Mastering the SMSF Sole Purpose Test for Compliance and Success
The sole purpose test is the foundation of the superannuation legislation. It is the overarching condition that must be met by all trustees at all times. The most important element of the sole purpose test is transactions and dealings between parties, but particularly related parties must be made at arm’s length. It is crucial the trustee obtains external supporting evidence when undertaking any related party transactions.
What is the Sole Purpose Test for a Self-Managed Super Fund?
In summary section 62 of the Superannuation Industry (Supervision) Act 1993 (SIS) provides that the self-managed superannuation fund must be maintained for certain core purposes which include the sole purpose of providing retirement benefits to its members or a member’s dependants on the member’s death (before retirement) as well as some ancillary purposes.
What is an example of an ancillary purpose?
Ancillary purposes include ceasing work due to ill-health, a member dying after retirement or after reaching the age of 60 and their benefit is paid to their dependants.
How to Meet the SMSF Sole Purpose Test
Simply the SMSF trustee must ensure the core purposes, and the ancillary purposes are complied with. The trustee must be able to show why they made an investment decision or undertook a specific activity. Documenting the trustee’s reasons in a minute or as part of the investment strategy can be very useful evidence for SMSF auditors.
To meet the sole purpose test, ensure:
- review and realign the fund’s investment strategy on a regular basis
- do not use the fund’s assets for personal or non-retirement purposes
- maintain detailed records of all trustee decisions
- seek financial advice from your SMSF Specialist or an Independent Financial Licensed Adviser
Key Questions to ask when reviewing if the Investment/Transaction will comply with the Sole Purpose Test
Test the decision to acquire the asset and query what use of the asset was made after it was acquired.
- What was the decision-making process undertaken by the trustee to acquire the asset?
- What was the trustee’s motivation?
- Does the decision align with the provision of providing retirement or death benefits?
- Is there another purpose which influenced the trustee’s decision?
Passing the sole purpose test when SMSFs provide retirement benefits to members or related parties pre-retirement?
The ATO in SMSF Ruling 2008/2 have acknowledged the following activities suggest a SMSF fund does not fail the sole purpose test even if the SMSF members may obtain a pre-retirement benefit which is insignificant, remote or incidental:
- The benefit is an inherent or unavoidable part of other activities undertaken by the trustee that are consistent with the provision of benefits specified by subsection 62(1).
- The benefit is remote or isolated, or is insignificant (whether it is provided once only or considered cumulatively with other like benefits) when assessed relative to other activities undertaken by the trustee that are consistent with the provision of benefits specified by subsection 62(1)
- The benefit is provided by the SMSF on arm’s length commercial terms (for example, if the benefit is provided at market value), consistent with the financial interests of the SMSF and at no cost or financial detriment to the SMSF.
- All of the activities of the trustee are in accordance with the covenants set out in section 52.
- All of the SMSF’s investments and activities are undertaken as part of or are consistent with a properly considered and formulated investment strategy.
Refer to “What is the Sole Purpose Test for a Self-Managed Super Fund?” in relation to what the core and the ancillary purposes are for subsection 62 (1).
From ATO SMSFR 2008/2
Example 3 – maintenance of asset: merely an incidental benefit
- In line with an SMSF’s investment strategy, the trustees of an SMSF decide to invest in a house near a beach in North Queensland. According to their research, the capital growth and rental demand of properties in the area will be strong in the future due to infrastructure and tourism developments in the local region.
- The house is managed by a local firm and is made available to unrelated third parties for short term holiday accommodation. The managers provide the trustees with regular reports detailing items requiring maintenance and repair. The SMSF trustees visit the house, as needed, for a few days in an off-peak period when the house is not booked to undertake significant maintenance and repairs. While staying at the beach house the members pay the normal commercial rates (that is those charged to non-related parties) to the management firm for staying at the house.
- The facts of themselves do not indicate that there is a breach of the sole purpose test in these circumstances. The benefit (short-term accommodation while undertaking necessary repairs and maintenance to the fund’s asset) is incidental to the legitimate maintenance of an investment that is in accordance with section 62, is relatively insignificant, and is provided for at market value to the SMSF trustees.
Example – Residential accommodation provided to the daughter of a sole member SMSF did not breach the sole purpose test.
