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The ATO has provided some welcome clarification for auditors regarding their obligations to report on non-arm’s length expenditure (NALE) incurred by a super fund of a general nature.

In mid-2018, the definition of non-arm’s length income (NALI) under the Income Tax Assessment Act 1997 was amended to include NALE. The NALE provisions are designed to apply where, in gaining or producing the income, if there is any NALE that is less than what might have been expected if the parties were dealing at arm’s length, that income is NALI. NALE includes not just an expenditure, but also a loss or outgoing that is lower than an arm’s length amount, and also includes where there is a nil amount (ie, no expenditure).

Following the NALE amendments, the ATO issued Draft Law Companion Ruling 2019/D3 (LCR 2019/D3) which clarified how the amendments to section 295-550 of the Income Tax Assessment Act 1997 operate in a scheme where the parties do not deal with each other at arm’s length and the trustee of a complying super entity incurs non-arm’s length expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income.

In an online update, the ATO explained that, ordinarily, SMSF auditors would be required to apply the preliminary view in draft LCR 2019/D3 and modify Part A of the Independent Auditor’s Report (IAR) if they consider the fund’s tax calculation may be materially misstated because the fund incurred non-arm’s length expenditure of a general nature with a sufficient nexus to all income derived by the fund, making the income NALI.

While LCR 2019/D3 remains in draft form, it has caused widespread concern in the industry. It appears from the LCR that the ATO is proposing to administer the law such that a wide range of activities would be caught by the NALE provisions. Most concerningly, the LCR suggests that ‘in some instances, the non-arm’s length expenditure will have a sufficient nexus to all of the ordinary and/or statutory income derived by the fund.’ If this approach is applied, potentially all the SMSF’s income and gains would be characterised as NALI (and taxed at 45%).

As the LCR remains in draft, in June 2020 the ATO issued Practical Compliance Guideline PCG 2020/5 (PCG 2020/5) which confirms the ATO’s transitional compliance approach to the NALI/NALE provisions, which covers the 2018–19, 2019–20 and 2020–21 income years.

In PCG 2020/5, the ATO recognises that fund trustees may not have realised that the NALE amendments will apply to NALE of a general nature to all ordinary and/or statutory income derived by the fund in an income year (noting that it was not explicitly stated in an earlier draft law companion guideline released in 2018).

Accordingly, under PCG 2020/5, the ATO will not allocate compliance resources for the 2018-19, 2019-20 and 2020-21 income years to determine whether the income of a complying super fund is non-arm’s length income where the fund incurred non-arm’s length expenditure of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund in those respective income years (for example, NALE on accounting services provided to an SMSF for free or for an under market value fee).

Ordinarily, SMSF auditors would be required to apply the preliminary view as set out in LCR 2019/D3 and modify Part A of the Independent auditor’s report (IAR) if they consider the fund’s tax calculation may be materially misstated because the fund incurred NALE of a general nature with a sufficient nexus to all income derived by the fund, making the income NALI.

The ATO has recognized that LCR 2019/D3 read together with PCG 2020/5 has created some uncertainty for auditors as to their audit and reporting obligations. To address this, the ATO have advised on their website that SMSF auditors do not need to modify their opinion in Part A of the IAR for the 2018-19, 2019-20 and 2020-21 income years in respect of NALE incurred by a fund of a general nature that has a sufficient nexus to all ordinary and/or statutory income derived by the fund, for which the ATO’s transitional compliance approach in PCG 2020/5 applies.

The ATO said SMSF auditors will still need to consider modifying their opinion in Part A of the IAR where the fund incurred non-arm’s length expenditure that directly related to the fund deriving particular ordinary or statutory income as the compliance approach in PCG 2020/5 does not apply.

The ATO are currently finalising the content of draft LCR 2019/D3, which has been delayed due to the impacts of COVID-19. The final ruling will provide further clarity around our position on the application of the NALI provisions to non-arm’s length expenditure of a general nature.

To discuss further or for more information please contact ISA SMSF AUDITS.