Non-arm’s length income (NALI) has received a lot of attention lately, particularly in regards to Limited Recourse Borrowing Arrangements (LRBA). NALI has never really received great attention, so much so that many public practitioners may not have even come across a SMSF that receives such income. However, the issue of increased interest in related party lending for LRBAs have recently grabbed much attention.
With material drawn from legitimate industry sources, this article presents a brief understanding of what NALI is and goes on to discuss a relevant case law, besides also the latest position of ATO on this issue.
Non-arm’s length income (NALI) provisions are simply anti-avoidance measures designed to prevent income being diverted in SMSF that would otherwise be taxed at personal marginal tax rates. S. 295-550 of ITAA 1997 defines NALI and includes 4 classes of income viz,
- Income from non-arm’s length transactions.
- Private company dividends.
- Trust distributions where there is no fixed entitlement.
- Trust distributions where there is a fixed entitlement.
NALI is taxed at the top personal marginal tax rate (MTR) which is currently 47 percent, and is specifically excluded from the exempt pension income from assets supporting income streams.
Income from non-arm’s length transactions
Income from non-arm’s length transactions primarily include income derived from schemes, transactions wherein parties were not dealing at arm’s length and/ or where the income is more than what the SMSF would ideally derive if the dealing was at arm’s length. In determining whether parties deal at arm’s length, it is necessary to consider any connection between them and any other relevant circumstance.
Darrelen Pty Ltd, Trustee of the Henfam Superannuation Fund v. The Commissioner of Taxation
On 10 October 1995 the trustee of the Fund acquired from an existing shareholder four shares (of the 100 on issue) in Vercot Pty Ltd (‘Vercot’) for $51,218. Vercot was a passive holding company that held 25,609,320 shares in Abigroup Limited (‘Abigroup’), a listed public company. The listed market value of each Abigroup share was $0.58 per share.
The acquisition had the effect that the Fund obtained an indirect interest in 1,024,373 shares in Abigroup, the market value of which on the date of acquisition was $594,136. The result was that the market value of the Fund’s shareholding in Vercot, both when it was acquired and thereafter (and during the relevant years of income), was far in excess of the amount paid for it; the price was about 10% of the market value and between 1/10th and 1/6th of the true value.
Abigroup paid substantial dividends to Vercot, which in turn paid dividends to its shareholders including the trustee of the Fund; the dividends in each of the relevant years of income were far in excess of the purchase price which the trustee of the Fund had paid for the shares. In this regard, against an acquisition cost of $51,218 (paid in October 1995), the trustee of the Fund received dividends as follows:
… in 2000 – $143,720; … in 2001 – $143,720; … in 2002 – $86,320 and … in 2003 – $76,640
The court held that the dividend income derived occurred from a non-arm’s length transaction and determined the dividends to be treated as NALI, with the key rationale that the purchase price of the shares was far below market value (the SMSF paid $51,218 for $594,136 worth of shares).
The ATO is of the view that non-commercial terms in LRBAs lead to NALI. This is because without the loan there would be no investment in the asset. Without the investment in the asset, there would be no income including capital gains. Therefore, all income treated as NALI. In line with the same, the ATO has released two interpretive decisions – ATO ID 2014/39 and ATO ID 2014/40.
As per ATO, Arm’s length borrowing arrangement will need to be consistent over several factors including:
- the nature of the acquirable asset
- the amount borrowed
- the term of the loan
- the loan to valuation ratio
- the interest rate
- principal repayments
- any personal guarantees
- the actual operation of the arrangement.
Safe Harbour Provisions
The ATO has recently issued guidelines on safe harbour provisions regarding NALI in respect of related party LRBAs entitled ‘Practical Compliance Guideline 2016/5’. Clients intending to rely on these safe harbour provisions must ensure that their LRBA terms comply with the provisions by 31 January 2017 for the whole of the 2015/16 financial year. Alternatively, trustees can benchmark their arrangement against commercially available terms and conditions; and ensure evidence that their LRBA has been established and maintained on terms consistent with arm’s length dealing.
These safe harbour provisions cover LRBAs over real property and a portfolio of listed shares in a company or units in a unit trust. Where trustees have LRBAs over other assets, they will need to ensure that benchmarking is undertaken.
– Melvyn Gilbert, Senior Tax Accountant & Brand Manager