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Treasury floats NALI rule change to stop unfair penalties for SMSFs
The federal government on January 24 released a consultation paper seeking stakeholder feedback on its proposal to tweak rules on non-arm’s-length-income (NALI) in a bid to prevent “disproportionately severe outcomes” for smaller and self-managed superannuation funds.
Critics have argued the NALI rules unfairly affect SMSFs and smaller funds by imposing a tax penalty on a fund’s entire income for breaching provisions concerning non-arm’s-length expenses (NALE).
The amendments – which would cap the penalty for a “general expenses breach” at five times the level of the breach – would not apply to larger funds regulated by the Australian Prudential Regulation Authority (APRA). These are exempted from the NALI provisions regarding general expenses.
“The NALI provisions are designed to prevent income from being unduly diverted into superannuation funds to benefit from lower rates of tax,” Financial Services Minister Stephen Jones said in a January 24 statement announcing the consultation.
“While the NALI provisions are operating broadly as intended, the government appreciates some superannuation industry stakeholders have raised the potential for disproportionately severe outcomes for breaches relating to general expenses,” he added.
New rules target NALE
Super funds’ income is generally taxed at a concessional rate of 15 per cent, or zero per cent if fund earnings are on assets supporting a retiree’s pension, the consultation paper explained. If income is deemed to have come from a non-arm’s-length (NAL) transaction, however, the highest marginal tax rate of 45 per cent is applied.
“This ensures that any income derived from a NAL arrangement does not receive the preferential tax treatment that superannuation income receives otherwise,” the paper said.
The NALI rules were first introduced in the Income Tax Assessment Act of 1997. Following the 2017-18 budget, the government expanded the definition of NALI to ensure it captured all NALE in all circumstances, after determining that “tax minimisation strategies where fund expenditures were reduced through non-arm’s-length dealings” could avoid the appropriate tax rate in certain circumstances.
As a result, “income is now treated as NALI where expenditure incurred in gaining or producing it was a non-arm’s-length dealing,” the paper explained. “If an expense is considered NALE, it taints any income associated with the scheme as NALI, which is then taxed at the highest marginal rate.”
The Australian Taxation Office established a transitional compliance approach for the new NALI rules. The transition period is set to expire, and the rules to take full effect, on July 1.
Tackling industry concerns
The consultation paper follows stakeholder feedback Treasury has received over potential scenarios in which SMSFs and smaller super funds are disproportionately penalised for breaching the general-expense rules. The government has also heard concerns the rules would represent an onerous compliance burden for super funds.
The proposed amendments would subject SMSFs and small APRA-regulated funds to a “factor-based approach” that would cap the amount of fund income taxable as NALI due to a general expenses breach at five times the level of the breach. The breach level is calculated as the difference between what would have been charged as an arm’s-length expense and what was actually charged to the fund.
“The approach outlined in the consultation paper seeks to balance maintaining the integrity of the tax system with providing a greater level of certainty for trustees regarding the consequences of any breaches relating to general expenses,” Jones said.
He noted the government encourages all super industry stakeholders and other interested parties to provide feedback on the consultation paper.
“Robust, proportionate integrity measures are an important part of maintaining confidence and providing clarity to trustees,” he said.
Treasury is seeking feedback on the consultation paper until February 21.
Unfair outcomes still feared
Leading industry body the SMSF Association, which has been a long-time advocate for reform of the NALI/NALE rules, said the proposed changes are not enough to prevent disproportionate outcomes for SMSFs and small funds.
Deputy CEO and director of policy/education Peter Burgess said the SMSF Association was pleased the government is considering options to “break, at least partially, the link between the general-expense breach and the income of the fund as a whole”.
However, he told The Inside Investor, “we still think the NALI fix that’s been proposed is heavy-handed and will still result in unfair outcomes for self-managed super funds.” He added that while the SMSF Association is “fully supportive of APRA funds being exempted from these rules”, it believes SMSFs should be exempted as well to avoid unfair outcomes.
Burgess pointed out that even with the penalty ceiling as proposed by Treasury, general-expenditure breaches could end up being taxed at an effective rate of 225 per cent for SMSFs. He also noted that the SMSF Association supports tax neutrality across the superannuation industry.
“We are not against the government tightening the rules around related-party transactions,” Burgess said. “But using the NALI rules to do so is, in our view, not the right approach.”
