SMSFs warned: stick to arm’s length rules or lose tax breaks

First published in the Financial Review on 20 July 2018.

The federal government is widening the scope of the non-arm’s-length income rules to make it clear to SMSF trustees who improve their superannuation earnings via transactions outside these requirements that they will be caught.

A bill, introduced to parliament on May 18, 2018 by Revenue and Financial Services Minister Kelly O’Dwyer, will tighten up the legislative framework to ensure all transactions, including expenses incurred by an SMSF, are at arm’s length, otherwise they will not be entitled to concessional tax treatment.

The amendments, which are before the Senate, will take effect from July 1, 2018 if they become law.

The requirement for SMSFs to conduct all financial transactions on an arm’s-length basis is integral to the system: the purchase and sale price of fund assets should always reflect their true market value; and the income from assets held by a fund should reflect the true market rate of return.

The amendments, foreshadowed in the Superannuation Taxation Integrity Measures consultation paper released in January, aim to give more clarity to the rules and to ensure that super funds can’t sidestep them by using non-arm’s-length expenditure rather than non-arm’s-length income. Effectively, this aims to stop super funds acquiring assets below market value from a related party, or entering into arrangements where expenses are below market value and benefiting from the higher, after-cost income generated by the asset being concessionally taxed in the superannuation environment.

It’s worth remembering that Section 66 of the Superannuation Industry (Supervision) Act 1993 expressly prohibits SMSFs from acquiring assets from related parties. Although there are exceptions to this rule, it obviously limits the number of related-party transactions that could be made on non-arm’s-length terms.

Integrity measure

Related party transactions are, however, still common for SMSFs. The most prominent is SMSFs holding members’ small business properties and member-funded limited recourse borrowing arrangements (LRBAs). These transactions can give rise to non-arm’s-length transactions and the latest amendments are another integrity measure by the government and the regulator, the ATO, to limit the fiscal slippage.

The existing laws only make sure that income received from a related-party transaction is not concessionally taxed if it’s higher than what would be received in a commercial arrangement. An example is rent paid to an SMSF by a member’s business for the lease of a property owned by the SMSF. That is, the laws only looked at the income received by the fund to determine if a transaction was non-arm’s length.

The new laws will also look at expenses incurred by the super fund to judge whether a transaction is made at arm’s length. This means that transactions where an SMSF purposely deflates expenses they pay to a related party to increase income in the fund will be caught by the rules.

Typically, the most common forms involve income derived from non-arm’s-length transactions, with related-party LRBAs often the financial vehicle involved. It’s imperative that trustees ensure their LRBAs are on commercial terms, otherwise income could be taxed at the highest marginal tax rate.

How new rules will work

So what are the practical implications of these amendments?

Let’s assume an SMSF buys a commercial property from an unrelated party at a market value of $2 million on March 31, 2018, and from that date it earns rental income of $2000 a week or $104,000 annually.

To acquire the property, the SMSF financed its purchase via an LRBA from a related party on terms consistent with the LRBA rules. But it did so on terms that excluded any interest, with no capital repayments until the end of the 25-year term and the purchase was fully funded by debt even though the SMSF was clearly in a financial position where it could enter into an LRBA on commercial terms. No interest and no repayments for 25 years clearly mean this arrangement contravenes the rules.

The proposed amendments makes it clear that because the SMSF has not incurred expenses that it might have been expected to incur in an arm’s-length dealing in deriving the rental income, that income will be fall outside the rules. The income (less deductions attributable to the income) will form part of the SMSF’s non-arm’s length component and would be taxed at 45 per cent.

For the rules to apply to non-arm’s-length expenses, there must also be a sufficient connection between the expenses and the income. That is, the expenditure must have been incurred in gaining or producing the relevant income. The amendments are also likely to require some sort of determination as to the expenses that a fund “might have been expected to have incurred” if the parties had been dealing with each other at arm’s length.

Opinion piece written by
John Maroney, 
SMSF Association