Every self managed super fund receives concessional tax treatment with most earnings taxed at fifteen per cent and sometimes nothing at all when the fund is paying retirement phase pensions. That attractive headline rate can vanish overnight when the Australian Taxation Office decides that the income is non-arm's length. In that moment the rate rockets to forty five per cent and the sting often lasts for the life of the asset that produced the income. Understanding why that happens and how to steer clear of the traps is essential for every trustee and adviser who wants to protect hard-earned retirement savings.
How the forty five per cent nightmare happens
The ordinary and statutory income of a complying SMSF is normally taxed at fifteen per cent after allowable deductions. Division 295 of the Income Tax Assessment Act 1997 contains a dedicated set of provisions that override that concessional treatment when the fund receives income from a scheme that is not at arm's length. Section 295-550 states that the whole of the income from that scheme is taxed at the top marginal rate if the parties were not dealing on commercial terms and if the fund received more income than it would have on normal market terms.
From the first of July 2018 the rules were expanded so that not only income but also expenditure can trigger the penalty. If a fund pays too little or nothing for services or assets that help it earn income, that shortfall is non-arm's length expenditure. The presence of NALE can taint the related income and in many situations the taint spreads to future capital gains as well.
The Australian Taxation Office has been clear that the rules apply even when the fund is in full retirement phase. A pension fund that would otherwise pay no tax can still face the forty five per cent impost if the income is non-arm's length. The deterrent effect is obvious and intentional.
The legal rules behind NALI and NALE
Section 295-550 identifies three broad pathways to non-arm's length income. The first is income derived where the parties to the arrangement were not dealing at arm's length and the amount is more than would have been expected on arm's length terms. The second is a private company dividend received under conditions that would not apply between independent parties. The third is trust income that the fund receives other than through a fixed entitlement that itself arose on arm's length terms.
Non-arm's length expenditure was bolted on to the regime with the same effective date of first July 2018 despite the legislation only receiving royal assent later. If the fund incurs specific expenditure that has a direct link to a particular asset and that outlay is not at arm's length, all income and any capital gain from that asset become NALI. General expenditure, such as accounting fees, is treated differently. The shortfall is multiplied under a formula and added to the fund's taxable income but only up to the cap introduced in two thousand and twenty four. That cap limits the non-arm's length component to the lesser of the calculated amount or the fund's adjusted taxable income excluding assessable contributions.
The Superannuation Industry Supervision Act adds further pressure through provisions on the sole purpose test, in-house assets and arm's length dealings. A breach of those sections can convert a complying fund into a non-complying fund which carries its own severe tax outcomes. While those sanctions are separate from NALI the ATO often looks at the entire picture when reviewing a fund.
Specific versus general expenditure and why it matters
Understanding the difference between a specific and a general expense is critical. A small saving on a specific cost can poison all future returns from the related asset. A haircut on a general expense, while still unwelcome, is at least bounded because the recent amendments introduced a cap.
| Type of expenditure | Link to asset | Effect on income | Is there a cap |
|---|---|---|---|
| Specific | Direct connection to identified asset or investment | All income and capital gains from that asset become NALI while the fund holds it | No cap. Effect can last for life of asset |
| General | Broad costs without direct link to a single asset | Shortfall amount multiplied and added to taxable income subject to cap | Yes. Non-arm's length component limited to lesser of formula amount or adjusted taxable income |
Because the cap does not apply to specific expenditure the ATO examples often show situations where a small service or renovation provided free by a related party causes a lifetime tax penalty that dwarfs the original saving.
Trap One Friends and family property deals
Residential property remains a favourite asset class for SMSF trustees. The Superannuation rules allow related party property transfers only when the asset is a business real property or listed securities. Despite that restriction many funds attempt to buy residential dwellings from members at mates rates or lease properties to relatives at discounted rent. Either transaction violates the arm's length requirement. The purchase price and the rental terms must both align with an objective market valuation arrived at using acceptable methods.
When a fund acquires property for less than market value the ATO treats the discount as specific non-arm's length expenditure. Future rental income and any capital gain on disposal become NALI. Adjusting the lease to market later does not reverse the taint. The forty five per cent rate can apply decades later when the asset is sold in pension phase.
