4 things to know about the sole purpose test

If you're an SMSF trustee, keep your eye on the sole purpose requirements

By Penny Pryor

As a self-managed superannuation fund trustee, you need to operate your fund for the sole purpose of providing retirement benefits to your members.

This is called the Sole Purpose Test and is Section 62 of the Superannuation Industry (Supervision) – or SIS – Act.

It’s not just a requirement for SMSFs but for all superannuation funds, regardless of the number of members or the size of the fund.

The requirement is there to make sure that you don’t run down your superannuation before you actually need the money at retirement, and the regulator is pretty hard on trustees that are caught out.

Here are four things to remember to make sure your fund doesn’t run afoul of the Act.

1. Ancillary purposes

As stated above, each trustee needs to ensure that an SMSF is maintained for one of the following core purposes:  

  • To provide benefits upon a member’s retirement
  • To provide benefits upon reaching a prescribed age (currently 65)
  • To provide benefits to a member’s dependents if a member dies before retirement or attaining the prescribed age.

But there are some ancillary benefits that you are allowed to provide as long as the fund’s core purpose is one of the three mentioned above.

These ancillary purposes include: 

  • The payment of benefits after termination of employment from an employer who has contributed to the fund
  • Payment of benefits after termination of employment due to ill health, either physical or mental
  • Payment of benefits after the death of a member, which occurred after retirement age or after the prescribed age, to either the member’s dependants or legal personal representative
  • The provision of such other benefits as the Regulator approves in writing.

2. Common breaches 

Many of the common SMSF breaches will also breach the sole purpose test. For example, lending to members or related party transactions are contraventions in themselves.

But lending to members is also a breach of the sole purpose test because the person to whom the loan is extended – a member or member’s relative – is obtaining a financial benefit that doesn't relate to superannuation.

Another common breach of the sole purpose test is making investment decisions that are more about present benefits than retirement benefit. For example, buying a holiday house in your SMSF because you (incorrectly) think you will be able to use it rent-free would be a breach of the sole purpose test.

If you also run a business, your SMSF accounts might get caught up with your business accounts. Although accidental, this is a breach of the sole purpose test. Petty cash is not a core purpose of your SMSF. 

3. What could happen to your fund?

Your fund is required to be audited annually and it is a legal requirement of your auditor to detail relevant contraventions in that report, which is sent to the Australian Taxation Office (ATO).

If an auditor finds any breach of the sole purpose test, the ATO is, more than likely, going to find out.

When it does, the ATO can do a number of things.

It can make the fund “non-complying”, which means it could be taxed at the highest marginal rate.

It could disqualify the trustee, which would mean he or she could never operate an SMSF again. The trustee could also be fined up to A$10,200, which has to come out of the trustee’s own funds, and not out of the SMSF’s.

The ATO’s powers to impose fines were introduced on 1 July 2014. Its first approach now, once it receives the auditor’s report, is to call the SMSF trustee. It is therefore very important that if you receive a call from the ATO, you are polite and engaging.

If the ATO has a constructive conversation with the trustee over the phone, and if the trustee can explain what happened (particularly if it was an accident), the regulator may be able to avoid confirming a contravention, which would mean the fund could also avoid a penalty.

And that would be the best possible outcome.

4. What not to do

This is best illustrated by a real-life example.

The Lyons Family Superannuation Fund had two members, Anthony and his former wife, Julianne. Between July 2008 and May 2009, the fund loaned A$190,000 to the spouse of Anthony Lyons’ sister, Paul Ellis. Under the super laws, Ellis is considered a relative of Anthony Lyons.

Ellis then loaned this money to the Lyons’ struggling business. But the business failed in March 2010 and its failure pushed the Lyons into bankruptcy.

In this instance the auditor identified problems with the loans that included a breach of the sole purpose test (along with breaches of the in-house asset and arms-length rules).

Anthony Lyons was eventually fined $37,500 for the breaches but if the contraventions had occurred after 1 July 2014, the ATO may have been able to impose fines for each confirmed breach.

To make sure you keep on the right side of the sole purpose test, follow the regulator’s advice. It suggests that before you make any investment for your SMSF, ask yourself: “What's the purpose of this investment?”

If the purpose is to immediately benefit members or anyone related to the fund then “you should skip that investment”.

Read the September 2021 issue of INTHEBLACK magazine.