The ATO is putting SMSF trustees on notice about the Sole Purpose Test. This test1 requires a trustee to maintain the SMSF solely:
- for one or more of a number of the 'core' purposes — related to providing retirement or death benefits for SMSF members or their dependants; or
- for one or more core purposes and one or more ancillary purposes — such as temporary disability insurance benefits.
This article comments on the ATO's latest take on the test — which is found in Draft Taxation Ruling SMSFR 2007/D1 (the SMSF Ruling).
The Strict Rule
In the SMSF Ruling, the ATO states:
A strict standard of compliance is required under the sole purpose test. The test requires exclusivity of purpose, which is a higher standard than the maintenance of the SMSF for a dominant or principal purpose.
Accordingly, the relevant question is whether the fund is being exclusively maintained for the core purposes, or the core purposes and one or more ancillary purposes, as set out in section 62(1). That is, the test is not whether one or more of those purposes is only the dominant or principal purpose of maintaining the fund.
The SMSF Ruling explains that the Sole Purpose Test may still be satisfied even if benefits that are incidental, remote or insignificant have been created by a transaction or decision. Of course, this is only if those benefits are incidental to the fund being maintained with the section 62(1) purposes exclusively in the trustee's mind.
Considerations in Interpreting the Strict Rule
The SMSF Ruling lists some of the ATO's considerations when determining whether a SMSF has complied with the Sole Purpose Test. The considerations are relevant only to the accumulation phase of an SMSF, not in retirement benefit or pension phase.
The following factors will lead the ATO to conclude that a benefit the SMSF delivers means that the SMSF is not being maintained for the required sole purpose:
- The trustee negotiated for the benefit, or sought it out — regardless of whether the trustee did so in the course of undertaking other activities that are consistent with section 62;
- The benefit influenced the trustee to favour one course of action over another;
- The benefit is provided by the SMSF to a member, or to another party, at a cost or financial detriment to the SMSF; or
- There is a pattern, or sequence of events, that viewed in the entirety, amounts to a material benefit being provided that is not specified under subsection 62(1).
The following factors will tend to lead the ATO to conclude that a benefit the SMSF delivers means that the SMSF is being maintained for the required sole purpose:
- 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 when assessed in light of other activities undertaken by the trustee that are consistent with the provision of benefits specified by subsection 62(1). It does not matter whether the benefit is provided once only or is considered cumulatively with other like benefits;
- The benefit is provided by the SMSF on normal commercial terms 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 of the SISA; and
- All of the SMSF's investments and activities are undertaken as part of, or are consistent with, a properly considered and formulated investment strategy.
Comments on the SMSF Ruling
The SMSF Ruling and the factors listed in it are drafted in an abstract fashion. However, they are more useful when considered with the ATO's examples in an Appendix to the SMSF Ruling.
For example, one of the ATO's examples of an impermissible "separately negotiated benefit" is:
- a trustee invests in a holiday resort for the SMSF in a place that the SMSF's members have always owned a holiday home;
- as part of the negotiations, the trustee negotiates that the members can stay at the property for free — importantly, this right does not apply generally to all investors in the holiday resort; and
- after investing, the members sell their holiday home.
The ATO considers that this separately negotiated benefit would breach the Sole Purpose Test.
Even though the examples are useful, trustees and their advisers need to remember the broad and abstract nature of the ATO's considerations when managing their SMSF's.
What does the SMSF Ruling mean for trustees of SMSFs?
The ATO proposes that once the SMSF Ruling is issued it will apply to years of income commencing both before and after its date of issue.
The nature of SMSFs makes it easy for the lines to be blurred for trustees in relation to the purpose for which the SMSF is maintained. Trustees should use the factors and examples in the SMSF Ruling to guide their day-to-day maintenance of their SMSFs.
The ATO has invited the public to comment on the SMSF Ruling. The due date for comments is 19 October 2007.
For more information about the SMSF Ruling or superannuation generally, contact Maddocks on 03 9288 0555 and ask for a member of the Maddocks Superannuation Team.