Sole Purpose Test
The golden rule of a self managed super fund (SMSF) is that the fund must be maintained only for the sole purpose of providing benefits to members upon their retirement, or benefits to their dependants should the member die before retirement (section 62 Superannuation Industry Supervision Act).
Therefore, any investment of the fund needs to be made with the intention that the investment will appreciate in value or that the member will be able to receive an ongoing regular income upon death, disability or retirement.
Failure to do this will result in a breach of the Act with the effect that the fund will be ‘non-complying’ and lose its status as a SMSF and associated benefits. There are also potentially civil and criminal penalties which can apply to members and trustees of SMSF for a breach of this rule.
A SMSF is at risk of breaching the sole purpose test if it does any of the following things:
- It purchases an investment that gives a benefit to a member or associate now. This is because the member of a SMSF should not generally enjoy a benefit from the investment before they retire. An example of this would be where an SMSF acquires real property and the member lives in it rent free
- It runs a business within the fund as part of the investment strategy. There are very limited circumstances where a SMSF can run a business through the fund on the basis that doing so demonstrates that the fund may not be administered for the sole purpose of providing benefits for its members and beneficiaries, rather it being administered to run a business. A SMSF may however invest in an entity which runs a business
- It provides financial assistance or a benefit to any person or entity outside the fund
The Commissioner of Taxation accepts that there are some circumstances where other benefits provided will not contravene the sole purpose test. In particular, benefits which are incidental, remote or insignificant do not result in a contravention of the sole purpose test. The Commissioner’s conclusion is supported by SMSFR 2008/2 which provides as follows:
- The benefit is an inherent or unavoidable part of other activities undertaken by the trustee that are consistent with the provision of benefits under the sole purpose test
- The benefit is remote or isolated, or is insignificant when assessed relative to other activities undertaken by the trustee
- The benefit is provided by the SMSF on arm’s length commercial terms, consistent with the financial interests of the SMSF and at no cost or financial detriment to the SMSF
- All the activities of the trustee are in accordance with the Act
- All of the investments and activities are undertaken as part of or are consistent with a properly considered and formulated investment strategy
Timing is also critical. If a benefit is received just prior to retirement, the Commissioner is likely to scrutinise it more closely.
For this reason, we recommend that trustees of an SMSF have a formal investment strategy for their fund which is reviewed on a regular basis and unique to that particular fund. This helps to reaffirm that the SMSF is carried on in a way which satisfies the sole purpose test and acts as a guide when making investment decisions.
The investment strategy should consider the following issues:
- How investments are to be made, for example they should provide sufficient member returns and take into account the risk associated with the investment.
- The level of desired diversification. A SMSF is permitted to invest in a number of asset classes as part of it’s long term strategy (for example shares, property and cash deposits).
- The fund’s ability to pay benefits as members retire and how operating costs incurred by the fund will be met.
- What each member will need upon retirement based on their age, income level and employment obligations.
- Whether members require insurance and if so, whether the fund should be responsible for managing the policy.
Given the highly complex nature of SMSFs, we recommend obtaining legal advice prior to the trustee engaging in any investment decisions.
We’re here to help.
Ann-Maree Ventura Special Counsel
Level 3, 1 Palmerston Crescent
South Melbourne, VIC 3205, Australia