ATO Seeks to Mitigate NALI Setback in BPFN Ruling

In April 2024, the Australian Taxation Office (ATO) released a draft Decision Impact Statement (DIS), responding to the outcome in BPFN and Commissioner of Taxation (Taxation) [2023] AATA 2330 (BPFN).

Background

Non-arm’s length income (NALI) refers to income generated by a superannuation fund where the income is more than what the fund would have received if the fund was dealing at arm’s length. NALI is taxed at the highest marginal rate of 45% compared to the concessional contribution tax rate of 15%.

The ATO has long maintained a tough stance on NALI, emphasising rigorous scrutiny in its public communications and audits. This approach has placed significant pressure on self-managed superannuation funds (SMSF) to demonstrate that their arrangements adhere to arm’s length standards, particularly concerning benchmarking.

While straightforward for certain transactions with readily available benchmarks, such as real estate valuation or rent, this approach presents challenges for unique commercial arrangements lacking comparable benchmarks. The focus on benchmarking has sometimes overshadowed a more commonsense evaluation of whether an arrangement is genuinely commercial.

BPFN Decision

In August 2023, the Administrative Appeals Tribunal (AAT) made a ruling in the case of BPFN delivering a setback to the ATO’s stringent stance on NALI, opting for a broader commercial perspective.

In this case, an SMSF invested in a related unit trust (JJUT), which then lent funds to a related company (ABC). ABC subsequently lent funds to a related discretionary trust (DEF), which in turn lent funds to unrelated third parties.

The terms of the loans from DEF to the third parties were deemed to be at arm’s length. Notably, the interest rates for the loans from JJUT to ABC and ABC to DEF matched those payable by the third parties to DEF, with no additional markup. Any interest paid by the third parties effectively flowed through to the SMSF. Additionally, the third parties paid certain fees to DEF, which DEF retained.

The taxpayers, supported by two expert witnesses experienced in private lending law, argued that such on-lending arrangements with interposed entities like DEF and ABC were customary and within reasonable commercial bounds.

Contrary to the ATO's position, the AAT found in favour of the taxpayers, accepting their arguments and evidence that the arrangement mirrored what one would expect between independent parties in the private lending market. Consequently, the AAT ruled that NALI was not triggered.

This decision is significant as it underscores the possibility of arrangements being deemed commercial, even without benchmarking or strict evidentiary requirements advocated by the ATO.

ATO’s Response

The ATO has since released the DIS on the BPFN case, inviting feedback by 10 May 2024. Notably, the ATO has confirmed its decision not to appeal the ruling.

The ATO acknowledges certain aspects of the decision favouring its stance (regarding the breadth of the scheme and the existence of non-arm’s length dealings) while attempting to downplay the adverse finding (that the super fund did not earn more income than it would under an arm’s length arrangement). Specifically, the ATO states:

“While acknowledging the Tribunal's conclusion at [95], which found that JJUT (and presumably BPFN as sole unit holder) did not earn additional income under this specific scheme based on the Tribunal's findings, we question whether this decision can be broadly applied to arrangements involving private lending.

In assessing the application of subsections 295-550(1) or (5) to private lending schemes, it is essential to evaluate whether the terms, rates of return, and other compensation between the parties align with what arm's length parties would expect.”

Key Takeaway

The ATO maintains its stance that benchmarking evidence is necessary for such arrangements. While BPFN has demonstrated that strict benchmarking isn't always mandatory, expert testimony regarding the commercial nature of the arrangement will likely be crucial in any future proceedings.

Alasdair Woodford
Principal Lawyer
T: 03 5225 5217| M: 0436 456 144
E: awoodford@ha.legal

Joseph Flanagan
Associate
T: 03 5226 8504
E: jflanagan@ha.legal

Ben Smith
Lawyer
T: 03 5225 5262
E: bsmith@ha.legal

Maddi Batchelor
Graduate Lawyer
T: 03 5225 5214
E: mbatchelor@ha.legal