Funds that borrow using a limited recourse borrowing arrangement must also respect safe harbour terms published by the ATO or otherwise demonstrate that the interest rate, security, loan to value ratio and repayment schedule are commercial. Soft loans from parents or related trusts with zero interest or extended terms usually fail that test and the income from the financed asset falls into the NALI net.
Trap Two Discounted or free professional services
Many trustees are accountants, real estate professionals or builders by trade. They often feel comfortable providing services to their own fund for nothing or at a nominal fee. The attitude is understandable but risky because the law draws a sharp distinction between services performed in the trustee capacity and services provided in a business capacity. Simple trustee tasks like reviewing bank statements or arranging an internal meeting can be performed without charge. Anything beyond that, such as preparing financial statements, managing a rental property portfolio or executing a renovation, is a business service that must be billed at arm's length rates.
If the fund does not pay the full market charge the shortfall is NALE. When that work relates directly to a property or investment the expenditure is specific and the taint locks on to the income from that asset. The ATO guidance in Law Companion Ruling 2021/2 underlines that even a nil shortfall creates the problem. In other words providing the service for free is worse than charging a token fee because both trigger the same punitive outcome.
Trap Three Trust distributions and private company dividends
Discretionary trust distributions are another minefield. If an SMSF receives income from a discretionary trust where it lacks a fixed entitlement the income is automatically non-arm's length. The policy reason is that the fund may have influenced the trustee of the distributing trust and therefore received income that it could not have expected from an arm's length entitlement. Fixed unit trusts provide a safer structure but only if the units were acquired on commercial terms and no other non-arm's length dealings exist.
Private company dividends can also be recharacterised. The ATO focuses on arrangements where a private company pays a franked dividend well above what would have been declared in a normal commercial scenario. That might happen when the company is controlled by the same individuals who control the fund. If the dividend is inflated the whole dividend is NALI. Franking credits are still attached but the forty five per cent tax rate applies to the grossed up amount and the excess franking credit is not refunded. This result can shock trustees who expected a tax rebate instead of a liability.
Trap Four LRBAs and informal loans
Limited recourse borrowing remains permissible for SMSFs although the policy climate has gradually tightened. An LRBA that is not commercial in every significant term exposes the financed asset to NALI. Common missteps include setting an interest rate below the ATO safe harbour, adopting interest-only payments for an extended period, omitting market comparable security and failing to register mortgages or caveats in line with state property law.
Informal on demand loans from members are equally hazardous. Even if the loan accrues interest at a market rate the absence of a written agreement, scheduled repayments and registered security can lead the ATO to conclude that the parties were not dealing at arm's length. The fund then faces the forty five per cent rate on all earnings that flow from the borrowed funds.
Trap Five Early access and personal services income diversion
Some promoters encourage individuals to use their super fund to funnel personal services income or to gain early access to cash. Often this involves the creation of a related company that invoices clients and then pays dividends to the SMSF. The idea is to move income from the individual's top marginal rate to the concessional fifteen per cent rate. The ATO has flagged such structures as schemes of concern. The income diverted to the SMSF is treated as NALI and the fund pays forty five per cent. The individual may also face assessments under the personal services income regime on top of penalties for participation in a scheme.
Early access arrangements where the fund purchases an asset that the member or relative then uses also breach the sole purpose test. Even if the asset produces some income the dominant purpose of providing a present day benefit undermines the concession. The ATO often strikes hard in these cases and can make the fund non-complying. That decision rests on separate powers but emphasises how quickly a compliance failure can escalate beyond NALI.
How the tax is calculated and reported
When the fund has non-arm's length income the amount is isolated into a separate non-arm's length component. The component is taxed at forty five per cent regardless of whether the fund has carried forward losses or is in pension phase.
For general expenditure shortfalls the law prescribes a formula that multiplies the shortfall by two to arrive at a notional income amount. That figure is then compared with the fund's adjusted taxable income and the lesser amount is included in the non-arm's length component. In contrast all ordinary or statutory income classed as NALI for other reasons is included in full.
