Self-Managed Super Funds (SMSFs) operate within a tightly regulated environment overseen by the Australian Taxation Office (ATO). Trustees (and their directors) are legally responsible for ensuring their fund complies with taxation and superannuation laws. However, administrative oversights and breaches, particularly in relation to the receipt of non-arm’s length income (NALI), pursuant to subdivision 295-H of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997), can and do occur.
In such instances, it is important to understand what arrangements can give rise to NALI and how these matters may be resolved by making a voluntary disclosure to the ATO.
1. Non-arm's length income (NALI)
The purpose of the NALI provisions contained in subdivision 295-H of the ITAA 1997 is to prevent the inflation of SMSF earnings through non-arm’s length dealings. For example, where a SMSF trustee uses non-commercial arrangements to stream income into a SMSF as a means of sheltering that income from the higher rates of tax that would otherwise apply to non-superannuation entities, the NALI provisions can apply.
Pursuant to section 295-545 of the ITAA 1997:
- the taxable income of a SMSF is generally taxed at a rate of 15%. This is referred to as the 'low tax component'; and
- the NALI of a SMSF is taxed at the top marginal rate of 45%. This is referred to as the 'non-arm's length component'.
These provisions ensure that income from transactions not conducted on commercial, arm’s length terms does not benefit from the concessional tax treatment typically available to SMSFs. In particular, the NALI provisions are designed to prevent SMSF trustees from adopting strategies to increase superannuation savings artificially and in a way that is not caught by the ordinary concessional contributions and non-concessional contributions caps.
2. Common examples of NALI
There are various ways in which an SMSF can derive income that will be considered NALI under the subdivision 295-H of the ITAA 1997. Those include:[1]
- income derived from non-arm’s length dealings;
- not incurring certain costs/expenses or having lower losses, outgoings or expenditure as a result of a non-arm's length dealing;
- receiving private company dividends that are not consistent with an arm’s length dealing;
- distributions from discretionary trusts; or
- distributions received from a fixed trust, but where the income is ultimately 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.
Some common examples of SMSF arrangements that may give rise to NALI include:
- entering loan arrangements with related parties at below-market interest or on favourable terms.
- receiving services at no cost or below market rates (such as paying under market rates of rent); or
- purchasing an asset undervalue from a related party;
3. Administrative penalties
- Subsection 284-75(1) of Schedule 1 to the Taxation Administration Act 1953 (Cth) (TAA) provides that a SMSF is liable to a penalty if a SMSF trustee makes a statement to the Commissioner of Taxation (Commissioner) and the statement is false or misleading in a material particular, whether because of things in it or omitted from it.
- This includes when a SMSF trustee lodges an income tax return that does not properly report the amount of NALI derived by an SMSF in a particular income year.
Shortfall amounts
Generally, where there has been a breach of the NALI provisions (i.e. a SMSF trustee has not properly accounted for the NALI derived by the SMSF in a particular income tax year), there will be a tax shortfall realised by the SMSF.
In other words, when NALI is not properly identified and accounted for in a particular income tax return by the trustee of a SMSF, it is likely that:
- the income will have not been reported at all; or
- the income will have been incorrectly reported as part of the low tax component of the SMSF's taxable income, instead of the NALI component.
As a result, the SMSF income will have not been taxed at all or taxed only at 15% instead of the appropriate 45% rate, leading to a shortfall of the amount of tax that should have been paid to the ATO.
Penalty rates
When there is a tax shortfall, the ATO distinguishes between genuine errors and behaviour that involves carelessness, recklessness, or intentional disregard of the law, and the penalties that apply under the TAA reflect these different circumstances.
These penalties are calculated under subsection 284-90(1) of Schedule 1 to the TAA as a percentage of the shortfall amount and vary based on the taxpayer's behaviour:
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Behaviour
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Penalty Rate
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Lack of reasonable care
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25% of the shortfall amount
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Recklessness
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50% of the shortfall amount
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Intentional disregard of law
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75% of the shortfall amount
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Increases/reductions in base penalty amount
These base penalties may be increased or decreased depending on mitigating or aggravating factors.
Base penalties can be increased by 20% if:
- the SMSF trustee prevented or obstructed the ATO from finding out about the shortfall/false statement;
- the SMSF trustee did not tell the ATO about the shortfall/false statement within a reasonable time after finding out about the liability; or
- the SMSF trustee has previously received a base penalty in respect of the SMSF for a prior accounting period.
Base penalties can potentially be reduced if:
- the false statement/shortfall arose due to advice from a tax agent or the ATO (reduction % is based on extent the advice caused the penalty); or
- the SMSF trustee makes a voluntary disclosure to the ATO:
- after the ATO commences an investigation (20% reduction); or
- before the ATO commences an investigation (80% reduction).
Other consequences
In addition to any administrative penalties, the Commissioner may also disqualify an individual from acting as a trustee of a SMSF (or director of a SMSF trustee) if they have contravened superannuation laws.
