NCC reflects market value consideration for the asset. This is the view of the High Court in Cook v Benson<\/em> in relation to contributions made by a member who was made bankrupt, at [36]:[1]<\/a><\/p>\n \u2026 the first respondent made contributions in return for the undertaking by the trustees of the funds of obligations to pay death, retirement or other related benefits, to him or his nominees, in accordance with the rules of the respective funds. He obtained consideration in money’s worth in return for the payments.<\/p>\n If the ATO seeks to change its long-established practice of treating an asset acquired below market value other than as a contribution, then the ATO should revise TR 2010\/1 and communicate its revised position to the tax industry.<\/p>\n Further, while the 2019 EM is not law and should only be referred to where there is ambiguity in the law, the commentary in the 2019 EM and the examples referred to[2]<\/a> all relate to a specific asset or category of income. There does not appear to be any commentary or example in the 2019 EM that refers to a general expense tainting all of a fund\u2019s income.<\/p>\n In summary, the current ATO view results in a potential \u2018double jeopardy\u2019 by applying the NALI provisions and also treating the same amount as a contribution under TR 2010\/1. If the ATO construction of the NALE Act is correct, then we would hope the ATO\u2019s contribution ruling is revised accordingly.<\/p>\n The Tax Institute\u2019s 4 December 2019 submission submits that, if a lower revenue expense is incurred by an SMSF in relation to the acquisition of an asset at market value, only the ordinary income should be assessed as NALI. \u00a0Consequently, NALI should only apply to any net capital gain (statutory income) when that asset is eventually sold if there is a relevant nexus. The Tax Institute\u2019s submission queries whether there is any relevant nexus when an arm\u2019s length price is paid and the capital gain is solely from capital appreciation of that asset.<\/p>\n In other words, a capital gain generally arises from capital appreciation over time and not \u2018as a result\u2019<\/em> of the lower revenue expense, ie, the lower revenue expense was not incurred in relation to \u2018gaining or producing the [statutory] income<\/em>\u2019 under s\u00a0295-550(1)(b) or (c).<\/p>\n Kellie\u2019s SMSF<\/em><\/p>\n Example 4 of the draft LCR provides the example of Kellie\u2019s SMSF. This example highlights a situation where both the net rental income and any net capital gain from the eventual disposal of a commercial property funded by a non-arm\u2019s length LRBA is NALE (where the SMSF borrows 100% of the purchase price, an interest rate of 1.5% pa applies and repayments made annually over a 25-year term). However, Kellie\u2019s SMSF paid the market value of $2 million for this property.<\/p>\n It is important to note here that many SMSFs are passive investors and benefit from long-term capital appreciation \u00a0of assets. In this type of case, why should Kellie\u2019s SMSF have its capital gain exposed to NALI if it incurred a lower revenue expense?<\/p>\n The capital gain in this situation generally remains the same, regardless of lower expenses such as discounted service fees or interest rates on a related party LRBA. Thus, The Tax Institute\u2019s submission argues that there is not a sufficient and relevant nexus between the lower revenue expense and the subsequent capital gain that may eventually be realised on disposal.<\/p>\n Indeed, the capital gain in relation to many SMSF investments including property, shares and many other investments arises from the original contract price and any capital appreciation subsequently received.<\/p>\n For example, \u00a0consider an SMSF that holds an investment property for 20 years and experiences a 400% increase in value over that time. In the final year prior to sale, the SMSF trustee who is a builder, does some free services to better position the property for sale enabling the fund to realise the best sale price. On the ATO\u2019s reasoning, the total capital gain acheived over the past 20 years would be NALI, despite there being no connection between the capital appreciation from the prior 19 or so years accrued before the builder provided free services. As discussed below, the ATO argue that there is no flexibility to pro-rata or apportion this gain for NALI purposes.<\/p>\n The Tax Institute submission also argues that there is also need to ensure that an appropriate nexus between an expense and the income that is tainted. In particular, a lower revenue expense can taint ordinary income and a lower capital expense can taint a capital gain (ie, statutory income). The Tax Institute\u2019s submission, for instance, readily accepts that in a case such as Kellie\u2019s SMSF (Example 4 of the draft LCR), there is a relevant nexus between NALE and the future capital gain on the eventual sale of the property, if the fund would not have been able to acquire that property but for the non-arm\u2019s length loan being provided. This approach is in line with the ATO\u2019s analysis in TD 2016\/16 (which is a public ruling that predates the NALE Act) on how the ATO applies NALI to a non-arm\u2019s length LRBA. Paragraphs 4 and 5 of TD 2016\/16 provide:<\/p>\n As mentioned above, assuming Kellie\u2019s SMSF could have acquired the property that is the subject of the LRBA without the non-arm\u2019s length LRBA, then The Tax Institute\u2019s view is that the capital gain on disposal of that asset lacks the relevant nexus to the expense.