SMSF's and the sole purpose test: does carrying on a business breach the test?

Trustees of a Self-Managed Superannuation Fund (SMSF) and their advisers should take great care (and seek legal advice) if the fund invests in a business — or even if it is involved in active share trading. These activities may mean the SMSF is operating for more than the sole purpose of providing benefits to members etc.

Accordingly, there is a risk that the fund may lose its complying status — and that the trustees may face penalties. Paul Ellis

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What is the sole purpose test?

The sole purpose test sets the primary and ancillary purposes for which a superannuation fund must be operated, namely to provide benefits to, or in relation to, members after their retirement, on reaching retirement age, or on their death. The test is in section 62 of the Superannuation Industry (Supervision) Act 1993 (SISA).

What are the problems of breaching the test?

Breaching the test may:

• cause an SMSF to lose its complying fund status; and
• involve the trustee being fined.

One of the trustee's key responsibilities is to invest the money paid into the fund. However, trustees must respect the restrictions that apply to these investment — especially when making an investment that may constitute the carrying on of a business.

May SMSFs carry on business?

The ATO has always been concerned that an SMSF carrying on a businesses may be in breach of the sole purpose test. This is because conducting the business — rather than providing retirement benefits — may become the sole purpose of the fund.

This issue was raised at the National Tax Liaison Group Superannuation Sub Committee meetings on both 26 October 2005 and 8 February 2006. The minutes of the earlier meeting state:

The Tax Office indicated that there is nothing in the legislation to prevent it. However, there are potentially a number of issues in carrying on a business that might lead to contraventions of the SIS Act and Regulations (such as the sole purpose test, or the borrowing of money). As each case must be considered on its own merits, the Tax Office cannot give a more definite answer.

The ATO's recent publication Self Managed Superannuation Funds - Roles and Responsibilities of Trustees states:

A possible indication that the sole purpose test has been contravened is where a fund is running a business as part of its investment strategy. If a superannuation fund is conducting a business, it may not be administered for the sole purpose of providing benefits for the members and beneficiaries of the fund.

Another ATO publication DIY Super - It's your money... but not yet! also discusses this issue, but is being reviewed.

Is share trading etc. "carrying on a business"?

The ATO also has concerns that some investment activities by SMSF trustees — such as share trading and making certain 'tax effective' investments — may amount to carrying on a business. If those activities are carrying on a business, then — again — the SMSF may lose its complying status and the trustee may face penalties.

What investment rules must an SMSF trustee comply with?

The ATO's concerns outlined above reflect its regulatory imperatives in ensuring SMSF trustees comply with:

• the sole purpose test: and
• investment rules generally.

It is important that trustees are aware of, and comply with, the investment rules set out in the SISA.

The key things to remember are:

Trustees must:

• develop an investment strategy and stick to it; and
• make and maintain investments on a commercial arm's length basis. This can be determined by asking whether a prudent person acting with due regard to his or her own commercial interests would have made such an investment;

Trustees must NOT:

• acquire assets from related parties (although there are certain exceptions)
• lend to, or provide financial assistance to, other members of the SMSF or to their relatives.

If you are uncertain about whether an SMSF is complying with these rules, you should seek legal advice as early as possible.