Ref: AMK:lg
24 February 2023
Retirement, Advice and Investment Division
Treasury
Langton Cres PARKES ACT 2600
By Email: superannuation@treasury.gov.au
Dear Sir/Madam
NON-ARM'S LENGTH EXPENSE RULES FOR SUPERANNUATION FUNDS
1. Thank you for the opportunity to provide comments to the Treasury in relation to the consultation paper titled Non-arm’s length expense rules for superannuation funds (“Consultation Paper”).
2. Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we service many clients that may be impacted by the non-arm’s length expense (“NALE”) rules.
3. We welcome Treasury exploring potential reforms to the NALE rules following the Australian Taxation Office’s (“ATO”) interpretation of the rules contained in Law Companion Ruling (LCR) 2021/2 which, if correct, would result in disproportionate and unfair outcomes for breaches, particularly those relating to non-material amounts of general expenditure.
4. We highlight that we do not support the recommended approach to dealing with the issues associated with the NALE provisions. We have outlined our concerns and alternatives in this submission.
Recommendations
5. The following sections outline our main recommendations with respect to the proposed changes to the NALE rules. In particular:
5.1. We recommend treating complying large APRA-regulated superannuation funds the same as other complying superannuation funds, as we do not agree with the distinction made which currently could be seen as being discriminatory.
Leo Gouzenfiter5.2. We recommend that, where breaches occur, the arm’s-length consideration (less the actual expenditure incurred) should be deemed to be a contribution to a fund. We believe that such a rule would be far simpler to apply than a proposed capping rule and result in more appropriate outcomes.
5.3. Such an approach is necessary in our view to deal with the inherent difficulties that exist in applying the current NALE rules, in particular, the issues of nexus.
5.4. In any event, the cost of compliance in determining arm’s-length fees would be significantly disproportionate where the difference between the amount charged and the arm’s-length fee was relatively immaterial. Accordingly, we recommend that it is critical to have a de minimis rule (of say $5,000 per fund per annum) to ensure that there is a balance between the integrity of the system and the costs of complying with the system.
5.5. Due to the high costs of applying the NALE rules and in determining the armslength service fee, we would recommend that Treasury should consider the option of requesting the ATO to release ‘acceptable’ benchmark thresholds for three common expenses: audit fees; accounting fees and investment manager fees.
5.6. Should Treasury continue with the proposed ‘capping’ rule, we request that further thought be given to how to apply the capping rule to different classes of income of the superannuation fund.
5.7. We do not believe that the NALE provisions should apply to assessable contributions. We recommend that the law be amended to make it clear that this class of income is excluded from the existing NALE provisions.
5.8. Lastly, we recommend that Treasury also reconsider the approach to specific expenses and consider treating such breaches as contributions, supported by a statutory de minimis to cover breaches that are immaterial.
6. The following sections provide further comments in relation to each of the items outlined above. We would be happy to discuss any of these options with you further.
Treatment of large APRA-funds and other superannuation funds
7. We do not agree with the proposal to treat large APRA-regulated funds differently from other complying superannuation entities.
7.1. The rationale provided in the Consultation Paper is that large funds generally enter into non-arm’s length arrangements with the primary intention of reducing costs in order to pass on savings to members, rather than for a dominant tax purpose. However, the NALE rules do not contain a purpose test. Accordingly, making a distinction on this basis is inappropriate. Further, this assertion is contradicted by Example 4 in the Consultation Paper which seeks to preserve the NALE treatment for non-general expenditure for large funds. It is not clear why large funds may have a tax avoidance purpose for one kind of expenditure as compared to another. Accordingly, we believe that the distinction may be seen as arbitrary, potentially discriminatory and not consistent with the current policy and set of provisions.
7.2. In respect of self-managed superannuation funds and small APRA-regulated funds, we believe that most breaches relating to general expenditure (according
to the interpretation taken by the ATO in LCR 2021/2) would result from relatively immaterial services provided to the fund by a member where the need to charge a fee to ensure the NALE rules do not apply is overlooked. These are not arrangements designed to exploit the tax system.
7.3. If a dominant tax avoidance purpose is thought necessary to engage the NALE rules, then they should be amended to include a purpose test. We believe that most of the arrangements would not satisfy such a purpose test and accordingly we believe that this would reduce the scope of the application of such provisions.
7.4. Whether one considers the effect on a large APRA-regulated fund or a selfmanaged superannuation fund, the need for reform in both cases is critical due to the severely disproportionate outcomes that would arise under the ATO’s interpretation of the rules. This is due to the nature of the rules which can ultimately only treat amounts of income as non-arm’s length income (“NALI”). Where an item of income is derived from non-arm’s length dealings then it is that item alone that is treated as NALI. Where expenditure, or a lack of expenditure, results from non-arm’s length dealings, this cannot be taxed directly and instead requires a nexus to be established to some items of income. Where such a nexus exists, the amount of the expenditure may be vastly different to the amount of the income to which it is said to relate.