Pursuant to section 109 of the Superannuation Industry (Supervision) Act 1993 (Cth), a trustee has the obligation to ensure that they must not make investments on behalf of a SMSF unless the transaction is entered into on arm's length terms. Where a trustee has engaged in activities contrary to these obligations, civil penalty provisions may apply.
When deciding whether to disqualify a trustee, the Commissioner will have regard to Practice Statement Law Administration 2006/17 as well as how:
- serious the contraventions are;
- many contraventions have occurred; and
- likely it is that the trustee will continue to be non-compliant.
4. Interest
If a SMSF is found to be liable for a repayment of a tax shortfall and an amendment of a SMSF's assessment for an income year occurs, the SMSF will also be required to pay a shortfall interest charge (SIC) pursuant to section 280-100 of Schedule 1 to the TAA.
The SIC rate is set by subsection 280-105(2) of Schedule 1 to the TAA and is calculated as the base interest rate for the day plus an uplift factor of three percentage points, divided by the number of days in the calendar year.
SICs are worked out daily on a compounding basis. They accrue each day on the balance of the account, which consists of both the unpaid tax and unpaid SIC.
The SMSF will have 21 days from the day the Commissioner gives notice of the charge to pay the relevant SIC.
Where the SIC is not paid within 21 days, the relevant SMSF trustee will also be liable to pay a general interest charge (GIC) on the unpaid amount for each day in a period that:
- starts at the beginning of the day by which the shortfall amount was due to be paid; and
- finishes at the end of the last day at the end of which any of the following remains unpaid:
- the amount of levy or SIC; or
- GIC on any of the amount of levy or SIC.
Where a SMSF trustee becomes aware of any compliance breaches or shortfalls, it is strongly advised to make a voluntary disclosure as soon as possible to remit any penalties or interest.
Remission of SIC
Pursuant to subsection 280-160(1) of Schedule 1 to the TAA, the Commissioner may remit all or part of the SIC payable if the Commissioner considers it fair and reasonable to do so.
However, in relation to the remission of the SIC, subsection 280-160(2)(b) of Schedule 1 to the TAA states that the Commissioner must have regard to the principle that remission should occur when the circumstances justify the Commonwealth bearing part or all of the cost of delayed payments.
Accordingly, remissions of the SIC are typically only likely to occur in circumstances where there has been a delay in issuing an amended assessment that is attributable to the ATO, such as:
- delay in commencing the audit/review,
- unreasonable delay during the audit/review,
- delay in completing the audit/review, and
- delay in processing amendment requests.
This is opposed to mitigating factors based on the taxpayer's circumstances (such as taking reasonable care or making a voluntary disclosure). This is because the Commissioner considers that a taxpayer, who has self-assessed incorrectly, even if reasonable care was exercised and a disclosure is made, should not end up in a more beneficial position than a taxpayer who has self-assessed, reported and paid correctly
However, there may be some circumstances surrounding a voluntary disclosure that will make it fair and reasonable for the Commissioner to remit the SIC.
When considering any remission of the SIC on the basis of a voluntary disclosure made by a SMSF trustee, the Commissioner may have regard to the following:[2]
- the timeliness of the disclosure after the error was first detected;
- whether the disclosure was made before being told of the commencement of an examination, or publication of a ATO initiative which may have led to the discovery of the shortfall by the Commissioner (remission is more unlikely if such notification or publication had occurred);
- whether the Commonwealth in any way contributed to the SMSF trustee taking its original position;
- the size of the shortfall, either in monetary terms or in relation to the whole of the SMSF's affairs; and
- the SMSF trustee's compliance history, including the number of times the trustee has had to disclose shortfalls following an initial self-assessment of liability.
5. Voluntary disclosures
As outlined above, when NALI has been incorrectly reported by a SMSF trustee, voluntary disclosures can lead to significant reductions in penalties (up to 80%), potential reductions in the SIC, avoid reputational damage, and demonstrate the trustee’s commitment to compliance.
In the evolving regulatory environment, a well-managed disclosure can be the most effective form of risk mitigation available to SMSFs.
In addition to potentially reducing any penalties or interest charges, by making a voluntary disclosure, a SMSF trustee has the opportunity to:
- make submissions regarding why the breach occurred and define the specific issues to be addressed, as opposed to responding to broader, open-ended queries raised by the ATO;
- confine the period in relation to the disclosure;
- provide explanatory material to support its reasons to the ATO;
- show compliance by assisting the ATO through its investigation process; and
- demonstrate to the ATO that the SMSF trustee takes accountability for its unintentional breach.
The process of a making a voluntary disclosure can be complex and we recommend engaging suitably qualified legal advisors to ensure that disclosures are handled accurately and appropriately. If you are concerned that you or your client has contravened the NALI provisions, we recommend seeking legal advice in relation to lodging a voluntary disclosure as soon as possible.
[1] Section 295-550 of the ITAA 1997.
[2] Australian Taxation Office, PSLA 2006/8, 30 October 2019, paragraph 20D.
