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The treatment of non-arm’s length income transgressions in SMSFs need to factor in the heavy penalties, says one adviser.
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When NALI punishment goes way beyond the crime
28 November 2023
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The “extremely heavy-handed treatment” of non-arm’s length income needs to be factored into the debate about penalties, one SMSF adviser says.
SMSF Alliance director David Busoli said advisers should ensure their clients understood the importance of dealing at arm’s length and, in cases involving related-party limited recourse borrowings, adhere strictly to established guidelines.
He said that if a specific asset breached non-arm’s length income (NALI), both its income and future capital gains could be permanently affected and result in a 45 per cent tax impost.
Three examples from Law Companion Ruling 2021/2 indicated the unreasonableness of this rule, he said.
LCR 2021/2 outlined the application of the ATO’s view on the non-arm’s length expenditure (NALE) provisions and clarified when and where an outgoing, expenditure or loss could constitute NALI.
It held that where an expense was incurred by a fund that was less than an arm’s length amount, all of the fund’s ordinary income and statutory income (including net capital gains and concessional contributions) was NALI and, after attributable expenses, taxed at 45 per cent.
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Mr Busoli said the first example in the LCR 2021/2 concerned Russell, whose SMSF purchases $900,000 of listed shares from a related entity for $500,000.
“He doesn’t take measures to have the difference treated as a non-concessional contribution,” Mr Busoli said.
“All future dividends and eventual net capital gain will be NALI and taxed at 45 per cent.”
He said that if Russell were trying to limit his CGT on the sale of the shares to his fund, he would have failed as the market substitution rules would revalue the transaction, for CGT purposes, to $900,000.
“In keeping with this principle, the cost base shown by the SMSF, for eventual CGT purposes, would also be $900,000,” Mr Busoli said.
In the second example, Kellie lent her SMSF 100 per cent of the $2 million required for the fund to purchase a property from an unrelated party using a related-party limited recourse borrowing.
“The interest rate is 1.5 per cent, paid annually over 25 years. The property is rented to an unrelated party at commercial rates,” Mr Busoli said.
“Because the terms of the loan are not allowable under the safe harbour provisions, the net rent, and subsequent taxable capital gain on sale of the property, will be NALI and subject to 45 per cent tax. This is a permanent position. Even refinancing the loan through a bank won’t help.”
The final example involved Trang, who was the trustee of her sole-member SMSF. She was a plumber and ran her own plumbing business as a sole trader.
“Trang renovates the bathroom and kitchen and doesn’t charge the SMSF. Trang has permanently tainted the asset, so it will be treated similarly to Kellie’s,” Mr Busoli said.
“Clearly, the punishment far outweighs the crime, but the regulator is reticent to consider changes simply because it doesn’t believe the provision has ever been applied to this type of scenario.”
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