A suboptimal outcome

NALE ruling

The ATO's final ruling on non-arm’s-length expenditure (NALE) will demand perfection in record keeping to stave off very high tax penalties.

In the last edition of this newsletter, we broke the news the ATO had finalised its interpretation of non-arm’s-length expenditure (NALE) through the release of Law Companion Ruling (LCR) 2021/2.

Unfortunately, it did not deliver what sector stakeholders had been hoping for and in particular has failed to resolve concerns over certain general expenses and how they may trigger the NALE rules.

Just as a reminder, the thought process behind NALE is if an SMSF has not paid a proper commercial charge for a particular service, the income associated with that expense will be deemed non-arm’s-length income (NALI), as defined in the Income Tax Assessment Act, consigning that income to be taxed at the highest marginal tax rate, being 45 per cent.

The industry’s greatest concern over the application of the NALE rules was the fact the draft version of the ruling, LCR 2019/D32, gave no consideration to the actual dollar amounts that may trigger these harsh provisions.

In effect it meant a general expense of an inconsequential amount could easily taint all of the income of the fund as NALI.

After the release of LCR 2019/D32, in mid-2018, there was a consultation period and many conversations were had about introducing a de minimus rule. This basically would have provided a safeguard ensuring if a general expense was by nature considered NALE, but was insufficient to have a material effect on the fund, it would not trigger the rule and the harsh tax treatment would not eventuate.

Alas, this detail was not included in LCR 2021/2.

The situation prompted three accounting bodies, Chartered Accountants Australia and New Zealand, the Institute of Public Accountants and The Tax Institute, to immediately call for a review of LCR 2021/2 as the ATO’s current stance is really demanding perfection when it comes to the general expenses of an SMSF.

Their thought being the slightest error, no matter how small, could now subject the entire income of the SMSF to be taxed at the highest marginal tax rate.

There is still hope the situation could be resolved as the regulator had already stipulated it would not be applying any enforcement resources to police the NALE rules until the 2023 financial year. This means there is still close to 11 months for the industry and the ATO to sort the situation out and rest assured that engagement is already happening.

One of the biggest groups at risk of being unduly punished under the NALE rules was accountants with an SMSF. Their biggest worry was if they did the administration, including the preparation of tax returns and accounts, for the fund, but did not charge for those services, they could fall foul of the rules and all of the fund income would be taxed at the highest marginal rate.

Thankfully, LCR 2021/2 offered some solace on this front, confirming if the accountant performed this role, but only used any relevant office equipment infrequently and did not use any staff of their accounting firm, they would not need to charge the fund a service fee to avoid being caught by the NALE rules.

The alarm around the application of the NALE rules is justified given the severity of the resulting penalty. As such, we hope LCR 2021/2 will be amended to include some sort of materiality measure to the general expenses of an SMSF when it comes to NALE. This would surely avoid the suboptimal outcome certain funds may face under the ATO’s current interpretation of the rule.


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