Recent legislative changes passed by the Federal Parliament clarify and tighten the operation of rules regulating the treatment of "non-arm's length income" received by superannuation funds, which of course includes Self Managed Superannuation Funds ("SMSF").
The taxable income of a complying SMSF is made up of two components: a low tax component which is taxed at 15 per cent and a non-arm’s length component ("the non-arm’s length component") which is taxed at the top marginal rate.
Non-arm’s length income can be comprised of "ordinary income" or "statutory income", such as net capital gains or franking credit refunds, and is calculated as the amount of the fund’s non-arm’s length income less any deductions that are attributable to that income. The low tax component is that amount of the fund’s taxable income remaining after deducting the non-arm’s length component from its total taxable income.
The purpose of the non-arm’s length income provisions is to prevent superannuation funds from inflating their earnings, and therefore the amount of money that is held in the low tax environment, through non-arm’s length dealings.
There are several categories of non-arm’s length income, including:
Ordinary or statutory income derived from a scheme where the parties are not dealing with each other at arm’s length and the amount of the income is greater than what it would have been had the parties been dealing at arm’s length.
Private company dividends (including income attributable to such dividends) unless the amount is consistent with an arm’s length dealing; and
Trust distributions where:
(a) income is derived by a beneficiary of a trust other than because of holding a fixed entitlement (i.e. discretionary trust distributions); or
(b) income is derived by a beneficiary of a trust through a fixed entitlement to the trust's income where the fund acquired the entitlement or income under a scheme where the parties were not dealing with each other at arm’s length and the amount of income is more than what might have been expected to have been derived if they had been dealing with each other at arm’s length.
The new provisions aim to ensure that an SMSF's non-arm’s length income includes income where the expenditure incurred in gaining or producing such income was not an arm’s length expense. This includes where no expense was incurred, but might be expected to have been incurred if the transaction were on arm’s length terms.
Non-arm’s length expenses (whether revenue or capital in nature) incurred by an SMSF in gaining or producing assessable income results in that income being included in the fund's non-arm’s length component. This means that such income will be taxed at the top marginal rate. Where the right to income from a trust through a fixed entitlement was acquired on a non-arm’s length basis, the income will also be included in an SMSF's non-arm’s length component and taxed at the top marginal rate.
The explanatory memoranda to the amending legislation gives the following examples of non-arm’s length income:
An SMSF acquires a commercial property from a third party at its market value of $1,000,000 on 1 July 2015. The SMSF derives rental income of $1,500 per week from the property ($78,000 per annum). The SMSF financed the purchase of the property under limited recourse borrowing arrangements from a related party on terms consistent with the legislation.
The limited recourse borrowing arrangements were entered into on terms that include no interest, no repayments until the end of the 25 year term and borrowing of the full purchase price of the commercial real property (i.e. 100 per cent gearing). The SMSF was in a financial position to enter into limited recourse borrowing arrangements on commercial terms with an interest rate of approximately 5.8 per cent.
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. As such, the income that it derived from the non-arm’s length scheme is non-arm’s length income. The rental income of $78,000 (less deductions attributable to the income) therefore forms part of the SMSF’s non-arm’s length component and is taxed at the highest marginal rate.
However, there will be no deduction for interest, which under the scheme was nil. Non-arm’s length interest on borrowings to acquire an asset will result in any eventual capital gain on disposal of the rental property being treated as non-arm’s length income.
A superannuation fund trustee acquires units in a unit trust as a beneficiary with a fixed entitlement, but pays a substantially lower amount for the units than stated in the promotional material for the unit trust due to a scheme the fund has entered into with the broker.
In acquiring the entitlement to a share of the unit trust’s earnings, the superannuation fund trustee did not incur the expenditure it might have been expected to incur if it were dealing at arm’s length with the broker in purchasing the units. The income derived from the units would have been the same whether or not they were acquired under an arm’s length transaction.
The amount earned is non-arm’s length income of the superannuation fund and any net capital gain made on disposal of the units may also be non-arm’s length income.
Lessons to be learnt
The concessional taxation of an SMSF's income is a deliberate government policy of many years that is intended to assist people in growing their wealth so that they may provide for themselves in their retirement. A key aspect of that policy is that superannuation wealth should be grown over a period of time and for that reason there are caps on the contributions that a member can make into their SMSF account.
The low tax environment of 15% can incentivise people to wrongly exceed their contributions' cap or engage in some other mechanism to inflate the value of an SMSF's low tax component income.
These recent legislative amendments are directed at schemes in which non-arm's length transactions result in the SMSF incurring little or no expenses in producing income, such that the amount of income that is derived is more than what might have been expected if there had been an arm’s length relationship. The effect of such non-arm's length transactions is to inflate the amount of income being held in the low tax component.
The legislative changes act to ensure that income derived by an SMSF which involves non-arm's-length expenditure is included in the funds "non-arm's-length component" and is taxed at the highest marginal rate. This not only extends to income earned in any particular financial year but may also extend to the net capital gain realised upon the disposal of an asset that benefited from such a scheme.
SMSF Trustees should ensure that income received or derived by the fund accords with the legislative framework that governs the operation of the low tax component. A failure to do so may result in the imposition of significant additional tax on earnings, and this may extend all the way through to the tax treatment of a net capital gain.