February 2019 – Non-Arm’s Length Income and Imputation Credits

Non-Arm’s Length Income

One area of the superannuation law that I am frequently asked about is SMSFs investing with members. 

Superannuation Law does allow SMSFs to invest with their members, but it is mostly restricted to 5% of an SMSF’s value.  For example, an SMSF that has a total value of $500,000 can invest up to $25,000 (i.e. 5%) in a member’s business by either purchasing shares in the member’s company business or lending money to the company.

In a situation where an SMSF owns a residential property, it can lease the property to a member as long as the value of the property does not exceed 5% of the total value of its assets.  If it is leased to a member who uses the property wholly and exclusively for their business than the value of the property can exceed the 5% limit.

An SMSF can invest more than 5% in a related non-geared entity – such as a company without any borrowings – if it satisfies the requirements of the law.

All investments with related parties must be entered into and maintained at arm’s length.  The interpretation of what is “arm’s length” under the superannuation law caused a lot of confusion back in 2010. This is because the law states that as long as the terms and conditions of the investment transaction is “not more favourable to the other party” then it is allowed.

The ATO expressed its view of the super law definition back in 2010 in the publication ATOID 2010/162. The publication gave an example of an SMSF borrowed money from a related party on terms that were more favourable to the SMSF.  The example involved a member borrowing money from a bank at a 5% interest rate and then loaning the money to their SMSF at 5%.  If the SMSF had borrowed the money directly from the bank, it would have been charged an interest rate of 6% or higher.  The publication states this arrangement is acceptable as the loan is not more favourable to the member, who in this case is the other party.

So, from 2010 to 2016, there were many clever trustees who took advantage of the ATOs interpretation. Their SMSFs borrowed from members, and the loan arrangements consisted of borrowing 100% of the asset value; no repayments being made for many years; and, an interest rate of zero per cent.  The ATO allowed these arrangements at the time due to the wording of the superannuation law.

Now the Commissioner of Taxation is responsible for ensuring that taxpayers comply with the superannuation law as well as the income tax law.  So, the problem he faced was that the definition of a “Non-Arm’s Length Income” (NALI) under the income tax law states that if a taxpayer received income from an investment that is more than what it would have received if the investment transaction was with an unrelated party, then the income will be treated as NALI and taxed at the highest marginal tax rate (i.e. 45%).

So in 2016, the ATO issued two new publications (PCG 2016/5 and TD 2016/16) to explain its position on the income tax law definition and how it would apply to SMSFs.  

In the PCG 2016/5, it states that if an SMSF borrows from a related party, the borrowing arrangement needs to be at arm’s length where the interest is charged at a commercial rate; the amount borrowed does not exceed 70% of the asset’s value; a registered mortgage is placed over the property; principal and interest is paid monthly; and, the borrowing period not more than 15 years.

TD 2016/16 gave an example where a hypothetical borrowing arrangement is compared with the actual arrangement entered into by an SMSF with a related party.  It states that if the SMSF could not have entered into the hypothetical arrangement (i.e. an arm’s length loan arrangement) then the income earned by the SMSF will be treated as NALI and taxed accordingly.     

So, if an SMSF trustee is thinking of borrowing from its members to acquire an asset for the SMSF, they need to ensure that the loan arrangement is at arm’s length to avoid the investment income being taxed at 45%.

I’m always impressed with how clever people are to exploit interpretations of the law. I guess as our example shows, the challenge for legislators and bureaucrats is to clearly express a law’s intent without making it indecipherable to us mere mortals.

Non-Arm’s Length Expenditure

Currently before the Senate, there is a proposal to amend NALI provisions in the income tax law to include expenses.   The proposed amendment is to ensure that SMSFs cannot circumvent the rules by using non-arm’s length expenditure. 

On 19 December 2018, the ATO released the publication LCR 2018/D10 that provides guidance on the proposed changes to NALI. LCR 2018/D10 lists the ATO’s views on how the proposed amendments will operate where an SMSF incurs non-arm’s length expenditure in gaining or producing income.

LCR 2018/D10 provides examples of where either SMSF’s expenses are less than what would have been incurred had the parties been dealing at arm’s length; or, there is no loss, outgoing or expense incurred by the SMSF where some would have been expected if the parties have been dealing at arm’s length. In these situations, the income earned by the SMSF are treated as NALI and taxed at 45%. Any capital gains from the subsequent disposal of the asset is also treated as NALI.

I have attached the link to LCR 2018/D10 for your reference here.

If the law is amended, SMSFs will need to ensure that all expenses are the same as if it had been dealing on an arm’s length basis.  SMSFs will need to undertake good record keeping of their expenses to avoid higher tax being imposed on either their investment income or on capital gains from disposal of their assets.  

