Non-arm's length income (NALI) under section 295-550 ITAA 1997 - 2024 amendments

What NALI is and the headline tax rate

Section 295-550 of the Income Tax Assessment Act 1997 governs non-arm's length income (NALI) for complying super funds. NALI represents the ‘non-arm’s length component’ of a fund’s taxable income. This income is taxed at 45%, the top marginal rate, irrespective of the fund’s overall tax status. Super contribution caps FY27

Income is classified as NALI when it is generated under a scheme where the parties involved were not dealing at arm's length. This occurs when the amount received exceeds what would have been received had the parties been dealing on arm's length terms. This applies to ordinary and statutory income, including dividends from private companies and trust distributions.

Capital gains can also be subject to NALI rules. Taxation Determination TD 2024/5 provides clarification regarding the interaction between the capital gains tax discount and the 45% NALI tax rate.

Non-arm's length expenses (NALE)

The definition of non-arm's length income (NALI) now includes non-arm's length expenditure that has a nexus to a superannuation fund’s income. This means expenses incurred that are not at an arm’s length rate can impact the taxability of income received by the fund. ATO Law Companion Ruling LCR 2021/2 provides guidance on the rules relating to non-arm's length expenses. SuperStream employer super contributions are an example of expenses that may be relevant.

Certain expenses, when linked to specific income streams, can result in that income being wholly classified as NALI, attracting the 45% tax rate. Previously, general expenses such as accounting, audit, and administration posed a risk of tainting the entire fund’s income as NALI.

To address concerns about the impact of general expenses, a two-times approach was implemented for expenses incurred between 1 July 2018 and 30 June 2023, pending the introduction of legislation.

2024 amendments for SMSFs and small APRA funds

The Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Act 2024 amended s 295-550 with effect from the 2018-19 income year. These amendments specifically impact self-managed superannuation funds (SMSFs) and small APRA funds. Trustees of these funds should review their investment governance practices, as outlined in APRA SPS 530 investment governance superannuation, to ensure compliance.

For SMSFs and small APRA funds, the amount of non-arm's length income (NALI) that can be attributed to general expenses is now limited. This cap is calculated as twice the difference between what an arm’s length expense would be and the actual expense incurred. Large APRA-regulated funds are excluded from these specific rules.

It is important to note that the amendments do not affect the treatment of non-arm’s length income arising from specific expenses. These specific expense NALI rules continue to apply, and can still taint all related income. Internal arrangements where a trustee performs duties in their individual capacity are not subject to these rules.

Practical compliance for SMSFs

SMSFs engaging in related-party transactions must prioritise demonstrating that those transactions are on arm’s length terms. Trustees should maintain thorough documentation for all such transactions, including loans, leases, and service arrangements, to support this position. Related-party LRBAs require particular attention; they must either comply with PCG 2016/5 safe harbour terms or be demonstrably on commercial terms.

Funds incurring general expenses below market rates should be prepared to evidence the calculation of the 2x factor, as required by the ATO. The ATO’s increased scrutiny includes auditor contravention reporting, which now flags suspected non-arm’s length income (NALI) and non-arm’s length expenses (NALE) for review. Failure to appropriately address NALI/NALE can have broader consequences.

Ultimately, a failure to satisfy arm’s length requirements can trigger a contravention of the SMSF sole purpose test - section 62 and the arm's length covenants outlined in s 52B of the SIS Act.