Background

Law Companion Ruling LCR 2018/D10 (‘LCR 2018/D10’) relates to proposed amendments to section 295-550 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA’) and the non-arm’s length income (‘NALI’) provisions. The Ruling is currently a draft Ruling, as the Treasury Laws Amendment (2018 Superannuation Measures No.1) Bill (2018) (Cth) (‘the Bill’), to which the Ruling relates, has yet to pass through the Senate. The purpose of the amendments in the Bill is to ensure that superannuation funds cannot circumvent the contribution caps by using non-arm’s length expenditure to inflate their overall income.

LCR 2018/D10 and the relevant provisions of the Bill apply in relation to income derived in the 2018-19 income year, and later years. The amendments proposed in the Bill are to ensure that a superannuation entity’s non-arm’s length income includes income where expenditure in gaining or producing it was not an arm’s length expense.

Taxable income of superannuation funds

The taxable income for a complying superannuation fund is comprised of two components. The first is the low tax component, which is taxed at 15%. The second is the non-arm’s length component. This is taxed at the top marginal rate. This is the NALI for an income year, minus any attributable deductions to that income. The first component is the superannuation fund’s total taxable income minus the amount of the second component.

What income falls under the NALI provisions?

Under the current legislation, the NALI provisions related to complying superannuation fund’s that derived ordinary or statutory income under a scheme where:

• the parties were not dealing with each other at arm’s length in relation to the scheme, and
• the amount of income from that scheme is more than what might have been expected to have been derived if those parties had been dealing with each other at arm’s length.

The provisions also related to income derived as a beneficiary of a trust through holding a fixed entitlement to the income of the trust, in situations where:

• the fund acquired the entitlement under a scheme where the parties were not dealing with each other at arm’s length, and
• the amount of income is more than what might have been expected to have been derived if those parties had been dealing with each other at arm’s length.

What are the proposed changes to the NALI provisions?

Under the proposed changes, these rules will remain the same. Changes to the NALI provisions aim to clarify the application of these provisions where a complying superannuation fund incurs a loss, outgoing or expenditure in certain circumstances. As is explained in LCR 2018/D10, an amount of ordinary or statutory income will be NALI of a complying superannuation fund where:

• there is a scheme in which the parties were not dealing with each other at arm’s length
• the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing the income, 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

The new rules also mean that income is NALI if the fund does not incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties had been dealing at arm’s length.

These rules concerning losses, outgoings and expenditures will also apply to other income derived by a complying superannuation fund as a beneficiary of a trust through holding a fixed entitlement to the income of the trust.

Purchase of an asset under a non-arm’s length arrangement

LCR 2018/D10 states that where a complying superannuation fund purchases an asset less than market value under a scheme where the parties were not dealing at arm’s length, the fund incurs non-arm’s length expenditure for the purposes of applying the NALI provisions. Where the NALI provisions apply to the purchase of either all or part of an asset, all of the income derived from that asset will be NALI.

Examples

The following examples are provided in LCR 2018/D10, along with several others.

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 (SMSF), 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. Accordingly, the arrangement did not involve an in-specie contribution being made to the SMSF.

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.

The non-arm’s length expenditure incurred in acquiring the shares will also result in any capital gain that might arise from a subsequent CGT event happening in relation to the shares (such as a disposal of the shares) being NALI.

Example 2 – 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.

Example 3 – SMSF incurs non-arm’s length expenditure in acquiring a fixed entitlement in a unit trust

During the 2016–17 income year, Scott, as trustee of his SMSF, entered into a non-commercial LRBA with himself in his personal capacity to purchase units, valued at $50,000, in a stock exchange listed unit trust. The SMSF borrowed 100% of the purchase price and the terms of the loan included no interest being charged and repayments of principal not being required until the end of the 25-year term of the loan. The units provide the SMSF with a fixed entitlement to the income of the unit trust. The unit trust distributes $8,000 to the SMSF at the end of the 2018–19 income year.

If Scott’s SMSF had entered into an LRBA on arm’s length terms, it would be expected that repayments of principal and interest would have occurred monthly and interest would have been charged under the LRBA at a commercial rate. It could have also used its own cash assets to fund part of the purchase to reduce the loan to market value ratio to commercial levels.

For the purposes of subsection 295-550(5), the scheme involves the SMSF entering into the LRBA with Scott, complying with the terms of the LRBA, purchasing the units in the unit trust, and deriving income from those units. The terms of the LRBA constitute a non-arm’s length dealing between the SMSF and Scott, which resulted in the SMSF incurring expenditure in gaining or producing 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 $8,000 distribution derived from the units in the unit trust in 2018–19 and any distribution derived in future years is, therefore, NALI.

The non-arm’s length expenditure under the LRBA will also result in any capital gain that might arise from a subsequent CGT event happening in relation to the units (such as a disposal of the units) being NALI.