SMSFs and Non-Arms Length Expenses

The Commissioner has released a draft Ruling (LCR 2018/D10 Non-arm’s length income – expenditure incurred under a non-arm’s length arrangement) on the proposed amendments to section 295-550 so that the non arms length income rules for super funds will apply to a scheme where a superannuation entity incurs non-arm’s length expenditure, or where expenditure is not incurred.

How will these rules work…

Example 1 – purchase less than market value and no in-specie contribution – NALI

During the 2018-19 income year, Russell, as trustee of his self-managed superannuation fund, purchased listed shares from a related entity for $500,000. The market value of the shares at the time of purchase was $900,000. The terms of the agreement specifies the purchase price as $500,000, rather than $900,000.

The non-arm’s length dealing between Russell’s SMSF and his related entity amounts to a scheme, which has resulted in his superannuation fund incurring capital expenditure that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The capital expenditure was incurred in gaining or producing the dividend income. Any dividend income derived by the superannuation fund from the shares will be NALI.

This seems simple but can get very messy… Have a look at how the Commissioner see this change applying to work done by the Trustee/Member of the SMSF in relation to the assets of the fund…

Lucky the Commissioner like accountants…

Example 4 – Internal arrangement within an SMSF – trustee provides services to the fund

Leonie is a trustee of an SMSF of which she is the sole member. She is a chartered accountant and also runs an accounting business. Leonie in her capacity as trustee, prepares the accounts and annual return for the fund. As she performs these duties or services as trustee of the SMSF, she does not charge the fund for this work.[18] The NALI provisions do not apply as the duties or services performed by Leonie are in her capacity as trustee rather than under an arrangement in which parties are dealing with one another on a non-arm’s length basis.

Example 5 – SMSF trustee carrying out duties in their personal capacity

Sharon is a trustee of an SMSF of which she is the sole member. She is a licensed real estate agent and runs a real estate business which includes property management services for rental properties. The SMSF holds a residential property which it leases for a commercial rate of rent. Sharon provides property management services in her personal capacity to the SMSF with respect to the residential property. She charges the SMSF 50% of the price for her services that she would otherwise charge a non-related party.

For the purposes of subsection 295-550(1), the scheme involves the SMSF obtaining the services from Sharon and deriving the rental income. The price Sharon charges the SMSF constitutes a non-arm’s length dealing between the SMSF and Sharon, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The rental income derived from the residential property is therefore NALI.

It is not all bad news. In this draft Ruling the Commissioner states how we can overcome some of these non arms length expense issues when buying assets by treating the difference as an in-species contribution…

Example 3 – part purchase/part in-specie contribution at market value – not NALI

During the 2018-19 income year, Nadia owns commercial premises that she leases to a third party which use the premises to carry on a business. The commercial premises have a market value of $500,000. Nadia would like to transfer it to her SMSF but her fund only has $400,000 in cash. Nadia’s SMSF purchases 50% of the commercial premises under a contract from Nadia for $250,000. Nadia makes an in-specie non-concessional contribution of the remaining 50% interest in the commercial premises (valued at $250,000). The acceptance of the in-specie contribution by Nadia as trustee of the SMSF is recorded by her in writing and the market value of the in-specie contribution is reported in the fund’s accounts. The SMSF reports the non-concessional contribution to the ATO.

Nadia’s SMSF continues to lease the commercial premises to the third party at a commercial rate of rent. As the commercial premises were acquired by the SMSF at market value and a commercial rate of rent was charged, the rental income derived by the SMSF is not considered to be NALI. Any capital gain that might arise from the disposal of the factory will also not be NALI.

Lastly, remember that where a superannuation fund acquires a CGT asset at less than its market value, the market value substitution rule will apply, and modify the cost base of the asset. The superannuation fund, when determining the cost base of its CGT asset, is treated as having acquired the asset at market value. This affects the amount of any capital gain that may arise from a later CGT event, but does not affect the application of the NALI provisions in determining whether the asset was acquired by the fund at market value.

Therefore, any capital gain that the fund makes from a subsequent CGT event happening in relation to the asset (such as a disposal of the CGT asset) will be Non Arms Length Income.

Example 7 – market value substitution rules (CGT consequences for the transferor and the fund)

Continuing with Example 1 above, Russell’s SMSF sells the shares it acquired for $500,000 for $1 million two years later.

When calculating the capital gain for the fund on disposal of the shares, the cost base of the shares will be modified by the market value substitution rule in section 112-20[20] as the parties did not deal with each other at arm’s length in relation to the acquisition.

This means that the cost base for the shares will be their market value at the time of acquisition by Russell’s SMSF, which was $900,000. The SMSF has therefore realised a gross capital gain of $100,000 ($1 million sale proceeds less deemed cost base of $900,000).

The $100,000 capital gain derived by the superannuation fund is NALI. This is because the amount of expenditure incurred by the superannuation fund in acquiring the asset was less than what the superannuation fund might have been expected to incur if the parties were dealing with each other at arm’s length.

Ouch!

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About Ken Mansell

As a stay at home Dad most of the week this is my way of pretending I am still the tax counsel of ASX and SEC listed companies, working at big 4 firms, working at the Federal Treasury, on the Henry Review and at Parliament House for the previous government.
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