DIY super funds: Beware the sole purpose test

DIY super funds may have outperformed retail funds recently, but the rules around DIY funds can be complex. TERRY HAYES explains how the sole purpose test for DIY super works.

By Terry Hayes

DIY super funds may have outperformed retail funds recently, but the rules around DIY funds can be complex. Here’s how the sole purpose test for DIY super works.

The sole purpose test is a fundamental aspect of the regulation of superannuation which prohibits trustees from maintaining a self-managed super fund (SMSF) for purposes other than the core or ancillary purposes specified under the law. The core purposes essentially relate to providing retirement or death benefits for, or in relation to, fund members.

The fund can also be maintained for one or more of the core purposes and other specified ancillary purposes, which relate to the provision of benefits on the cessation of a member’s employment and other death benefits not specified under the core purposes. However, a trustee who maintains an SMSF for other purposes contravenes the superannuation law.

This is serious stuff!

Why? Because failing the sole purpose test can result in the super fund losing its complying status, and thereby being subject to a much higher rate of tax. A breach of this test may also result in the fund trustees being subject to civil and criminal penalties, with fines up to $220,000 and five years in prison.

And not all SMSF trustees have a good record in complying with these rules. So much so that the tax office has even suggested that some trustees don’t seem to appreciate the importance of the test.

Now comes a major ruling recently released by the tax office that outlines the Tax Commissioner’s approach to the application of the sole purpose test – Self Managed Superannuation Funds Ruling SMSFR 2008/2. It is an important ruling.

In particular, the tax office sets out the factors it will consider in determining whether the provision of an incidental, remote or insignificant benefit by an SMSF amounts to a breach of the sole purpose test.

The tax office warns that a strict standard of compliance is required under the sole purpose test, requiring exclusivity of purpose, which is a higher standard than the maintenance of the SMSF for a dominant or principal purpose.

Incidental benefits

The ruling acknowledges that the provision of incidental benefits that fall outside the scope of the core or ancillary purposes specified in the law (such as retirement, employment termination or death benefits) may occur in certain circumstances, particularly as an inherent or unavoidable consequence of otherwise legitimate activities of the SMSF.

Nevertheless, the provision of benefits other than those specified in the law that are incidental, remote or insignificant does not of itself displace an assessment that the trustee has not contravened the sole purpose test.

Rather, the ruling says that determining whether benefits are incidental, remote or insignificant requires the circumstances surrounding the SMSF’s maintenance to be viewed holistically and objectively.

For example, the Commissioner says an SMSF may provide benefits that fall outside the scope of those that are specified in the law as an incident of activities carried on by it that meet the requirements of the sole purpose test.

In contrast, the provision of benefits (other than those specified in the law) that are not an inherent or unavoidable consequence of otherwise legitimate activities of the SMSF may result in a contravention of the sole purpose test, particularly if the benefits are relatively significant in nature.

Relevant factors for consideration

The tax office says that determining the purpose for which an SMSF is being maintained requires a survey of all of the events and circumstances relating to the fund’s maintenance. The Commissioner also indicates that the sole purpose test is particularly concerned with how a trustee of an SMSF came to make an investment or undertake an activity, which is likely to vary from trustee to trustee.

Factors suggesting a failure of the test

Factors the Commissioner considers weigh in favour of a conclusion that an SMSF is not being maintained in accordance with the sole purpose test are:

• 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 the law).
• 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 fund member or another party at a cost or financial detriment to the fund.
• There is a pattern of events that, when viewed in their entirety, amount to a material benefit being provided that is not specified under the law.

Factors suggesting no failure

Factors that weigh in favour of the Commissioner reaching a conclusion that an SMSF is being maintained in accordance with the sole purpose test, despite the provision of benefits not specified in the law, include:

• The benefit is an inherent or unavoidable part of other activities that are consistent with the provision of benefits under the law.
• The benefit is remote or isolated, or is insignificant (whether it is provided once only or considered cumulatively with other like benefits) when assessed in light of other activities undertaken by the trustee that are consistent with the law.
• The benefit is provided by the SMSF on arm’s length commercial terms (for example, the benefit is provided at market value), consistent with the financial interests of the SMSF and at no cost or financial detriment to the fund.
• All of the SMSF’s investments and activities are undertaken as part of, or are consistent with, a properly considered and formulated investment strategy.

Applying the rules

The ruling notes that investments consisting of collectables and other boutique items such as works of art, antiques, jewellery, classic cars and wine, pose particular issues in relation to the application of the sole purpose test.

The Commissioner considers that these kinds of assets lend themselves to personal enjoyment and therefore can involve significant “current day benefits” being derived by those using or accessing the asset.

As a result, the Commissioner says trustees should be in a position to show (such as by reference to independent expert opinion) how acquiring assets of this kind involves a reasonable investment for the SMSF.

The ruling sets out a number of examples demonstrating the Commissioner’s approach to determining whether the provision of an incidental benefit amounts to a breach of the sole purpose test.

Holiday apartments and upgrade rights

In one example, as part of a portfolio of property investments, an SMSF trustee invests in a number of holiday apartments through a property syndicate. The investments are made through a widely held trust and the apartments are owned and managed by the trust. Income is pooled and allocated to investors on a pro-rata basis. No particular investor has a right to a specified holiday apartment.

All investors in the property syndicate pay normal market rates when staying at the apartments but, subject to availability on the day of arrival, may be able to upgrade their accommodation at no extra cost. Investors cannot dispose of this right.

Two members of the fund stay at the apartments and have their accommodation upgraded.

The tax office view is that this benefit, represented by the upgrade right and its exercise, is incidental to the SMSF’s investment in the holiday apartments. According to the tax office, the trustee does not contravene the sole purpose test in these circumstances.

Maintenance of beach house

In another example, in line with an SMSF’s investment strategy, the trustees of the fund decide to invest in a house near a beach. According to their research, the capital growth and rental demand of properties in the area will be strong in the future.

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 fund members pay the normal commercial rates to the management firm for staying at the house.

The taxman considers the facts of themselves do not indicate that there is a breach of the sole purpose test in these circumstances.

Use and lease of artwork

In this example, a trustee of an SMSF acquires a significant work of art. The investment strategy of the fund requires it to hold a certain percentage of its assets in a portfolio of listed securities. The fund trustee liquidates all of the listed securities that the SMSF holds to fund the acquisition of the work of art.

The trustee is unable to demonstrate how the acquisition of the work of art is a better investment than the listed securities it previously held. Soon after the work of art is acquired, it is displayed in the home of a member, who pays the fund a reasonable rental fee for this privilege.

The tax office considers that these facts indicate a contravention of the sole purpose test.

Other examples to consider SMSF investments in:

• Shares in a golf club with assignable membership rights attached.
• Shareholder discount cards (which result in reduced dividend rights).
• Instalment warrant arrangements involving limited recourse borrowing from a related party at excessive rates.
• Reimbursement of expenses on travel to inspect overseas property investments.

What may seem like “everyday” innocent activities carried out by SMSFs can get the fund into trouble from a tax standpoint. Any SMEs with these funds should carefully consider what this tax office ruling has to say.

Breaching the sole purpose test can have dire consequences and fund trustees need to take this matter seriously. Tax office audits are increasing, and the Commissioner is aware of the problem areas. If in doubt, seek expert advice.

Read more on sole purpose tests

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.