THE NEW NON-ARM’S-LENGTH HEADACHE

In the classic children’s story Alice in Wonderland, the title character enters a nonsensical world of talking animals and animated playing cards after falling down a rabbit hole before waking and discovering it was just a vivid dream.

For the SMSF sector, the non-arm’s-length wonderland was partly closed on 1 July 2018 when legislation was amended to capture non-arm’s-length income (NALI) and tax it at top marginal tax rates.

Since that time, NALI has become a known and accepted quantity within the SMSF sector, but looming in the background has been the issue of how non-arm’s-length expenses (NALE) would be treated, and on 9 October 2019 the SMSF sector was invited to its own version of the Mad Hatter’s Tea Party with the release of ATO Law Companion Ruling (LCR ) 2019/D3.

The release of the LCR – which it should be noted is only currently in draft form – and even the emergence of NALE should not be considered a surprise as it was first put forward in superannuation legislation in 2018 that did not pass through parliament prior to the May 2019 federal election.

That legislation, the Treasury Laws Amendment (2018 Superannuation Measures No 1) Act 2019, did pass through both houses in mid-September last year and received royal assent on 2 October, carrying with it the original start date of 1 July 2018, effectively making the NALE provisions retrospective from the moment the act became law, and leading to the release of the LCR a week later.

This document has raised serious concerns for advisers and accountants who run their own funds, as well as for their trustee clients who may maintain an asset or investment using their own skills and resources, because while the LCR not only demonstrated how NALE would be processed, it also raised questions as to how deep the rabbit hole will go in applying it to expenditure or expenses related to the fund.

The LCR states it “clarifies how the amendments to section 295-550 of the Income Tax Assessment Act 1997 operate in a scheme where the parties do not deal with each other at arm’s length and the trustee of a complying superannuation entity incurs non-arm’s-length expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income”.

Importantly, it also introduces the issue of a nexus between the NALE and the ordinary and/or statutory income derived by the fund. In short, where a fund acquires services under a non-arm’s-length arrangement, such as those of an accountant or adviser running their own fund, that nexus is sufficient to render all income in the fund as NALI and taxed at 45 per cent.

DBA Lawyers director Dan Butler says the nexus issue “is an extreme and an extraordinary outcome which the legislative provisions were not intended to produce” and if enacted as proposed in the LCR will be an ongoing problem.

“Extrapolating the ATO’s view on this point would lead one to consider that any future income or net capital gain on all assets held by the fund at that time would also give rise to NALI,” Butler wrote in a recent technical article detailing the nature of the nexus.

“Based on the current draft ATO view, for example, a $100 reduction in an accounting cost for an SMSF could expose all future income and, on an extrapolation of the current ATO view, all future net capital gains on all assets to NALI.

“While this example is an absurd outcome, it reflects the ATO’s current view that a general expense has a nexus to the derivation of all the fund’s ordinary income and statutory income, which includes a net capital gain,” he says.

Interestingly, the application of NALE in the LCR seems to differ from that presented in the Explanatory Memorandum to the act, which states, in paragraph 2.38, that “where there is a scheme that produced non-arm’slength income by applying non-arm’s-length expenses, there must also be a sufficient nexus between the expense/s and the income, that is, the expenditure must have been incurred ‘in’ gaining or producing the relevant income”.

This would appear to exclude any discounted fees or services from an SMSF adviser or accountant as they have no impact on the NALI situation.

However, Butler points out the LCR must also be considered when dealing with non-arm’s-length arrangements and that document makes it clear, in paragraphs 16 and 18, that a nexus can exist between NALE and ordinary or statutory income earned as a result of those expenses, and it can also extend to all of the ordinary or statutory income earned by the fund.

The reason for this nexus creating such a widespread effect comes down to the issue of ‘capacity’, which, according to the LCR, is how the ATO views an SMSF accountant, adviser or trustee at the time they use their skills or resources to administer their own fund.

If they act in their capacity as a trustee, not drawing on any resources used in their profession or employment, including licensing, qualifications or insurances related to their work, they are considered to be acting in their capacity as a trustee. If they do draw on any of these resources, they are considered to be acting in an individual capacity and the NALE provisions will apply.

DFK Everalls managing director Rob Shelton sees this approach as running counter to the underlying ethos of SMSFs and the ability for people to be directly engaged in their superannuation.

“SMSFs are the best way to be engaged in superannuation and to beef up a retirement outcome by bringing your own expertise to the task, but saying someone can no longer use those skills is nuts,” Shelton says.

“This impacts more than just advisers and accountants and will include real estate agents managing their own property and tradespeople who own and maintain their real estate investments. Being told we can’t use the skills that are available to us is nonsensical.”

His view has been reflected in a number of submissions made to the ATO in October and November last year seeking changes to the nexus and capacity definitions within the LCR.

In a submission from SuperConcepts provided to selfmanagedsuper, technical services and education general manager Peter Burgess says: “We are not convinced that discouraging professionals from using their own skills and expertise to manage their fund is an appropriate policy outcome.

“Whilst these individuals could simply choose to charge their fund an arm’s-length fee for the activity, we suspect many will choose not to provide the activity given there may be uncertainty about what constitutes an arm’s-length fee and the severe consequences of getting it wrong,” SuperConcepts SMSF technical services executive manager Mark Ellem adds: “Even where a professional charges their fund an arm’s-length fee, for example, for accounting services, there is still the risk that in a subsequent ATO audit of their fund that it is decided that the fee charged is not arm’s length, potentially resulting in all the income of the fund being assessed as NALI and taxed at 45 per cent.”

Shelton says this uncertainty about what should be considered NALE will also affect advisers and accountants dealing with trustee clients as they will be forced to ask questions about transactions that never took place.

