Non-Arm's-Length Income for SMSFs in retirement: the 45% tax penalty trustees must avoid

For Australian retirees managing self-managed super funds (SMSFs), Non-Arm's-Length Income (NALI) is one of the highest-stakes tax risks in fund operation. The rule, governed by section 295-550 of the Income Tax Assessment Act 1997, applies a 45% tax rate to fund income that arises from non-arm's-length transactions with related parties. The contrast with normal SMSF taxation is stark: accumulation phase taxed at 15%, pension phase tax-free at 0%, NALI at 45% — and pension phase does not shelter NALI. For a retiree expecting tax-free pension-phase outcomes, falling foul of NALI converts what should be zero tax into the highest marginal rate.

The rule operates in three elements. The fund derives income from a scheme — broadly any arrangement involving the SMSF and another party. The parties were not dealing at arm's length — typically meaning related parties (member, member's family, member-controlled business, member's trust) on terms not agreed between unrelated parties. The income is more than would have been derived had the parties been dealing at arm's length (or arises from non-arm's-length expenditure). When all three elements are present, the income is NALI and taxed at the 45% rate.

A worked example illustrates the stakes. An SMSF in pension phase owns a commercial property leased to a member-controlled business at $5,000 per month rent. Independent market valuation indicates arm's-length rent for that property would be $3,000 per month. The SMSF is receiving $24,000 per year more than arm's-length — and the entire rental income from this lease may be NALI, taxed at 45%. The pension-phase exemption does not apply. What should be tax-free pension-phase rental income becomes a substantial annual tax bill.

What is Non-Arm's-Length Expenses (NALE)?

A significant expansion of the rule occurred through the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019, introducing Non-Arm's-Length Expenses (NALE). NALE captures situations where the SMSF pays less than market value for goods or services connected to fund income. Two flavours apply. General NALE addresses below-market expenditure connected to specific income — for example, a member who manages the SMSF's investment property at no charge or below-market rates may taint the rental income from that property as NALI. Specific NALE addresses below-market expenditure for general fund services — for example, a member who is an accountant providing free or below-market accounting services to the fund may taint all fund income as NALI. The general NALE provisions came into effect from 1 July 2018, with transitional compliance relief for general (non-specific) NALE covering the 2018-19 to 2022-23 income years; from 1 July 2022 onwards, ATO compliance focus centres on whether a reasonable attempt was made to determine an arm's-length expenditure amount. ATO guidance through PCG 2020/5 and LCR 2021/2 clarifies the operation.

What are the common NALI scenarios for retirees?

A few common scenarios for SMSF retirees illustrate the risk. Below-market rent on member-business property lease — the most common NALI scenario; below-market rent (NALE) or above-market rent both create exposure. Free or below-market member services — the member who provides accounting, audit, property management, or administrative services without charging market rate is creating NALE that may taint fund income. Below-market interest on related-party lending — historically a common trigger, particularly for limited recourse borrowing arrangements (LRBAs) from related-party lenders at non-commercial rates. Acquisition from member at below-market price — the difference is treated as a contribution; subsequent income from the asset may be NALI. Investment in member-controlled trust or entity at non-arm's-length terms — returns received may be NALI.

Why doesn't pension phase shelter NALI?

For SMSF retirees, the pension phase issue is critical to understand. Moving the fund to pension phase achieves a 0% tax rate on ordinary fund income — the well-known feature that makes pension-phase SMSFs tax-efficient. NALI is carved out of the pension-phase exemption. The 45% rate applies to NALI regardless of pension phase status. For an SMSF retiree expecting tax-free pension-phase outcomes, NALI is the most damaging breach because the gap between expected (0%) and actual (45%) is the full 45 percentage points.

How can trustees avoid NALI?

Avoiding NALI requires deliberate structuring and documentation of related-party transactions. Document arm's-length terms. All transactions between the SMSF and related parties should be documented at market value with appropriate evidence — rental valuations, comparable lease terms, professional service agreements, market interest rates. Use independent valuations. For property leases, professional rental valuations support the arm's-length position; for business sale transactions, independent business valuations. Pay market rates for member services. Where members provide services to the fund (accounting, audit, property management), pay market rates. Below-market rates are NALE. Arm's-length lending terms. Where the fund borrows from related parties or lends to them, terms at commercial rates with proper documentation. Trustee resolutions. Documenting the basis for transaction terms supports the arm's-length position. Annual review. Market rates change; a transaction arm's-length when entered may need re-pricing. Annual review with the SMSF accountant catches drift.

How does NALI relate to the 5% in-house asset limit?

NALI sits alongside but distinct from the 5% in-house asset limit under the SIS Act. Some related-party transactions that aren't NALI may still breach the 5% in-house asset cap. SMSF trustees navigate both rules — arm's-length terms address NALI; 5% limit addresses in-house asset caps (with exemptions for business real property and specific scenarios). A transaction can be arm's-length but breach the 5% cap; or compliant with the 5% cap but breach NALI through non-arm's-length terms.

What is the ATO's compliance focus on NALI?

ATO compliance focus on NALI has been substantial in recent years. The ATO has conducted reviews focused on related-party transactions, published practical compliance guidance, applied transitional concessions for some pre-existing arrangements, and issued NALI assessments where non-compliance is identified. For SMSF retirees with related-party transactions, ATO scrutiny is realistic and ongoing.

What common pitfalls should trustees avoid?

A few common pitfalls to avoid. Below-market rent on member-business property lease — the most common scenario; both below-market and above-market trigger exposure. Free or below-market member services to the fund — a particular issue where members are professional service providers themselves. Below-market interest on related-party lending — often historic LRBA arrangements. Not documenting the arm's-length basis even where the transaction is arm's-length — lack of documentation is a problem on review. Assuming pension phase shelters NALI — it doesn't. Annual review oversight — market rates change.

For SMSF retirees, NALI is typically managed through coordination between the SMSF accountant/auditor (annual review of transactions, identifying risk), the financial adviser (strategy and structure recommendations), an independent valuer where required (property or business valuations), and a solicitor for complex related-party arrangements. The cost of professional support is meaningful but small relative to a 45% tax penalty applying to fund income that should be tax-free.

For Australian SMSF retirees, NALI is the rule that converts careful retirement planning into a substantial tax bill where related-party transactions are not properly structured. The framework is technical but navigable. Worth engaging with deliberately, ideally with professional support, rather than discovering the issue in an ATO audit.

Sources

• ATO — How SMSFs are taxed
• ATO — Non-arm's length income (SMSF annual return instructions)
• ATO — Law Companion Ruling LCR 2021/2: Non-arm's length income — expenditure
• ATO — What are the SMSF investment restrictions?