Overview and why it matters
Non‑arm’s length income (NALI) and non‑arm’s length expenditure (NALE) are integrity rules that can materially change the tax outcome for a self‑managed superannuation fund (SMSF). Where income or expenditure is found to arise from non‑arm’s length arrangements, the ATO can treat affected income as NALI and tax it at the top marginal rate rather than the concessional superannuation rates. The rules have been the subject of legislative change, extensive ATO guidance and active litigation and tribunal review, and trustees must understand both the legal tests and the practical evidence required to withstand scrutiny.
Legislative and regulatory framework
Core statutory provision
The principal statutory vehicle is section 295‑550 of the Income Tax Assessment Act 1997 (ITAA 1997), which sets out the NALI tests. Those tests capture income derived under schemes where parties are not dealing at arm’s length and where the income is greater than would have been expected under arm’s‑length terms. The provision also contemplates situations where non‑arm’s length expenditure gives rise to NALI.
Interaction with NALE
NALE operates as the expenditure side of the integrity rule: if an SMSF incurs expenditure that is not on arm’s‑length terms (for example, discounted acquisition price, free or discounted services from related parties, or other non‑commercial terms), that expenditure can be linked to the fund’s income and cause that income to be treated as NALI. Legislative amendments and explanatory materials have clarified and, in some respects, broadened the ATO’s reach to include general fund expenses as well as expenditure tied to specific assets.
ATO guidance and rulings to know
LCR 2021/2 (finalised) and compendium
The ATO finalised Law Companion Ruling LCR 2021/2 (and associated compendium LCR 2021/2EC2) to explain how the NALI rules apply where non‑arm’s length expenditure is incurred. The finalised ruling, released in September 2025, sets out the ATO’s view on the connection between NALE and income, examples of arm’s‑length and non‑arm’s‑length arrangements, and the ATO’s compliance approach. The compendium records submissions on the draft ruling and the ATO’s responses. The ruling takes effect from 1 July 2018, consistent with the retrospective application of earlier legislative amendments.
Key interpretive points in ATO guidance
- Connection test — The ATO treats NALE as capable of tainting income where there is a causal or sufficient connection between the non‑arm’s length expenditure and the income derived by the fund. The ATO’s examples show both direct connections (e.g., discounted purchase of an income‑producing asset) and broader scenarios (e.g., general fund expenses that reduce the fund’s outgoings).
- Scope of “general expenses” — The ATO’s position in the final ruling confirms that general expenses can be relevant to NALE analysis, a point that attracted significant industry comment during the draft stage.
- Burden of evidence — While the ATO sets out its interpretive approach, the practical outcome in disputes often turns on the quality of contemporaneous documentation, independent valuations, and expert evidence.
How the tests operate in practice
Four NALI tests (practical summary)
The NALI rules are commonly explained as four tests that capture different factual patterns:
- Test 1 — Income derived from a scheme where parties are not dealing at arm’s length and the income is greater than would be expected under arm’s‑length terms.
- Test 2 — Income (including dividends) from private companies where the amount is inconsistent with arm’s‑length dealings.
- Test 3 — Income from trusts where distributions to the SMSF are inconsistent with arm’s‑length expectations.
- Test 4 — Income that is greater because the SMSF incurred NALE.
Practical examples that trigger NALI
- Discounted asset acquisition from a related party that produces income or capital gains.
- Private lending to related parties where interest rates, security or terms are not commercial.
- Services provided free or at a discount by related parties (for example, accounting or management services).
- General fund expenses that are non‑arm’s length and materially reduce the fund’s outgoings.
Selected tribunal and court decisions
AAT decision on arm’s‑length private lending (2023)
A notable Administrative Appeals Tribunal (AAT) decision in 2023 involved an SMSF that made private loans to related parties. The AAT overturned the ATO’s amended assessments where the SMSF produced independent expert evidence showing the loan terms were commercially reasonable, and where the fund’s documentation and processes supported the commerciality of the arrangement. The decision highlights that robust contemporaneous evidence and independent valuation or expert reports can be decisive in contesting an ATO NALI determination.
BPFN v FTC and challenges to the ATO’s breadth
Industry commentary and seminars have discussed litigation and challenges (for example, matters referenced as BPFN v FTC) that question whether the ATO’s broad approach to general expenses and NALE is legally sustainable. These challenges focus on whether general fund expenses should taint all fund income and whether the ATO’s causal tests are too expansive. While some matters remain at early stages or are discussed in professional forums rather than reported judgments, they illustrate ongoing legal tension and the potential for further judicial clarification.
Broader jurisprudential themes
Cases that survive ATO scrutiny typically share features: independent valuations, contemporaneous commercial rationale, consistent trustee conduct, and evidence that transactions were negotiated on commercial terms. Conversely, arrangements lacking documentation, with informal or family‑style terms, are more likely to be characterised as non‑arm’s length.
Practical compliance steps for SMSF trustees
Documentation and process
- Valuations — Obtain independent market valuations for acquisitions or disposals involving related parties.
- Written agreements — Use formal loan agreements, service contracts and security documents when dealing with related parties.
- Market comparators — Keep evidence of comparable market rates (e.g., bank loan rates, market management fees).
- Contemporaneous records — Minutes, trustee resolutions and professional advice should be recorded at the time of the transaction.
Avoiding common pitfalls
- Do not accept or provide free or heavily discounted services without clear commercial justification.
- Avoid informal family loans without formal documentation and independent evidence of commercial terms.
- Treat general fund expenses with care: ensure fees for audit, accounting and investment management are market‑based and supported by quotes or contracts.
Responding to an ATO review
When the ATO raises NALI/NALE concerns, trustees should assemble: independent valuations, expert reports (where appropriate), contemporaneous documentation and a clear commercial narrative explaining why terms were arm’s length. The 2023 AAT outcome shows that well‑prepared evidence can overturn ATO positions.
Practical consequences and tax outcomes
Tax treatment
If income is characterised as NALI, the tax consequences are significant: affected income may be taxed at the top marginal rate rather than the concessional rates that typically apply to SMSF income. Penalties and interest can also follow where the ATO amends assessments. The potential for retrospective application (from 1 July 2018 in the ATO’s ruling) increases the compliance risk for prior years.
Risk management trade‑offs
Trustees must balance the desire to use related‑party arrangements (which can be efficient) against the compliance risk and evidentiary burden. Using independent third‑party providers for key services or ensuring formal market‑based contracts can reduce the risk of an adverse NALI finding.
Key takeaways
- NALI and NALE are high‑risk areas for SMSFs and can lead to top‑rate taxation of affected income.
- ATO’s LCR 2021/2 sets out a broad interpretive approach and applies from 1 July 2018; trustees should familiarise themselves with the ruling and compendium.
- Evidence matters: independent valuations, formal agreements and contemporaneous records are often decisive in tribunal and court reviews.
- General expenses are in scope of the NALE analysis under the ATO’s view, so routine fund costs should be demonstrably market‑based.
*https://www.ato.gov.au/law/view/pdf/pbr/lcr2021-cp002.pdf