SMSF annual return forms contain specific fields where trustees must disclose NALI amounts. Auditors must also address the presence of NALI in the audit report. Failure to report correctly raises the prospect of administrative penalties and can prompt ATO scrutiny.
| Step in process | Treatment | Tax rate |
|---|---|---|
| Calculate ordinary and statutory income | Segregate amounts that are NALI | NALI moves to non-arm's length component |
| Apply NALE formula for general expenses | Add lesser of formula amount or adjusted taxable income | Component taxed at forty five per cent |
| Remaining taxable income | Taxed at normal fifteen per cent or exempt under pension provisions | Normal rate applies |
Practical steps to keep your fund safe
The first and most effective defence is documentation. Obtain independent market valuations before every related party transaction whether it is a property purchase, lease renewal, loan or service engagement. Keep written agreements signed and dated. Store invoices that show an amount actually paid by the fund from its bank account.
The second safeguard is a healthy scepticism about mates rates. Ask whether an unrelated stranger would accept the same terms. If the answer is no then the arrangement is probably non-arm's length. Adjust the terms before signing. Do not rely on the hope that the ATO will ignore a small favour.
Thirdly undertake periodic reviews especially for longstanding arrangements predating the two thousand and eighteen changes. Interest rates, market rents and service fees move over time. What was commercial five years ago may no longer be so. An annual check with your accountant and auditor helps identify issues early.
When professional help is essential
Complex structures that involve trusts, companies, borrowings or property development require specialist advice. Consult an SMSF accredited accountant, a superannuation lawyer or both before committing the fund to any transaction where related parties feature. When the fund already holds a potentially tainted asset obtain advice on mitigation. While the legislation offers limited pathways to fix specific NALE, informed professionals can sometimes restructure future dealings to contain or at least measure the exposure. Early engagement with the auditor and voluntary disclosure to the ATO may soften penalties.
Frequently asked questions
What is non-arm's length income in an SMSF
Non-arm's length income is any ordinary or statutory income that a self managed super fund receives from a scheme where the parties did not deal on commercial terms and the income is higher than expected in a genuine market arrangement. The entire amount is taxed at forty five per cent within the fund.
How can the forty five per cent rate apply when my fund is in pension phase
The NALI rules override the exemption on earnings that ordinarily applies in retirement phase. If income is non-arm's length the fund pays forty five per cent even though other pension income remains tax free.
What is non-arm's length expenditure and how does it trigger NALI
Non-arm's length expenditure is an outlay or cost that the fund either does not incur or incurs at less than market value for the purpose of earning income. If that shortfall exists and the expenditure relates directly to an asset the income and capital gains from that asset become NALI.
Can a tainted asset ever be cleansed
Where the taint comes from specific NALE such as a discounted acquisition price or free renovation service the stain usually lasts for the duration of the fund's ownership. Selling the asset to a third party can end future exposure but the historical income already assessed remains subject to the forty five per cent rate.
Do trust distributions always create NALI
Distributions from a discretionary trust to an SMSF are always non-arm's length because the entitlement lacks fixed rights. Distributions from a fixed unit trust can avoid NALI only if all dealings including the acquisition of units occurred on arm's length terms.
How does the cap on general expenditure shortfalls work
For general expenses the legislation limits the non-arm's length component to the lesser of the calculated uplift amount or the fund's adjusted taxable income excluding assessable contributions. This protects small funds from disproportionate tax bills where a trivial accounting discount might otherwise create a large penalty.
What evidence does the ATO expect in an audit
The ATO looks for independent valuations, written contracts, market rental appraisals, loan documents with commercial terms and proof of payments. Absence of this evidence shifts the burden to the trustee to justify that the dealings were arm's length.
Is the non-arm's length component reported separately in the annual return
Yes. The SMSF annual return has dedicated labels for non-arm's length income. Accurate reporting is mandatory and auditors must verify the amounts.
Will franking credits offset the forty five per cent tax on a NALI dividend
The fund still receives the franking credit but tax is calculated at forty five per cent on the grossed up dividend. Excess franking credits are not refundable when the income is NALI so the fund may face an additional payment instead of a refund.
When should I seek professional advice
Obtain advice before any transaction with a related party especially property purchases, loans, service agreements or trust restructures. Seek help immediately if you suspect an existing arrangement may not be commercial.
Final reflection
The concessional tax framework for self managed super funds rewards disciplined compliance with arm's length principles. The price of a shortcut can be a permanent forty five per cent tax rate that wipes out the advantage of operating a fund in the first place. By documenting every transaction, insisting on commercial terms and seeking professional guidance before acting, trustees can avoid the common traps and retain the full benefit of the superannuation system for their retirement.
