NALI or NALE? Treasury Releases Exposure Draft Legislation

Following the 2023-24 Federal Budget, the Federal Government has released exposure draft legislation Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s length expense rules for superannuation funds (Exposure Draft) for consultation.  If enacted, the Exposure Draft will give effect to proposed amendments to the non-arm’s length income (NALI) and non-arm’s length expense (NALE) rules for superannuation funds. 

The consultation on the Exposure Draft is set to end on 7 July 2023.  Should you wish to discuss the Exposure Draft, please contact one of the authors or your KWM contact. 

We discuss some further details below.

Background to the Exposure Draft

The NALI and NALE provisions

The taxable income of “complying superannuation funds” is divided into a “non-arm’s length component” and a “low tax component” under section 295-545(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).  The non-arm’s length component includes any NALI less certain attributable deductions.

NALI is defined under section 295-550 of the ITAA 1997 and broadly includes where a complying superannuation entity derives NALI from a scheme involving a non-arm’s length dealing, and:

• the amount of income is more than the amount the entity might have been expected to derive if the parties had been dealing at arm’s length;
• in deriving the income, the entity incurs a loss, outgoing or expenditure that is less than the amount expected to have been incurred if the parties had been dealing at arm’s length; or
• in deriving the income, the entity does not incur a loss, outgoing or expenditure that might have been expected to have been incurred if the parties had been dealing at arm’s length.

Any income derived as NALI is then taxed at the top marginal tax rate (i.e. 45%), as opposed to the concessional rate of 15% that typically applies to superannuation funds.

The provision was introduced as an integrity measure, in order to prevent entities from shifting income into superannuation funds to take advantage of the concessional tax rates enjoyed by these entities. 

ATO guidance

On 28 July 2021, the ATO released Law Companion Ruling 2021/2 (LCR 2021/2), which provides the ATO’s views on the application of the NALI provisions to NALE.  In particular, the ATO indicates that there must be a “sufficient nexus” between the NALE and the relevant income identified as NALI.  In Example 2 in LCR 2021/2, the ATO further states that NALE of a “general” nature (including accounting fees, actuarial fees) may have a sufficient nexus to all of the ordinary and statutory income of the fund. 

Accordingly, under this interpretation, this had the potential to mean that even if a “general” expense was lower than an arm’s length amount, this could have the potential to make all of the income of a superannuation fund, including a large APRA-regulated superannuation fund, subject to the NALI rules and taxed at the highest marginal tax rate.

This was regarded, especially for large APRA-regulated superannuation funds, as being not only a disproportionate outcome (where the whole income of a fund was subject to the highest marginal tax rate despite potentially only small amounts of NALE being incurred by the fund as part of ordinary transactions) but directly contrary to government policy around how large superannuation funds should be operated, where there is an emphasis on efficiency and not paying more costs or expenses than are required.

Treasury’s consultation paper

On 24 January 2023, in response to industry lobbying, Treasury released a consultation paper on the NALE rules, proposing amendments that sought to address the issue of general expenses having a sufficient nexus to the income of superannuation funds in order to ensure the NALI provisions operated in line with their original purpose ahead of the expiry of the ATO’s compliance approach set out in the ATO’s Practical Compliance Guideline PCG 2020/5 (PCG 2020/5).  The main intention behind the proposed amendments was to mitigate the ‘tainting effect’ highlighted by industry stakeholders, where all of the fund’s income would potentially be subject to the top marginal rate in the event of a relatively minor breach of the NALE provisions.

The proposed amendments included:

• SMSFs and SAFs being subject to a factor-based approach which would set an upper limit on the amount of fund income taxable as NALI at five times the level of the general expenditure breach (calculated as the difference between the amount that would have been charged as an arm’s length expense and the amount actually charged to the fund). Where the product of five times the breach is greater than all fund income, all fund income would be taxed at the highest marginal rate.
• Large APRA-regulated funds would be exempted from the NALI provisions for general expenses.

