The NALI and NALE legislation, can be confusing for most SMSF members and trustees, which is what has prompted us to write this article, so it sheds more light on this important topic.
A Comprehensive Guide
The NALI and NALE legislation, can be confusing for most SMSF members and trustees, which is what has prompted us to write this article, so it sheds more light on this important topic. Recent legislative amendments by the ATO have further clarified these concepts, underscoring the importance of compliance to avoid significant tax implications.
Table of Contents
- Defining Non-Arm’s Length Income (NALI)
- What Constitutes NALI?
- Understanding Non-Arm’s Length Expenditure (NALE)
- Recent Legislative Changes
- Implications for SMSF Trustees
- Practical Steps for Compliance
- Key Takeaways
Defining Non-Arm’s Length Income (NALI)
NALI refers to income that an SMSF derives from arrangements where dealings are not conducted at arm’s length—that is, transactions do not reflect standard commercial terms and conditions. This income is taxed at the highest marginal rate (currently 45%), rather than the concessional rates typically enjoyed by superannuation funds.
Here are three practical examples to help you better grasp NALI and NALE:
Example 1: Discounted Property Purchase (NALI)
Scenario:
Your SMSF purchases a residential property from a related party for $200,000, but the property’s market value is $500,000.
Why this is NALI:
The purchase price is significantly below market value, and as a result, any income generated from this property—such as rental income—will be classified as non-arm’s length income. This income will be taxed at 45%, instead of the concessional SMSF tax rate.
Key Takeaway:
Ensure all property transactions involving related parties are conducted at market value, supported by proper valuation evidence.
Example 2: Underpriced Loan Arrangement (NALE)
Scenario:
Your SMSF borrows funds from a related party to acquire shares. The loan is provided at a 0% interest rate with no formal repayment terms.
Why this is NALE:
The loan terms are not commercial. Even though the SMSF might generate dividends or capital gains from the shares, the earnings may be classified as NALI because the fund benefited from a non-arm’s length expenditure (i.e., the favorable loan terms).
Key Takeaway:
All loan arrangements involving your SMSF must be on a commercial basis, with interest rates, repayment terms, and conditions comparable to those offered by an independent lender.
Example 3: Reduced Professional Fees (General NALE)
Scenario:
A trustee of the SMSF, who is also an accountant, provides professional services—such as preparing financial statements and tax returns—for the SMSF at no cost or at a significantly reduced rate.
Why this is NALE:
Charging reduced or nil fees for professional services is below what would be charged on an arm’s length basis. This results in general NALE, potentially causing part or all of the SMSF’s income to be classified as NALI and taxed at 45%.
Key Takeaway:
If you are a professional providing services to your SMSF, ensure fees are consistent with standard commercial rates to avoid any risk of general NALE classification.
Why It Matters:
- Higher tax rate (45%) applies if income is classified as NALI
- Ensures transactions within an SMSF adhere to commercial standards
What Constitutes NALI?
Income is classified as NALI if:
- Non-Commercial Transactions
– The SMSF earns income from a scheme where parties were not dealing at arm’s length, resulting in the fund receiving more income than it would have under commercial terms. - Non-Arm’s Length Expenditure (NALE)
– From 1 July 2018, if the SMSF incurs expenses below what would be expected at arm’s length, any income related to those expenses may be treated as NALI.
Quick Reference Table: NALI vs. NALE
| Aspect | NALI | NALE |
| Definition | Income earned from non-commercial arrangements | Expenses incurred below market value or not incurred at all |
| Tax Rate | 45% (highest marginal rate) | Not a separate tax rate but triggers NALI status for related income |
| Examples | Inflated rental income from related parties | Underpaid or waived accounting, audit, or property management fees |
| Effective Date | Applies at all times | New provisions from 1 July 2018 |
| Primary Concern | Income side of the transaction | Expense side of the transaction |
Understanding Non-Arm’s Length Expenditure (NALE)
NALE occurs when an SMSF incurs expenses below market value or does not incur expenses that would normally be expected in a commercial setting. This can result in income being classified as NALI, attracting higher tax rates.
Types of NALE:
- Specific Expenses
– Directly related to a particular asset (e.g., discounted maintenance costs for a rental property).
– If these are non-arm’s length, all income from that asset becomes NALI. - General Expenses
– Related to the overall operation of the fund (e.g., below-market accounting fees).
– non-arm’s length general expenses can taint a portion of the fund’s income as NALI.
Recent Legislative Changes
The Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Act 2024 introduced key amendments to section 295-550 of the Income Tax Assessment Act 1997, effective from 1 July 2018:
- Twice the Difference Approach
– For small complying funds (including SMSFs), the amount of NALI arising from a non-arm’s length general expense is calculated as twice the difference between the actual expense incurred (which could be nil) and the expected arm’s length expense. - Pre-2018 Expenditure
– Expenditure incurred before the 2018–19 income year is exempt from the NALE provisions.
NALI & NALE Timeline
| Aspect | Pre-2018 | 2018 | 2019–2023 | 2024 Onwards |
| NALE | NA | Effective | Ongoing compliance | NALI approach remains |
| NALI | Standard rules | Reinforced | Legislative updates | Extended clarity |
Implications for SMSF Trustees
Non-compliance with arm’s length principles can lead to substantial tax liabilities. Trustees must ensure that all transactions—both income and expenses—are conducted on commercial terms. This includes paying market rates for services and ensuring that any income received is not inflated due to non-commercial arrangements.
Opinion Note
“It’s always better to err on the side of caution and document transactions meticulously. The ATO (Australian Taxation Office) pays particular attention to related-party dealings, so transparency is crucial.”
Question: Is an insurance payment a general expense or a specific expense?
Answer: generally speaking, most of the SMSF experts agree that it is a specific expense not caught up in the NALE provisions.
Practical Steps for Compliance
- Review Service Agreements
– Ensure all services provided to the SMSF (by both related parties and external providers) are charged at market rates. - Document Transactions
– Keep comprehensive records (invoices, appraisals, contracts) demonstrating that all dealings are at arm’s length. - Seek Professional Advice
– Consult with tax or superannuation professionals to stay up to date on legislative changes. - Periodic Audits
– Conduct internal compliance checks or periodic audits to identify potential NALE risks and rectify them promptly.
Key Takeaways
- High Tax Rate: NALI is taxed at 45%.
- NALE Triggers NALI: Underpaid or waived expenses can taint related income.
- Document Everything: Meticulous records can protect you from non-compliance.
- Legislative Changes: Familiarize yourself with the latest rules effective from 1 July 2018.
- Professional Support: Engage experts for peace of mind.
Final Thoughts
By adhering to these guidelines, SMSF trustees can mitigate the risk of income being classified as NALI and avoid the associated and unnecessary higher tax payments. Staying informed about legislative changes and maintaining rigorous compliance practices are essential for the effective management of your SMSF, so always seek advice where in doubt.
Disclaimer:
This article is for general informational purposes only and does not constitute financial or legal advice. Please consult with a qualified professional before making any decisions related to your SMSF.
