The tax laws that penalise uncommercial transactions between SMSFs and related parties are set to get tougher, with an SMSF’s expenses to come under the spotlight.
Now more than ever, SMSF trustees should be aware of the potential for these penalties to apply and seek advice before entering any related party transactions.
One of the key investment rules that SMSF trustees must be familiar with are the laws restricting “non-arm’s length” dealings. In essence, SMSFs are prohibited from dealing with a related party of the fund on uncommercial terms and, where these terms are too favourable to the SMSF, hefty tax penalties can apply.
Proposed laws before Parliament are set to tighten these rules further, so now is a good time for SMSF trustees to ensure they understand this area.
What is non-arm’s length income?
Any dealing between an SMSF trustee and a related party (such as a member or member’s relative, or a trust or company the member controls) must be on “arm’s length” terms. This means SMSFs cannot enter into transactions that are less or more favourable to the SMSF than commercial transactions.
Importantly, where an SMSF is not dealing at arm’s length with the other party and it earns more income than it might have been expected to earn under an arm’s length arrangement, all of the income from the arrangement – not just the excessive component – is taxed at a penalty rate of 45%.
This is in contrast to the usual 15% tax rate for funds in accumulation phase (or 0% to the extent the earnings come from assets supporting a pension). This is known as “non-arm’s length income” (NALI) and is illustrated by the following example:
Bob’s SMSF owns a commercial property that it leases to Bob’s manufacturing business. The parties sign a lease with rent set at $1,200 per week, even though the market rate of rent for comparable commercial premises in the area is around $800 per week. This results in the SMSF earning more rental income than it would under an arm’s length arrangement. All of the SMSF’s rental income – not just the amount by which it exceeds the market rate – will be taxed at 45%.
Proposed changes to capture expenses
Proposed amendments before Parliament will expand this regime so that income received by an SMSF that has not been dealing at arm’s length will also be taxed as NALI if, in gaining or producing the income, the fund has either not incurred a loss or expense that it might have been expected to incur if the parties had been dealing at arm’s length, or incurred a loss or expense that is less than the amount it might have been expected to incur.
One specific scenario that the amendments aim to capture is property acquired under a limited recourse borrowing arrangement where the rental income earned by the SMSF is at market rates, but the interest expenses paid by the SMSF to a related party lender are less than market rates. Under the proposed new laws, the rental income would be taxed as NALI because, even though it is at market rates, it is earned in connection with a scheme where the SMSF has not incurred arm’s length expenses.
The new laws also clarify that the NALI measures apply to capital expenditure. For example, where an SMSF acquires an asset below market value, not only will the rental income be taxed as NALI, but also the capital gain that results when the SMSF later disposes of the asset.
Know when to seek advice
The key to ensuring your SMSF does not fall foul of the NALI rules is to seek advice before entering into any arrangements with related parties. Contact us today if you are thinking about an investment opportunity for your SMSF that may involve a related party.