How A Contribution Can Trigger NALI

The ATO has clarified how a contribution can trigger non-arm’s length income (“NALI”) in its latest draft taxation ruling on contributions, TR 2010/1DC2, and the draft law companion ruling on NALI, LCR 2021/2DC.

Where non-arm’s length expenses (“NALE”) are involved, these documents work hand in hand to explain how, depending on the circumstances, a part in-specie contribution is not a contribution and can trigger NALI.

What is NALE?

Where an SMSF is involved in a scheme where the parties are not dealing with each other at arm’s length, and the amount of the loss, outgoing or expenditure, is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm’s length in relation to the scheme, it will trigger the NALI provisions.

The term ‘scheme’ is very loosely defined and casts an extensive net.

While a scheme traditionally has sinister overtones, it can mean any arrangement, agreement understanding, promise or undertaking regardless of whether it’s express or implied and whether or not enforceable. It can also include a plan, proposal, action and course of action or conduct.

NALE can relate to either a specific expense concerning a particular asset (or assets) or be of a general nature.

The Penalties

Where the SMSF more than benefits, the NALI provisions tax the fund at the highest marginal tax rate, which applies to: 

• Ordinary or statutory income derived from schemes 
• Dividends or amounts attributable to dividends 
• Entitlements to trust income (both fixed and non-fixed entitlements) 

Where the ATO deems the income to come from a specific NALE,  all income generated from that asset will be classified as NALI and taxed at the top marginal tax rate of 45%, even if the member is in the pension phase.   

Where the income is deemed to come from general NALE, it is also classified as NALI but calculated in line with the ‘twice the difference’ approach.

The maximum amount of NALI payable is restricted to twice the shortfall between the actual expense incurred and the expected market rate of the expense, capped at the fund’s taxable income.

Where NALI is less than the fund’s taxable income, the non-arm’s length component is taxed at the top marginal tax rate, and the remainder is the low tax component taxed at 15%.

The materiality level set by SMSF auditors will affect whether or not NALE is an issue. To this end, general NALE may not be identified during the audit.

The Contribution/NALI Issue

Firstly, TR 2010/1DC2  sets out how a person’s purpose is determined, how a fund’s capital is increased and when a contribution is made.

The draft ruling states that a person’s purpose will not benefit a member if “they are simply fulfilling the terms of a contract or arrangement entered into on a commercial or arm’s length basis”.

It is the first clue as to why an SMSF may not accept a contribution even though “paying an amount to a third party for the benefit of the superannuation provider” can increase the capital of the fund.

The ATO has determined that when an SMSF enters into a sale contract explicitly stating that the fund is acquiring the asset, any difference between the consideration paid by the fund and the market value of the asset cannot be considered an in specie contribution by the other party.

While both rulings state that a member can make a part in-specie contribution to purchase an asset, it will not count as a contribution where a contract specifies the fund as the purchaser.

How A Contribution Can Trigger NALI

The ATO is saying that the in-specie contribution results in the fund paying less than the market value of the asset because the acquisition is not a contribution where the legal right is purchased under a sale contract.

By way of example, a contract stipulates that the purchase price is $500,000, but the fund has physically paid $450,000.

The other $50,000 paid by the member personally cannot represent an in-specie contribution because the fund acquired the property through a sales contract and not an in-specie contribution.

Under these circumstances, the fund has incurred non-arm’s length expenditure under a non-arm’s length dealing for the purposes of applying NALI.

Furthermore, the non-arm’s length expenditure is a specific expense associated with the property, so all income derived from the asset will be NALI, including any capital gains from the disposal of the asset, effective from 1 July 2018.

The Solution

A fund can accept an in-specie contribution when purchasing an asset under a sale contract where the fund only acquires part of the asset.

The solution is to have the contract identify the fund’s interest in the asset and the in-specie contribution associated with the remaining interest.

However, this solution may not be practical if the vendor does not agree to modify the contract.

Luckily, example 5 of LCR 2021/2DC provides an alternative get-out-of-jail-free card for SMSFs.

Nadia wants to transfer business real property into her fund worth $500,000, but the fund only has $400,000 in cash.

The fund purchases 50% of the premises for $250,000, and she makes an in-specie non-concessional contribution of the remaining 50% for $250,000.

Nadia accepts the in-specie contribution as trustee of the SMSF and records it in writing with the market value of the in-specie contribution reported in the SMSF accounts. The fund subsequently reports the non-concessional contribution to the ATO.

Documenting the transaction in a separate minute, resolution, or other format should (hopefully!) be sufficient to stop triggering the NALI provisions.

Conclusion

The ATO’s new approach of not recognising a part in-specie contribution where a sales contract is in place does not align with the previous industry practice of categorising the difference paid by a member personally as a contribution.

It is an important distinction that SMSF professionals must be aware of because not only can it trigger NALI, but they may also face litigation if their advice does not align with ATO requirements.

Effective 1 July 2018, the retrospective application of the new draft ruling will significantly impact the SMSF industry. All we can do is wait.

Read more articles in our NALI series.

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