Most SMSF compliance problems cost you a penalty. This one costs you the tax concession itself, and it is the reason the ATO looks so hard at anything involving a related party.
Non-arm's length income, universally called NALI, is income your fund earns from an arrangement that is more favourable than what you would have got dealing at arm's length with a stranger. When income is tainted as NALI, it is taxed at 45 per cent instead of 15 per cent, and being in pension phase does not help you.
Where it actually comes from
It is rarely deliberate. It is usually generosity or convenience.
Discounted rent, in either direction. If your fund owns business premises leased to your own business, the rent has to be commercial. Charging your business a favourable rate is the obvious problem. Less obvious is that charging above market can also be a problem, because it moves value into the fund on non-commercial terms.
Related party loans on soft terms. A loan to the fund from a member or a related entity at zero interest, or with no fixed repayment schedule, or with terms no bank would offer. The ATO publishes safe harbour terms for related party limited recourse borrowing arrangements. Arrangements outside those terms are not automatically NALI, but you need to demonstrate the terms are commercial, and that is harder than just following the safe harbour.
Services provided cheaply to the fund. This is the one that catches professionals. If you are an accountant, a real estate agent, a builder or a lawyer and you do work for your own fund at mates rates or for free, using your professional capacity, you have potentially created a non-arm's length expense. A lower expense means higher income, and that income can be tainted. Doing genuinely trustee level work yourself for free is fine. Doing professional work for your fund at a discount is where the risk sits.
Assets acquired below market value from a related party.
Why the ATO is focused on it now
Related party dealings are on the ATO's stated compliance focus list, and they have specifically flagged undervalued services from related parties, non-commercial loan terms, and discounted rent on business real property. With the borrowing rules pushing more new arrangements toward business real property, related party leases are about to become more common, not less.
What protects you
Documentation, and it has to exist at the time rather than being written later.
A written lease at a rate you can support with evidence, reviewed periodically like a real lease would be. Rent actually paid, on time, from the tenant's account to the fund's account. Loan agreements with real terms and a repayment schedule that is actually followed. Trustee minutes recording the decision and the basis for it. Where you have used a professional service, an invoice at normal rates.
The test the ATO applies is whether an unrelated party would have accepted the same deal. If the honest answer is no, the arrangement needs fixing before the auditor finds it, not after.