Tax Tip 166: Non-Arm’s Length Income (NALI) and Taxation of Superfunds

Tax Tip 166: Non-Arm’s Length Income (NALI) and Taxation of Superfunds

There are various laws designed to prevent people exploiting the lower tax rates of superfunds by diverting more income into them then they should. These are known as the NALI rules – Non-Arm’s Length income.

Where a SMSF contracts with another entity and the income is “non-arm’s length” it will be taxed at the top marginal tax rate instead of the superannuation tax rate of 15%. ‘Non-arm’s length’ is broadly on uncommercial or non-market value terms.

NALI rules also apply to situations such as:
• Distributions from discretionary trusts to SMSFs,
• Company dividends to a SMSF shareholder where the company makes NALI
• Distributions from a Unit Trust where the unit trust makes NALI.

Example
The Simpson SMSF owns units in the Simpson Unit Trust which owns an investment property. Homer is running a nuclear power plant owned by the Simpson Discretionary Trust and he causes the Simpson Discretionary Trust to distribute $100,000 of income to the Simpson Unit Trust which then distributes this to the Simpson SMSF.

This $100,000 is NALI income and will be taxed at 45% in the Simpson SMSF.

 

In some cases NALI can also see a fund found non-complying eg where the income arises from a prohibited or restricted source or where the SMSF interest is an inhouse asset that exceeds the statutory cap. Non-compliant funds may have the top marginal tax rate applied to the member non-concessional balances - Meaning after tax is applied to the fund income at 45% then the member balances (subject to their components) may also be subject to 45% tax. And the issue is difficult to appeal as the only issue to object to is the issue of whether the fund was non-compliant....Often a matter of fact.

The Commissioner has other penalties too which include substantial fines, gaol and re-education of trustees in simple issues. Trustees can be disqualified for a period of time or for life. This can dramatically impact a SMSF which may need to become a small APRA fund IF its investments permit.

Care must always be taken with SMSFs and ANY trust involvement. There are five permitted types of trust investments:

1. A fixed unit trust (Reg 13.22 compliant)
2. A widely held unit trust
3. A pre 1999 unit trust
4. A listed trust
5. A unrelated unlisted trust

1-3 have very specific and strict rules which always must be met. In the event of a breach of any of these strict rules especially a Reg 13.22 trust - The fund may be required to sell the asset within 6 months.