8. As such, we believe that the provisions should adopt an exemption or exclusion that can be applied to all complying superannuation funds in respect of general expenditure.
Concerns with LCR 2021/2 and policy design
9. The ATO’s interpretation of the NALE rules in paragraphs 295-550(1)(b)-(c) highlights the inherent flaw in the current policy design around rules intended to provide integrity around taxable income being diverted into superannuation funds through non-arm’s length dealings relating to expenses.
10. In Example 2, LCR 2021/2 takes the view that an expense that is not incurred (but might have been expected to have been incurred) “for” an income year has a sufficient nexus to all the income for that income year. Example 1A of the Consultation Paper proceeds under the assumption that this is correct and states that “under the current NALI rules, there is a sufficient nexus between the accounting services expense and all income of the SMSF”.
11. The concept of nexus is complex with an extensive body of case law behind it with new disputes emerging.1 In Ronpibon Tin NL v FCT2, the High Court stated that:
it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income
12. The principles of nexus do not require linking a particular loss or outgoing to a particular item of income. Nexus looks at what is productive of income more broadly, rather than matching a particular expense to a particular item of income or many
1 For example, refer to the recent Full Federal Court decisions in Clough Limited v FCT [2021] FCAFC 197 and Watson as trustee for the Murrindindi Bushfire Class Action Settlement Fund v FCT [2020] FCAFC 92 which both considered nexus under section 8-1 as the primary issue for the deductibility of certain expenses.
2 [1949] HCA 15.
particular items of income. In Toohey’s Ltd v C. of T. (N.S.W.)3 Ferguson J stated that it is not necessary to “track each item of expense… and allocate it to some definite item of income”, as if to determine that a “lump of coal put into a steamer’s furnace was responsible for a particular blast from the whistle”.
13. The Federal Court in FCT v Total Holdings (Australia) Pty Ltd4 stated that “the circumstance that each item of expenditure cannot be traced to a particular item of income does not prevent the deduction of the expenditure”. That is, there may not be a nexus to any particular item of income (or all items of income), but rather to the production of income more generally.
14. TR 2004/4 considers issues of nexus in more detail, particularly around expenses incurred prior to the commencement of income earning activities and those incurred following the cessation of income earning activities.
15. Additionally, TR 93/17 states that superannuation funds may be able to deduct expenses under the second positive limb in section 8-1, dealing with those necessarily incurred in carrying on a business (rather than incurred in gaining or producing assessable income). As such in many cases, the kinds of expenses listed in paragraph 19 of LCR 2021/2 may not have the kind nexus required by the NALE rules (i.e. a first positive limb kind of nexus).
16. LCR 2021/2 seems to conclude that a general expenses breach will result in all the income of the fund for a particular year being NALI. The Consultation Paper assumes this is correct and follows this approach. But it is not explained what this means in practice. Does an accounting service performed in May 2023 cause all of the income for the 2022-23 income year to become NALI given that it relates to preparing the accounts for that prior income year or is it the income in the 2023-24 year? If services are provided in respect of the three previous income years does this result in all that prior income becoming NALI? Is the nexus different for investment advisory fees? Why does an expense incurred (or not incurred) on 29 June 2023 more likely have a nexus to an item of income derived on 1 July 2022 (or even 1 July 2021 if the nexus is supposed to be to the prior year) rather than 1 July 2023?
17. We do not believe that the principles in LCR 2021/2 are fundamentally correct. The ATO (at paragraph 21) considers the nexus between a scheme and the fund’s income, rather than the nexus between expenditure and the fund’s income. Further, LCR 2021/2 does not appear to consider the requirement for there to be a scheme and simply assumes that everything is a scheme. Example 9 seems to assume that carrying out works and repairs on a property is a scheme.
18. These principles highlight the inherent difficulties of applying the NALE provisions, particularly to general expenses, all of which stem from the current design of the rules which do not seek to directly tax the subject matter itself (i.e. the lack of expenditure), but rather seek to indirectly tax something else (i.e. the income to which the lack of expenditure has a nexus). For this reason, we believe that there would be significantly less complexity (from a design perspective) to deal with the subject matter directly, by treating it as a contribution to the fund.
19. We are concerned that the Consultation Paper improperly proceeds on the assumption that the law actually operates as LCR 2021/2 states, and merely looks to add one additional feature to those rules by introducing a cap. However, we urge Treasury to
3 (1922) S.E. (N.S.W.) 432.
