Highlights

  • The difficulty is that it appears in two different places in the law, for two different purposes, with different consequences.
  • Treating them as the same thing can lead trustees to assume a transaction is fine when it is not.
  • The ATO's guidance on how SMSFs are taxed also reminds trustees that SMSFs must transact on an arm's length basis.
  • Because the two tests look in opposite directions, a single arrangement can raise different questions under each.

"Arm's length" is one of the most frequently used phrases in SMSF compliance. Trustees hear it from their accountant, their auditor and the ATO.

The first is a regulatory rule in the Superannuation law about how trustees must deal with others. The second is a tax rule about non-arm's length income, known as NALI. A transaction can raise issues under one, the other or both.

The regulatory rule

The Superannuation Industry (Supervision) Act 1993 requires trustees to deal at arm's length.

This rule is primarily about protecting the fund.

The tax rule

NALI works in the other direction.

According to the ATO, NALI includes income from a scheme where the parties were not dealing at arm's length and the fund's income is more than it would have been.

The ATO explains that the treatment differs depending on the type of expense.

How the two rules interact

Some examples:

  • a member's Business pays the fund below-market rent for a commercial property: the main concern is the regulatory rule, because the fund is disadvantaged;
  • a related-party lender gives the fund an interest-free Loan to buy an asset: the fund benefits, so NALI is the main risk;
  • a Trustee who is an Accountant prepares the fund's accounts for free: this raises a NALI question about non-arm's length general expenses, even though the fund is better off.

Hypothetical example: a fund leases a Warehouse to the members' company at half the market rent. The trustees assume that, because NALI is about a fund receiving too much income, a discounted rent raises no compliance issue.

Practical considerations for trustees

Trustees can reduce risk by:

  • documenting market evidence, such as rental appraisals, Interest Rate comparisons or quotes, for any related-party dealing;
  • putting leases, loans and service arrangements in writing on commercial terms;
  • reviewing those terms regularly, for example when rent reviews are due;
  • asking whether each arrangement is too favourable to the other party, or too favourable to the fund; and
  • checking the ATO's guidance, including LCR 2021/2 and PCG 2020/5, with their adviser where related-party expenses are involved.

The takeaway

The superannuation law's arm's length requirement protects the fund from unfavourable deals, while NALI imposes tax at 45% where the fund benefits from non-commercial terms. Both matter, and they ask different questions.