“As professionals we understand NALI and can see the transactions and ask questions about them, but with NALE, actions will have occurred but there is no sign of anything and we will have to look for what is not there with no way of being sure of what we need to find,” he notes.

He is also concerned about the scarcity of information about the NALE provisions given the potential impact on the advisory sector and trustees.

“There is no education campaign at all and the only information we have to work from is the legislation, the LCR and the Practical Compliance Guide, and which trustee will read those? We are still working out what questions we need to ask ourselves and our trustee clients,” he says.

KPMG enterprise director Julie Dolan says there is a lack of information and awareness extended to auditors as well, with many still unaware of the depth of the issue.

“Questions remain as to how auditors will administer NALE and how they will pick it up and work out in what capacity a trustee acted when the expenditure took place, which will become an expensive and bespoke process,” Dolan notes.

“At present, I don’t see auditors as being aware or practically able to apply a specific expense approach given their separate workload around SMSF investment strategies and the extra information they will require for NALE.”

Referring to the consultation period and submissions received on the NALE issues, she says the SMSF sector was in limbo as it waited for a pragmatic outcome from the ATO.

To this end, the regulator has taken some of the pressure off SMSF professionals with the release of Practical Compliance Guideline (PCG) 2019/D6, which states it will not enforce compliance with the NALE provisions for the 2019 and 2020 financial years.

Yet even this act of relief carries a hidden trap, according to Ellem, who says the transitional relief offered under the PCG only refers to general expenses incurred by an SMSF, but not specific expenses.

He points to paragraph 9 of the PCG, which states the relief only applied to NALE of a general nature that had a nexus to income derived by an SMSF during those two financial years, and which is confirmed in paragraph 10, which adds the relief “does not apply where the fund incurred non-arm’slength expenditure that directly related to the fund deriving particular ordinary or statutory income during the 2018/19 and 2019/20 income years”.

“Consequently, accountants, administrators and those involved in preparing the SMSF annual return for the 2018/19 and 2019/20 income years still need to consider and review SMSFs where they incur non-arm’slength expenditure or where expenditure is not incurred and such expenditure has a direct connection to a specific source of income,” he says.

Beyond this, though, there is little SMSF advisers, accountants, trustees and the wider sector can do but wait for the ATO to respond to the submissions made during the consultation period last year. That does not mean there is a shortage of possible solutions being put forward.

Butler says the ATO has in the past treated any free service that added value to an asset as a contribution, and in this case could consider it a non-concessional contribution provided by the member that reflected the value of the service, effectively neutralising the need for the ATO to apply the NALE provisions.

It is an idea SuperConcepts has also put forward in its submission to the ATO, where it suggested the creation of a safe harbour threshold for all NALE, including general and specific expenses, and only expenditure beyond the threshold should be covered by the new provisions. “The safe harbour threshold should be sufficiently high to ensure the typical activities undertaken by the trustees to comply with the legislation does not give rise to NALE if the fund doesn’t incur arm’s-length expenditure in relation to those activities,” Burgess’s submission says.

He adds the activities that should be considered under a safe harbour provision would include the preparation and lodgement of an SMSF’s annual returns, the maintenance of records of the fund’s financial transactions and statements, investment advice and any activities required to comply with the sole purpose test.

Alternatively, Shelton recommends the ATO could adopt a Part IVA approach, effectively dropping the general enforcement of NALE provisions except where the regulator deems it necessary to apply them.

“Bad policy gives rise to bad solutions and in this case attacks every cent of income with consequences not commensurate with the problem at hand,” he says.

“A better approach would be to use a Part IVA model that could be applied in extreme circumstances and where the ATO has found problems with non-arm’s-length arrangements. As the regulator it has the tools to go looking for these types of issues and to detect and expose them, instead of applying a measure to the SMSF sector that will not be applied to APRA (Australian Prudential Regulation Authority) and industry funds.”

Currently there is little indication the path the ATO will head down, with the regulator stating it has yet to confirm a release date for a finalised LCR as it is still processing the submissions related to the draft version.

Advisers, accountants and trustees are hoping it will be sooner rather than later. While the PCG offers temporary relief, many SMSF professionals are preparing work on 2018/19 annual returns and are hoping for a more practical solution than the one currently on the table.

One of the key questions behind the NALE provisions is what amount of revenue the ATO and Treasury may be missing out on as result of SMSF practitioners, and trustees, not charging their own funds for work completed to administer the fund or its underlying assets.

In response to this question, the ATO states it is analysing industry submissions on the matter, while Treasury directed selfmanagedsuper’s attention to the Explanatory Memorandum for the act, adding “the NALI measure as a whole is estimated to result in a total gain to revenue of $30 million over the forward estimates period, reflecting the additional tax paid by non-arm’s-length lenders on interest income earned on loans”.

When questioned about the revenue expected to be recovered from SMSF advisers and accountants under the NALE provisions, its response was: “Treasury does not separately publish detailed splits of the revenue impacts of the provisions as they apply to different activities or entities.”

KPMG enterprise director Julie Dolan, however, believes the figure could be much higher.

Dolan says if the $745 billion SMSF sector returned a weighted average rate of earnings of 4 per cent annually, that would equate to close to $30 billion for the current year.

While the exact level of income earned by funds held by advisers, accountants and other sector professionals is unknown, it would still equate to tens of millions of dollars which could be considered as NALI and taxed accordingly.

“Based on these numbers there is a sufficient motivation to implement the NALE provisions and pursue the potential revenue off the back of fund-related expenses, which may be significant mainly due to the massive size of the earnings in SMSFs and the assets under management,” Dolan says.