Stakeholder feedback on the proposed amendments indicated that while the distinction between the tax treatment “specific expenses” and “general expenses” was welcome, there remained concerns in relation to the continued application of the NALI provisions in respect of “specific expenses” incurred by large APRA-regulated funds, and the impact the provisions had in respect of superannuation ‘contributions’.

Proposed measures in the Exposure Draft

The Exposure Draft proposes a number of changes to the NALI and NALE provisions, including:

• a proposed new subsection 295-550(8), which limits the amount of an SMSF’s and SAF’s taxable income where NALE is derived to twice the difference between the amount incurred as a result of a non-arm’s length dealing, and the amount expected to have been incurred;
• a proposed new subsection 295-545(2A), which changes the way the non-arm’s length component is calculated with respect to SMSFs and SAFs;
• amending the NALE rules in paragraphs 295-550(1)(b) and (c) (as well as the equivalent beneficiary of trust provisions in paragraphs 295-550(5)(b) and (c)) to clarify that they only apply to SMSF and SAFs; and
• amendments to Schedule 2 to the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019  to confirm that the NALE rules do not apply to expenses incurred prior to 1 July 2018.

Observations

The amendments in the Exposure Draft present welcome changes to the NALI and NALE provisions, in order to ensure that the provisions properly apply to the integrity measure initially sought to be addressed when the provisions were first introduced. 

In particular, the reduction of the ‘cap’ on the maximum amount of fund income taxable as NALI (from five times the level of the general expenditure breach to two times the level of the general expenditure breach) will provide some relief around industry concerns on the disproportionate consequence of certain general expenditure breaches for SMSFs.  

Clarity around the application of the NALE rules are also useful, given the ATO’s PCG 2020/5 is set to end on 30 June 2023.

While the amendments propose to exempt large funds from the NALE rules, they remain subject to the remaining NALI rules for income derived on a non-arm’s length basis. As such, they should still be alive to the potential application of these rules.

For example, while the initial NALE changes excluded income derived from fixed trusts where a lower than non-arm’s length amount is paid for the interest, the following income will continue to be NALI:

• income derived by a fund as a beneficiary of a trust, other than income derived from holding a fixed entitlement to the income (subsection 295-550(4) of the ITAA 1997) – for example income from interest in a discretionary trusts; and
• income made from shares in companies (e.g., a dividend or income reasonably attributable to such a dividend) that an entity acquires at a discount to market value unless it is consistent with an arm’s length dealing (subsection 295-550(2) of the ITAA 1997).

TA 2023/2

The ATO has also recently released TA 2023/2, flagging that it is looking at arrangements involving:

1. SMSFs having or acquiring ownership (directly or indirectly) of a special purpose vehicle (SPV) that undertakes a property development project; and
2. non-arm’s length arrangements between the SPV and other entities which result in the SPV deriving a profit ultimately benefitting the SMSFs more than what would have been if the parties dealt at arm’s length.

The particular concern is the shifting of profits to SMSFs and taking advantage of the concessional tax rate, particularly if the SPV is a company and provides the SMSFs further tax offset refunds such as franking credits attached to dividends received.

Accordingly, the ATO states that its views in respect of such arrangements include:

• dividends and franking credits received by the SMSFs, derived from their direct or indirect interest in the relevant SPV, are NALI and taxed at the top marginal rate;
• capital gains (or income flowing from capital gains) arising in respect of the disposal of entities in the scheme (e.g. interposed entities) may have NALI consequences;
• The Commissioner of Taxation (Commissioner) may make a determination under Part IVA of the Income Tax Assessment Act 1936 (Cth) in relation to any tax benefit arising under the arrangement;
• The Commissioner may disqualify a person from acting as trustee (or director of a corporate trustee) of the SMSF and may also issue a notice of non-compliance to the SMSFs.

It will be important for SMSFs to consider its current arrangements, in light of both the Exposure Draft and TA 2023/2.