By Monica Rule

Non-Arm’s Length Income

One area of the superannuation law I am frequently asked about is Self-Managed Superannuation Funds (SMSF) investing with members. 

Superannuation Law does allow SMSFs to invest with their members, but it is mostly restricted to 5% of an SMSF’s value.  For example, an SMSF that has a total value of $500,000 can invest up to $25,000 (i.e. 5%) in a member’s business by either purchasing shares in the member’s company business or lending money to the company.

In a situation where an SMSF owns a residential property, it can lease the property to a member as long as the value of the property does not exceed 5% of the total value of its assets.  If it is leased to a member who uses the property wholly and exclusively for their business then the value of the property can exceed the 5% limit.

An SMSF can invest more than 5% in a related non-geared entity – such as a company without any borrowings – if it satisfies the requirements of the law.

All investments with related parties must be entered into and maintained at arm’s length.  The interpretation of what is “arm’s length” under the superannuation law caused a lot of confusion back in 2010. This is because the law states that as long as the terms and conditions of the investment transaction are “not more favourable to the other party” then it is allowed.

The ATO expressed its view of the super law definition back in 2010 in the publication ATOID 2010/162. The publication gave an example where an SMSF borrowed money from a related party on terms that were more favourable to the SMSF.  The example involved a member borrowing money from a bank at a 5% interest rate and then loaning the money to their SMSF at 5%.  If the SMSF had borrowed the money directly from the bank, it would have been charged an interest rate of 6% or higher.  The publication states this arrangement is acceptable as the loan is not more favourable to the member, who in this case is the other party.

So, from 2010 to 2016, there were many clever trustees who took advantage of the ATO’s interpretation. Their SMSFs borrowed from members, and the loan arrangements consisted of borrowing 100% of the asset value; no repayments being made for many years; and, an interest rate of zero per cent.  The ATO allowed these arrangements at the time due to the wording of the superannuation law.

Now, the Commissioner of Taxation is responsible for ensuring that taxpayers comply with the superannuation law as well as the income tax law.  So, the problem he faced was that the definition of a “Non-Arm’s Length Income” (NALI) under the income tax law states that if a taxpayer received income from an investment that is more than what it would have received if the investment transaction was with an unrelated party, then the income will be treated as NALI and taxed at the highest marginal tax rate (i.e. 45%).

So in 2016, the ATO issued two new publications (PCG 2016/5 and TD 2016/16) to explain its position on the income tax law definition and how it would apply to SMSFs.  

In the PCG 2016/5, it states that if an SMSF borrows from a related party, the borrowing arrangement needs to be at arm’s length where the interest is charged at a commercial rate; the amount borrowed does not exceed 70% of the asset’s value; a registered mortgage is placed over the property; principal and interest is paid monthly; and, the borrowing period is not more than 15 years.

TD 2016/16 gave an example where a hypothetical borrowing arrangement is compared with the actual arrangement entered into by an SMSF with a related party.  It states that if the SMSF could not have entered into the hypothetical arrangement (i.e. an arm’s length loan arrangement) then the income earned by the SMSF will be treated as NALI and taxed accordingly.     

So, if an SMSF trustee is thinking of borrowing from its members to acquire an asset for the SMSF, they need to ensure that the loan arrangement is at arm’s length to avoid the investment income being taxed at 45%.

I’m always impressed with how clever people are to exploit interpretations of the law. I guess as our example shows, the challenge for legislators and bureaucrats is to clearly express a law’s intent without making it indecipherable to us mere mortals.

Non-Arm’s Length Expenditure

Currently before the Senate, there is a proposal to amend NALI provisions in the income tax law to include expenses. The proposed amendment is to ensure that SMSFs cannot circumvent the rules by using non-arm’s length expenditure. 

On 19 December 2018, the Tax Office released the publication LCR 2018/D10 that provides guidance on the proposed changes to NALI. LCR 2018/D10 lists the Tax Office’s views on how the proposed amendments will operate where an SMSF incurs non-arm’s length expenditure in gaining or producing income.

LCR 2018/D10 provides examples of where either the SMSF’s expenses are less than what would have been incurred had the parties been dealing at arm’s length; or, there is no loss, outgoing or expense incurred by the SMSF where some would have been expected if the parties had been dealing at arm’s length. In these situations, the income earned by the SMSF are treated as NALI and taxed at 45%. Any capital gains from the subsequent disposal of the asset is also treated as NALI.

If the law is amended, SMSFs will need to ensure that all expenses are the same as if it had been dealing on an arm’s length basis.  SMSFs will need to undertake good record keeping of their expenses to avoid higher tax being imposed on either their investment income or on capital gains from disposal of their assets.  

For Gold and Platinum members, Monica has provided a summary of the examples provided in LCR 2018/D10.

Monica Rule is the author of The Self Managed Super Handbook – Superannuation Law for SMSFs in plain English – www.monicarule.com.au

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. The statements and opinions are the expression of the author, not Law Central, and have not been checked for their accuracy, completeness or changes in the law. Law Central recommends you seek professional advice before taking any action based on the content of this Bulletin.

Related documents:

• Self Managed Superannuation Fund Deed
• SMSF Limited Recourse Borrowing Arrangement
• Declaration of Trust (before you Buy)
• Acknowledgement of Trust (already own asset)
• Loan Agreement (No Security)

Related webinars:

• Webinar - Superannuation: Current Status Of The Proposed Changes
• Webinar Recording - Investment Restrictions For Self Managed Superannuation Funds