<\/p>\n The question of apportionment of value caused by different acts\/events also needs to be considered. Referring again to the above example, where capital appreciation of a residential property by 400% may be tainted in the final (20th) year of disposal by free services provided by the builder who is an SMSF trustee\/member, appears most unfair and brutal. Assume further that planning approval via an external consultant was also obtained which also resulted in considerable capital appreciation. This increase in the value of the property due to the planning approval should not be tainted by NALI. The overall increase in value should at least be apportioned between the free services provided by the builder (which is also treated as a contribution by the ATO under TR 2010\/1) and the increase in value that relates to the planning approval.<\/p>\n As noted above, the ATO has for many years treated free services that added value to an asset as a contribution (eg free services provided by an SMSF member have been treated as an NCC reflective of the value of the services provided[3]<\/a>). If an NCC was recognised for these free services, this should neutralise any need for the ATO to apply NALI.<\/p>\n It is recommend that the ATO review and revise TR 2010\/1 in view of its construction of NALI.<\/p>\n Following the controversy arising from the substantial broadening of the NALE provisions provisions to cover lower general expenses (ie, NALE that taints all ordinary and statutory income of a fund), the ATO sought to provide a practical concession to industry to adjust to this much wider tax net.<\/p>\n The following are the key paragaphs from PCG 2020\/5 that was issued on 9 April 2021:<\/p>\n On 24 March 2021 the ATO Assistant Commissioner, Mr Justin Micale announced a 12 month extension to the period covered by PCG 2020\/5 so that it also covers the 2021-22 financial year; thus the revised PCG 2020\/5 that was issued on 9 April 2021 now covers the 2018-19, 2019-20, 2020-21 and 2021-22 financial years. Mr Micale said that given the complexity and level of interest in this issue, the ATO will be seeking independent, specialist advice from the public advice and guidance panel before finalising the draft LCR.<\/p>\n Mr Micale confirmed that it is important to recognise the ATO\u2019s transitional compliance approach does not apply in other circumstances where the\u00a0fund incurs NALE <\/a>that relates directly to particular income.<\/p>\n The NALE changes have proved very controversial. The legislation was enacted on 2 October 2019 and the Draft LCR is still to be finalised (at a guess could possibly be 6\u00a0 to 9 months; say late 2021 or early 2022). It appears the initial intent of the exposure draft legislation has taken on a far broader application, given the ATO\u2019s views in relation to how a general expense can taint all income (ordinary and statutory). Specifically, the interpretation that a sufficient nexus is very easily established even if that nexus is remote and tenuous (as illustrated above by the examples of the property held for 20 years and the $100 accounting fee discount tainting all the fund\u2019s income).<\/p>\n Bearing in mind that the evidential burden falls on the taxpayer and the current expansive and pro-revenue construction of the NALI provisions being espoused by the ATO, SMSF trustees need to take great care to ensure they have sufficient and appropriate evidence to defend themselves against NALI claims. Broadly, SMSF trustees may assume that in any related party dealing NALI will apply unless they can prove otherwise given the ATO may issue an assessment and place the burden on the SMSF trustee to prove it is excessive.<\/p>\n Certainly, this is not at all a fair system and urgent action and reform is needed. Considerable uncertainty exists with the application of NALE and NALI until the ruling is finalised.<\/p>\n [1]<\/a> [2003] HCA 36 at [36] per Gleeson CJ, Gummow, Hayne and Heydon JJ.<\/p>\n [2]<\/a> For example, paras 2.17, 2.19, 2.20, 2.21, 2.35, 2.39, 2.41, 2.44, 2.45, 2.46, 2.47, 2.48, 2.49 and 2.50 and examples 2.1 and 2.2.<\/p>\n [3]<\/a> See TR 2010\/1 and the ATO National Tax Liaison Group Superannuation Technical minutes of March 2013.<\/p>\n Related articles and links below:<\/p>\n *\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 *\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 *<\/p>\n Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au<\/a> or call 03 9092 9400.<\/p>\n For more information regarding how DBA Lawyers can assist in your SMSF practice, visit www.dbalawyers.com.au<\/a>.<\/p>\n By Daniel Butler (dbutler@dbalawyers.com.au), Director, and Shaun Backhaus, Lawyer (sbackhaus@dbalawyers.com.au)<\/p>\n DBA LAWYERS<\/strong><\/p>\n 29 April 2021<\/a><\/p>\n<\/a>What nexus?<\/h3>\n
Background to NALE being introduced<\/h3>\n
\n
\n
\n
\n
\n
\n
The NALI \/ NALE legislative changes in late 2019<\/h3>\n
<\/a>Assets acquired below market value \u2013 is there a nexus?<\/h3>\n
<\/a>Assets acquired for market value \u2013 is there a nexus to all income?<\/h3>\n
\n
\n
<\/a>Should ordinary income or statutory income be apportioned?<\/h3>\n
PCG 2020\/5 \u2013 general expenses<\/h3>\n
\n
\n
Conclusions<\/h3>\n
\nRelated articles<\/h3>\n
\n
![\"Print](\"https:\/\/cdn.printfriendly.com\/buttons\/printfriendly-pdf-button.png\")
<\/a><\/div>\n","protected":false},"excerpt":{"rendered":"