The ATO has released Practical Compliance Guideline PCG 2020/5 which explains their compliance approach in respect of applying the non-arm’s length income (NALI) provisions to non-arm’s length expenditure. This Guideline is the finalised version of the draft guidelines previously released as PCG 2019/D6 in October 2019.
To date, much of the industry’s attention has focused on the ATO’s transitional compliance approach and their decision not to allocate compliance resources to checking whether the recently amended NALI provisions have been correctly applied in certain situations.
These situations related to general expenses or ‘fund level’ expenses, such as accounting fees, which have either not been incurred or have been incurred on non-arm’s length terms by an SMSF. In PCG 2020/5, the ATO say they will not allocate compliance resources to determine whether the NALI provisions have been applied where the fund incurs non-arm’s length expenditure of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund. PCG 2020/5 says the ATO will apply this transitional compliance approach to income derived by the fund during the 2018-19, 2019-20 and 2020/21 income years.
But there is another aspect of PCG 2019/D6 and PCG 2020/5 that has received far less attention and which could have important implications for SMSFs which, under normal commercial arrangements, could be expected to incur expenses linked to a particular investment of the fund. Importantly, the ATO’s transitional compliance approach does not apply to these situations and trustees are expected to apply the new NALI provisions as they were intended to apply. That is, if an activity or service is performed for the SMSF by a third party, or by the trustees in their individual capacity, and the non-arm’s length expense to which it relates can be linked to a particular investment of the fund, the income the fund derives from that investment will need to be taxed as NALI.
For example, where an SMSF owns direct property, and does not incur an expense on arm’s length terms for the property management services provided by a third party, then the ordinary or statutory income that the fund receives from that property for that income year will need to be taxed as NALI. This is the case for the 2018-19 income year and beyond.
There was certainly no indication in PCG 2020/5 that the ATO is looking to take a relaxed approach to the application of the new NALI rules to expenses which relate directly to a particular investment of the fund – only a transitional compliance approach to non-arm’s length expenses that have no such direct relationship.
In fact in the compendium to PCG 2020/5, the ATO provides a gentle reminder that they expect the industry to be applying the new NALI rules from the 2018-19 income year and beyond where the fund incurs non-arm’s length expenditure that directly relates to the fund deriving particular ordinary or statutory income in those income years. This is the case where the activity or service, that would normally give rise to an arms-length expense being incurred by the fund, has been provided by a third party or by the trustees in their individual capacity.
In the compendium, in response to a request by the industry to extend the transitional compliance approach beyond just general expenses, the ATO stated their transitional compliance approach would not be extended beyond that outlined in the PCG 2020/5, and that the final Guideline confirms that the transitional compliance approach will not apply where the fund incurred non-arm’s length expenditure that directly related to the fund deriving particular ordinary or statutory income.
Which bring me to Draft Law Companion Ruling LCR 2019/D3 and the many issues raised by industry about the application of the new NALI rules in situations where the non-arm’s length expense may be immaterial or trivial. This ruling is yet to be finalised and given the extensive industry feedback received by the ATO following the release of LCR 2019/D3, the SMSF Association has proposed a further round of consultations to ensure the final outcome is both balanced and practical.
In the compendium to PCG 2020/5, in response to a request by the SMSF Association and others to adopt a de minimis or safe harbour rule to avoid nonsensical outcomes where the failure to charge a small or immaterial expense could result in NALI, the ATO stated that they were considering a further practical compliance guideline as part of the finalisation of LCR 2019/D3.
While we wait for the Law Companion Ruling to be finalised its important not to overlook the application of the new NALI rules in situations where an SMSF does not incur an arm’s length expense for an activity performed by a third party, or by the trustees in their individual capacity, and which directly relates to a particular investment of the fund. We also suggest a common-sense approach when determining whether those expenses are trivial and therefore should invoke the new NALI rules.
Opinion piece written by
Peter Burgess, Deputy CEO / Director of Policy & Education,