A Full Federal court case “The case of Aussiegolfa Pty Ltd (Trustee) v Commissioner of Taxation (2018) FCAFC 122 looked at this issue in some detail. One of the issues involved looking at contravening the sole purpose test. A sole member fund, Benson Family Superannuation Fund (Benson Fund), invested into DomCom Fund which was a widely held trust. A ‘sub-fund’ within DomCom Fund was established to purchase a property for student accommodation and the units were held by Benson Fund and other related parties. Mr. Benson’s daughter leased the property from the Custodian and not directly from the Benson Fund. The ‘sub-fund’ was determined to be an in-house asset but the court decided there was no breach of the sole purpose test. The decision turned on the facts that unrelated students had previously leased the accommodation and when the daughter occupied the property 2 years later she paid the same equivalent rent as the previous tenants. The property purchase had not been influenced by wanting to provide student accommodation for Mr Benson’s daughter and the Benson Fund did not suffer any loss or detriment.
Failing the sole purpose test when SMSFs provide retirement benefits to members or related parties pre-retirement?
The ATO in Self Managed Superannuation Fund Ruling 2008/2 have acknowledged the following activities suggest a SMSF fund fails the sole purpose test under the following circumstances:
- The trustee negotiated for or sought out the benefit, even if the additional benefit is negotiated for or sought out in the course of undertaking other activities that are consistent with section 62.
- The benefit has influenced the decision-making of the trustee to favour one course of action over another.
- 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 or preponderance of events that, when viewed in their entirety, amount to a material benefit being provided that is not specified under subsection 62(1).
From ATO SMSFR 2008/2
Example 15 – reimbursement for dual purpose: more than an incidental benefit
- Jackie and Phillip are trustees and members of an SMSF. The SMSF invests in overseas properties, including in the United States. Jackie and Phillip regularly travel overseas and decided to plan a family trip to the United States. The overseas trip was planned for four weeks, during which time they visited several theme parks and tourist attractions. They also spent several days inspecting existing investment properties as well as other properties identified as potential further investments for the SMSF.
- The SMSF funded the airfares and accommodation for the entire trip.
- The sole purpose test is contravened in these circumstances. The expenses reimbursed do not relate only to the performance of trustee duties or services by Jackie and Phillip. The SMSF is being used to provide a benefit other than those specified in subsection 62(1).
Aligning SMSF Investments with the Sole Purpose Test
The assets of a fund should consist of investments that will yield advantages for members over the medium to long term, ensuring compliance with the sole purpose test. Typically, short-term goals are not emphasised, as the majority of new self-managed superannuation funds (SMSFs) are set up during a member’s accumulation phase, with retirement remaining a remote objective.
Regular Compliance Reviews
At all times the SMSF must meet the sole purpose test to continue to comply with the test. Regular reviews should be undertaken to ensure that a SMSF does not provide a pre-retirement benefit to a member unless it is insignificant, remote or incidental.
Common Examples of a SMSF Breaching the Sole Purpose Test
The Australian Taxation Office (ATO) are concerned with a fund member receiving a pre-retirement benefit.
Examples of common breaches include:
- lending money to a related company with no or low interest rates being charged
- acquiring commercial property from members or related parties at inflated prices
- selling a fund asset such as a property to a member at a discounted price
- allowing a member’s child to reside in a residential property owned by a SMSF for no or discounted rent
Please note the examples above may also breach other sections of the SIS Act and possibly Tax laws.
What Penalties will the ATO impose if the SMSF Fails to Meet the Sole Purpose Test?
- Administrative penalties which usually include a fine.
- Rectification directions or enforceable undertakings – this is a contract negotiated between the trustee and the ATO and must be complied with.
- Education directions – when the ATO are concerned about the trustee’s super knowledge they may require the trustee to complete an education program.
- The trustees can be disqualified from their roles (meaning they can no longer be members of the SMSF, nor can they start a new fund).
- Civil and criminal penalties -the ATO doesn’t generally seek criminal penalties and similar to making a fund non-compliant will only seek civil penalties from the courts if the breach is very serious. The current maximum civil penalty is 2,400 penalty points which relates to a maximum penalty of $751,200
- A SMSF can be made non-compliant and tax concessions normally available are lost (meaning the fund may need to pay additional tax on its superannuation contributions and investment earnings) – this is usually one of the last steps undertaken by the ATO.
The penalties imposed are based on a number of considerations such as the compliance history of the trustee, willingness of the trustee to rectify the breach, seriousness of the breach, period of time over which the breach has occurred or continues to occur and multiple breaches.
Key Takeaways | Superannuation Rules
- a SMSF is maintained for the sole purpose to provide benefits to members on their retirement or death benefits or the member’s beneficiaries
- all dealings with members and related parties should be at arm’s length
- tax concessions normally available to super funds may be lost if the SMSF fails the sole purpose test
- seek professional advice if the SMSF trustees are unsure if a proposed investment purchase passes the sole purpose test
- formalise the SMSF trustee’s decision to make an investment in a minute and ensure it aligns with the fund’s investment strategy
Do you need help with understanding the SMSF Sole Purpose Test?
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