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.
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.
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 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
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.
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John Maroney, CEO,