Imputation Credits

An imputation credit (also known as a franking credit) is essentially a note that comes with share dividends that says company tax has already been paid on the dividend, giving the shareholder a discount on their tax at tax time.  Its purpose is to stop the double taxation of company profits.  Under the current system, for shareholders that do not earn enough income to pay tax, there is nothing for them to offset the imputation credits against, so these surplus credits are paid to them in cash.  This means, the company profit is not being taxed at all.

The imputation credit system was instigated in 1987 by the Hawke-Keating government to safeguard company profits against double taxation on shareholder dividends.  Then in 2000 under the Howard-Costello government, it was expanded to provide some individuals and superannuation funds with cash refunds should their imputation credits surpass the tax they owed.   The decision to introduce cash refunds for excess imputation credits came at a time when the budget was in structural surplus of 1-2% GDP and when superannuation assets in the retirement phase were not tax-free.

Example 1:  No imputation credit

If a company made $100 profit and paid $30 tax, then it has $70 left it can pay out as dividends.  Shareholders were then subject to tax on the $70 dividends at their own tax rate.

Example 2:  With imputation credit, but no cash refund

A company makes $100 profit and pays $30 tax, and then pays out the $70 dividend to shareholders.  Because the company has already paid $30 tax on its income, it attaches $30 worth of imputation credits (referred to as franking credits) in addition to the $70 dividend.  This means, the shareholder has $70 cash, plus $30 of imputation credits – a grossed up dividend of $100.  The $30 imputation credit could be used by the shareholder to reduce their tax liability which ensures that tax will not be paid a second time on this income.  However, cash refunds could not be claimed if any imputation credits exceeded their tax liabilities.   

Example 3:  With imputation credit and cash refund

Using the same scenario as in Example 2, shareholders who received this $30 imputation credit could use it to reduce their tax liability at tax time and also claim it as a cash refund if the value of their imputation credits exceeded their tax liabilities.

The ALP proposal

On 13 March 2018, the opposition (The Australian Labor Party) announced its proposal to abolish, from 1 July 2019, the net refunding of franking credits to Australian investors other than for charities and endowments. That is, the policy will not apply to ATO endorsed income tax exempt charities and Not-for-profit institutions (e.g. universities) with deductible gift recipient status.  Then on 26 March 2018, the policy was revised to provide a “pensioner guarantee” exemption for people receiving the Centrelink age pension (part and full) and other welfare payments (e.g. disability) from the franking credit changes.  These people will still receive their refunds, as well as SMSFs (i.e. does not apply to other super funds) with at least one member in receipt of an age pension (i.e. a government pension and not a superannuation pension) on or before 28 March 2018. 

How the imputation credit changes will affect SMSFs:  SMSFs with members in pension phase are likely to be impacted if there are insufficient or no tax liabilities that can be reduced by imputation credits. The only SMSFs exempt from the changes are those that currently have at least one member receiving the government Age Pension prior to 28 March 2018 (grandfathering of SMSFs).  Grandfathering means investment decisions taken before a certain date remain subject to the old rule. SMSFs with at least one pensioner (Age Pension) or allowance recipient before 28 March will be exempt from the changes Labor plans to implement if it wins the next federal election. 

Why the change?:  By making imputation credits as a non-refundable tax offset, it will be consistent with the tax treatment of most other tax offsets.  For example, Low Income Tax Offset (LITO) and the Seniors and Pensioners Tax Offset (SAPTO) can be used to reduce tax liabilities, but cannot be claimed as cash refunds.  Also, Australia is one of the few OECD countries that currently have a dividend imputation system and is the only country with fully refundable imputation credits.

The effective tax rate on superannuation fund earnings in the retirement pension benefit phase is also negative since funds pay no tax on earnings but receive full refunds on any unused dividend imputation credits.  With an ageing population and a maturing superannuation system, the cost of allowing cash refunds for excess imputation credits will continue to grow.  In 2016, there were 3.7 million Australian aged 65 and over.  By 2050 there will be 8.7 million.  Therefore, according to Labor,  Australia’s current refundable dividend imputation system is fiscally unsustainable.  If the current arrangements are allowed to continue, future governments will be faced with an $8 billion annual hole in the budget over the medium term. Even so, it’s still not easy to swallow if you had relied on franking credits as part of your retirement strategy. Unfortunately, things like this only shake our confidence in super as people feel the goal posts are constantly being moved. If you are worried about this issue, talk to your financial planner to see if you can compensate for the possible loss of franking credits. M


Monica Rule is an SMSF specialist and author.  Her advice is general in nature and you should seek advice that relates to your specific circumstances before making any decisions. www.monicarule.com.au