4 [1979] FCA 30.
reconsider the design of the rules holistically given the significant issues that are present in the law as currently written and we make recommendations in this regard below.
Treating the value as a contribution to the fund
20. In our view, the simplest mechanism that would address the issue would be to treat the arm’s length value of the services provided to the fund (in excess of the consideration paid) as a contribution to the fund. This may result in the fund being taxed on the value of that contribution or the relevant member being taxed to the extent it causes a breach of their contribution caps. This would achieve a more appropriate and proportional outcome in respect of such breaches.
21. We note that our alternative proposal is one that has been considered historically and we believe would work quite easily in practice. We refer to TR 2010/1 “Income tax: superannuation contributions”, Examples 1 and 2, that deal with scenarios broadly similar to those covered by the NALE provisions. While Example 2 (services provided for no fee) does not result in an amount being treated as a contribution to a superannuation fund under the current superannuation provisions, we note that a minor amendment to the provisions could ensure that this would be the outcome.
22. We believe that this alternative approach would remove significant complexities in applying the NALE rules and provide appropriate outcomes for funds that happened to have a low amount of taxable income for the year in which the breach occurs. As Example 1B of the Consultation Paper demonstrates, the fund with lower income can suffer a disproportionately lower consequence for the same breach as the fund with higher income in Example 1A. If a fund had no taxable income for the year then it would suffer no consequence at all under the proposed cap, or under the NALE rules as they currently operate. Treating the breach as a contribution would result in the same consequence for all funds, regardless of their size or levels of income.
Introducing a de minimis rule
23. Regardless of the policy ultimately adopted to deal with general expenses (i.e. a capping rule versus a contribution rule), we believe that it is critical that Treasury consider introducing a statutory de minimis to exclude minor breaches. The cost of complying with the provisions (i.e. determining the value of arm’s-length service fees) may significantly outweigh the amount of the adjustment required to the taxable income of the superannuation fund. A de minimis rule would strike a balance between compliance and the cost to revenue and would prevent severely disproportionate and unfair outcomes occurring in respect of common expenses that all funds typically incur each year, being accounting fees, audit fees, investment adviser fees and other administrative management costs. These are listed as examples of general expenses at paragraph 19 of LCR 2021/2.
24. We recommend that, where the annual general expense breaches for an income year in relation to these common general expenses are below a statutory de minimis, say $5,000, then an exemption from the NALE rule should apply. This would help to ensure that taxpayers are protected where there are minor breaches or oversights and provide a level of comfort from being subject to ATO scrutiny in respect of relatively immaterial amounts.
25. By way of example, if general expenses of $2,000 where incurred by a superannuation fund, a de minimis of $5,000 would mean that the ATO would need to allege that the
expenses should have been in excess of $7,000 for the provisions to apply. Accordingly, this would apply an appropriate safeguard to the superannuation fund without the need to incur further costs in relation to immaterial amounts.
26. A statutory de minimis would therefore ensure compliance costs are only incurred where services of material value are provided to the fund from related parties.
Annual benchmarking by the ATO
27. In addition, where taxpayers are outside of the de minimis rule, compliance costs may still be significant for a superannuation fund to determine the extent of the application of the provisions and whether there is an amount of NALE.
28. We believe that compliance costs would be significantly reduced if the ATO were required to publish benchmarks for what they may consider to be acceptable ranges for common services to superannuation funds. This could be in the form of a practical compliance guidelines that sets out low-risk and high-risk zones indicating in what circumstances the ATO are likely to dedicate compliance activities to reviewing these arrangements from 1 July 2023.
29. We believe that the three main expenses that this would be required for are accounting fees, audit fees and investment advisory fees. Given that benchmarking would be limited to these three areas, we do not believe it would be difficult for the ATO to provide appropriate ranges for these typical costs.
Determining the non-arm’s length component
30. Section 295-5455 states that the non-arm’s length component (“NALC”) of a superannuation fund’s taxable income is its NALI for the year less any deductions that are attributable to that income.6 The NALC is therefore a net concept rather than a gross concept.
31. It is not clear whether the “5 times” cap proposed in the Consultation Paper would operate by deeming the NALC to be increased by 5 times the amount of the general expenditure breach (up to the level of taxable income) or whether it would treat 5 times the amount of the breach as NALI.
32. In the former case, this would disregard the effect of deductible expenses which are intended to reduce the proportion of the fund’s taxable income that is taxed at the 45% rate where they are attributable to its NALI.
33. In the latter case, this would require determining which actual items of ordinary or statutory income are NALI and to what extent.
