The “sole purpose test” is one the fundamental requirements for SMSFs to obtain tax concessions. It requires that the SMSF be maintained for the sole purpose of providing retirement benefits to its members, or to their dependents if a member dies before retirement. Broadly, the test is contravened when a member or a related party, directly or indirectly obtains a financial benefit other than the above intended benefits.

Trustees need to be extremely vigilant as the ATO’s standards of compliance in relation to the sole purpose test are high, and the consequences of breach can be dire!

Trustees need to ensure that they do not provide a purposeful benefit to members when undertaking SMSF activities.  This is the case even if there is no net cost to the SMSF in providing the benefit. Ultimately, it is the purpose of providing the benefit rather than the net financial impact of the arrangement on the SMSF’s resources that determines whether the sole purpose test is contravened.

The ATO, which administers the relevant super laws in relation to SMSFs, requires “exclusivity of purpose”, but does accept that the provision of incidental, remote or insignificant benefits that fall outside of the scope of those specified in legislation may occur in certain circumstances.

In assessing whether a fund has met or breached the sole purpose test, the ATO is particularly concerned with how an SMSF came to make an investment or undertake an activity.

Factors that indicate the sole purpose test being contravened include situations where:

• The trustee negotiated or sought out an addition benefit, even if the additional benefit was sought out in the course of undertaking other activities consistent with the sole purpose test;
• The benefit influenced the decision-making of the trustee;
• The benefit is provided by the SMSF to a member or another party at a cost or financial detriment to the SMSF;
• There is a pattern of events that, when viewed in their entirety, amount to a material benefit being provided that is not consistent with the sole purpose test.

Factors that weigh in favour of an SMSF being maintained in accordance with the sole purpose test include:

• The benefit is inherent or unavoidable part of other activities consistent with the sole purpose test;
• The benefit is remote, isolate, or insignificant when considered in light of other activities;
• The benefit was provided on arm’s length commercial terms consistent with the financial interests of the SMSF;
• All activities of the trustee are in accordance with covenants specified in the legislation;
• All investment activities are undertaken as part of, or are consistent with, a properly considered and formulated investment strategy.

As explained in APRA’s Superannuation Circular III, “there should always be a reasonable, direct and transparent connection between a particular scheme feature or trustee action, and the core or ancillary purposes”.

Specific limitations on investments

Some specific investment limitations have been built into the superannuation legislation, which are reflective of SMSF’s requirement to meet the sole purpose test. These include:

• Prohibiting a SMSF from lending or providing financial assistance to members;
• Prohibiting an SMSF from acquiring assets belonging to members or their relatives (with some exceptions);
• Prohibiting an SMSF from investing in related parties other than on an arm’s length basis; and
• Limitations on investment in related parties (eg. purchasing units in a related unit trust).

Examples of investments that could breach the sole purpose test

Below are some examples of investments or activities that could result in a breach of the sole purpose test:

• A property owned by the fund being used by a member, their family or an associate for a few days while on holiday (whether rent is paid or not);
• Artwork leased to (or part of a lease arrangement with) a related party, used by a related party, or stored or displayed in a private residence of a related party;
• A sailing boat, which the member uses to take their family, associates or employees on a sailing day;
• Shares or units owned in a related party, where the value of the investment exceeds 5% of the fund (noting that the value of the shares/units as well as the other investments of the fund will increase or decrease over time);
• A member or their relative or associate doing repair or improvement works to a property owned by the fund without charging an arms’ length fee;
• Taking out and paying for some types of insurance policies (eg. own-occupation TPD insurance, trauma insurance after 1 July 2014).

Consequences of breach

The following courses of action are available to the ATO to deal with SMSF trustees who have not complied with super laws:

• Education direction
• Enforceable undertaking
• Rectification direction
• Administrative penalties
• Disqualification of a trustee
• Civil and criminal penalties
• Allowing the SMSF to wind up
• Notice of non-compliance
• Freezing an SMSF’s assets.

If a fund is determined by the ATO to be non-complying, the consequences are:

• The fund will lose its concessional tax status and be required to pay tax on all income at the top marginal tax rate (currently 45%);
• In the first year a fund becomes non-complying, the fund’s assessable income for that year includes its ordinary and statutory income from prior years. In effect, the fund loses the benefit of tax concessions that it obtained as a complying superannuation fund, which is achieved by the fund paying tax at the top marginal rate (currently 45%) on the total market value of all assets of the fund at 30 June of the prior year less any non-concessional contributions. This means the fund could have to pay nearly half the market value of its assets in tax.

The importance of sound advice

Determining whether an investment in an SMSF meets the sole purpose test is a complex area and, as you can see above, the consequences of a breach can be administratively and financially detrimental. It is always best to check with your financial advisor before making decisions about new investments or if your fund’s circumstances change. ·