34. Take the following example:
34.1. Fund A holds two assets each of which generate $100,000 of ordinary income for the year.
5 All statutory references are to the Income Tax Assessment Act 1997 unless otherwise indicated.
6 This is the amount to which the 45% tax rate applies by virtue of section 26 of the Income Tax Rates Act 1986
34.2. Asset 1 is real property and is funded by permitted borrowings resulting in $100,000 of deductible expenses for the year (e.g. interest, depreciation, maintenance, etc)
34.3. Asset 2 is a bank deposit which does not result in any allowable deductions for the year.
34.4. Fund A’s taxable income is $100,000 for the year (i.e. $200,000 of ordinary income less $100,000 of allowable deductions).
35. If there is a $2,000 NALE general expenditure breach, one option could be to deem $10,000 to be the NALC, with the remaining $90,000 of taxable income taxed at 15%.
36. The second option is to treat $10,000 of the gross $200,000 ordinary income as NALI and allocate this on a pro-rata basis. This would result in $5,000 of income generated by each of Asset 1 and Asset 2 as NALI. The NALC could then be reduced by any deductions attributable to the $10,000 of NALI. In this example, it would be appropriate to attribute $5,000 of deductions relating to Asset 1 to the $5,000 of NALI generated by Asset 1 using the same 1:1 ratio of income to deductions generated by that asset. Under this option, the NALC would therefore be $5,000 with the remaining $95,000 of taxable income taxed at 15%.
37. We believe that the second option, while more complex, provides a more appropriate outcome and is more consistent with the fundamental basis underpinning the view that general expenditure has a nexus to all income of a fund, being gross income rather than taxable income.
38. We highlight the complexity that may arise in designing the “cap”, which we believe further supports our main submission that general expenditure breaches should instead be treated as contributions to the fund.
Assessable contributions should be excluded from NALE
39. The view taken at paragraph 19 of LCR 2021/2 is that NALE will have a sufficient nexus to all ordinary and/or statutory income. If this is correct, this would include member contributions that would form part of a complying superannuation fund’s statutory income under Subdivision 295-C.
40. By their nature, there should be no circumstance under which contributions are treated as NALI. It is only through a strained and questionable interpretation of the nexus concept, being that general expenditure that is considered NALE has a nexus to each and every item of ordinary and statutory income of a fund, that could see contributions taxed at 45% (in addition to potential Division 293 tax).
41. In reforming the NALE rules, Treasury should, as a minimum, ensure that assessable contributions of a complying superannuation entity cannot be treated as NALI.
Specific expenses
42. We recognise that the Consultation Paper does not propose to alter the treatment for “expenses of a specific nature”. However, the exact same kinds of disproportionate outcomes may apply to these kinds of expenses if they are considered NALE.
43. This is due to the same fundamental structural issue, being that NALE itself cannot be taxed as it is the income that it has a nexus to it that is considered NALI. The reliance on nexus produces the same kind of disproportionate outcomes. For example, the failure of a self-managed superannuation fund to pay an arm’s length fee to a member who is a tradesperson in respect of minor repairs to an investment property held by the fund could result in all the taxable income of the fund from that asset being taxed at 45%.
44. In fact, the outcome is even more disproportionate for such specific expenditures as LCR 2021/2 takes the view that there is a tainting effect for all time so that income derived from that asset years or even decades later is still considered NALI, including any ultimate capital gain. Further, there is nothing that can be done to remedy the breach. Unlike with NALI resulting from excessive income being charged, which can be remedied for future years by reducing the income to an arm’s length amount, the expenditure breach cannot be undone, with the nexus to income from that asset continuing indefinitely into the future.
45. We believe that there would be serious doubt as to whether the ATO’s view would be the correct position. There is likely to be a point at which the expenditure is considered far too remote to have any nexus to the income generate by the asset and as such we disagree with the ATO’s interpretation of the NALE rules.
46. However, the Consultation Paper seems to proceed on the basis that this is the correct application of the law and that no reforms are required as, presumably, this is also the appropriate outcome from a policy perspective.
47. We suggest that the need for policy reform of the NALE rules is simply due to the disproportionate outcomes arising as a result of the potential interpretation of the nexus concept. These outcomes are present for both specific and general expenditures and, in many cases, even more pronounced for specific expenditures as the consequences (according to the ATO) are not limited to one income year. Additionally, general expenditure breaches are more likely to be present for non-professionals (e.g. tradespersons who hold real property in their self-managed fund) who are less likely to be aware of the risk as compared to professionals.
48. Therefore, similar to our submissions related to general expenses, we suggest that breaches relating to specific expenses by treated as a contribution in addition to a statutory de minimis that would cover minor breaches related to specific expenses.
If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8610 5170.
Yours sincerely
A M KOKKINOS Executive Director