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Home / SMSFs / SMSF admin and compliance / What is the sole purpose test, and how does it work?

What is the sole purpose test, and how does it work?

Barbara DruryBarbara Drury

Now that Australia’s superannuation system has passed the 30-year mark – with constant change, lobbying by vested interests and government tinkering with the rules along the way – it’s easy to lose sight of the reason super exists.

With calls to use Australians’ collective superannuation savings to solve national problems from housing affordability to infrastructure, intergenerational equity and Budget repair via a tightening of super tax concessions, change is ongoing.  

Assistant treasurer and minister for financial services Stephen Jones argues that after 30 years there is a need for a clear and shared understanding of super’s policy objective. To that end, he announced in November 2022 that the government would legislate an objective for super “that delivers for all Australians” and “ensures all Australians can retire with dignity”.

This objective appears to go further than the current guiding principle of super – the sole purpose test.

All super funds must satisfy the sole purpose test to be eligible to receive the tax concessions available under Australian superannuation legislation. Super contributions and earnings are generally taxed at the concessional rate of 15% (up to certain contribution limits), while income and earnings are tax free in retirement phase.

What is the meaning of the sole purpose test?

Put simply, the Australian Taxation Office (ATO) requires all activities of super funds must be for the sole purpose of providing retirement benefits to their members (or to their dependants if any of their fund members die before retiring).

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This is the case whether it’s a big public offer fund or a one-person self-managed super fund (SMSF).

Every investment or management decision made by super fund trustees must be consistent with this sole purpose. Essentially, the intention of the sole purpose test is to ensure that fund trustees make decisions that are in the best retirement interests of their members, not their current interests (or those of related parties).

In terms of SMSFs, it’s important to note that ‘related parties’ can include business associates of fund trustees, as well as their blood or marital relatives.

How is the sole purpose test administered?

There is no formal sole purpose test for super fund trustees to pass. It’s a legal compliance guide the ATO can apply to fund transactions and the decision-making of fund trustees if necessary.

While one of the main attractions of SMSFs is the level of control they give to their member/trustees, there are limits to that control. For instance, a common misunderstanding among small business owners is to treat their SMSF like a personal fund they can dip into when their business is going through a rough patch. Some SMSF trustees may also be tempted to help family members with a loan from fund money, or cheap rent in a property owned by the fund.

But the rules are clear: the early release of money or assets to fund members or their relatives is illegal.

If any super fund transactions or decisions are deemed by the ATO to provide significant, non-incidental, direct or indirect financial benefit to fund trustees, members or related parties before retirement, the trustees are in breach of the sole purpose test.

SMSF members must not use or gain any benefits from any of the fund’s assets until they have met a condition of release. Common conditions of release include:

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How does the sole purpose test apply to SMSFs?

Setting up an SMSF requires the creation of a trust deed and a documented investment strategy. Once a fund is set up, it must be registered with the ATO.

The trust deed typically states that the fund has been set up with the objective of providing retirement benefits for members (or to their dependants if they die before retirement).

The investment strategy broadly outlines how members’ funds will be invested to meet the sole purpose objective.

It is a legal requirement for SMSFs to be audited each year by an independent auditor. This auditor must be registered with the Australian Securities and Investments Commission (ASIC).

SMSF auditors check that all the fund’s transactions are consistent with its trust deed and investment strategy as part of their annual audit. They must ensure compliance with all super legislation (including the sole purpose test). Any potential legislative breaches must be reported by the auditor to the fund trustees and the ATO.

What happens if you fail the sole purpose test?

While the vast majority of SMSFs comply with the sole purpose test, a significant minority have not heeded the message.

According to the ATO’s latest SMSF statistics, the sole purpose test represented 10.3% of total contraventions by SMSFs in the year to June 2023, up almost 10% in two years. The sole purpose test remains the fifth biggest source of contraventions by type.

Failing the sole purpose test can lead to:

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  • An SMSF losing its concessional tax treatment (meaning the fund may need to pay additional tax on its super contributions and investment earnings)
  • The trustees being disqualified from their roles (meaning they can no longer be members of the SMSF, nor can they start a new fund)
  • Fines or imprisonment of the fund trustees, depending on the seriousness of the legislative breach.

How can you ensure your SMSF meets the sole purpose test?

Fund trustees can ensure they pass the sole purpose test by asking themselves a simple question before making any decision on investing SMSF funds:

“What’s the purpose of this investment?” The answer, of course, should be to provide retirement benefits for SMSF members.

If the purpose is to immediately benefit SMSF members or related parties, the trustees should avoid making the investment.

What are common ways you can breach the sole purpose test?

Common ways that SMSFs can breach the sole purpose test include:

  • Fund members gaining personal, current benefits from investment assets. For example, the SMSF investing in assets (such as a holiday house) or collectables (such as wine or art) that fund members use or access prior to retirement.
  • The reimbursement of trustee expenses that are not related solely to the performance of their trustee duties. For example, fund trustees writing off the expense of a holiday even if they spent some of their time looking for potential SMSF investment properties (and even if these properties were consistent with their fund’s investment strategy).
  • Funds borrowing money for investment from a member (or a related party) at an interest rate significantly higher than the market rate.
  • Funds lending money to members or related parties. This exposes the SMSF to accusations of the illegal early release of funds (that is, before a member has reached their preservation age and met a condition of release).
  • Funds running active businesses that are not outlined in the trust deed and not operated for the sole purpose of providing member retirement benefits. SMSFs running businesses can potentially fail the sole purpose test if:
    • They employ a family member at a wage or salary that’s above market rates
    • Their business activity is considered more of a hobby
    • The business has links to other entities
    • Their business assets are available for private use by fund members or related parties.

Does paying for financial advice through your SMSF breach the sole purpose test?

Paying for pre-retirement financial advice through an SMSF complies with the sole purpose test, and these advice fees can be deducted from an SMSF member’s accumulation account. However, the advisers must be licensed by ASIC.

The bottom line

Until such time as an objective for super is legislated, the sole purpose test is the guiding light for trustees.

All super funds (including SMSFs) must satisfy the sole purpose test. This is a legal requirement and there are heavy penalties for non-compliance, including civil and potential criminal sanctions. If you’re unsure whether a potential investment decision or transaction by your SMSF will satisfy the test, it’s best to seek independent professional advice before you act. 

Common questions about the sole purpose test

Transcript

Q: We all know what the sole purpose test (SPT) is. However, what I need to know is when the sole surviving or even the youngest member of the fund finally turns 65 does the sole purpose test then become redundant? Consequences for example: if the fund owns a rental property – can family members now live in it? But the main query relates to the role of the SPT once the youngest member attains age 65.

A: Thanks for the question, Paul. This is a common query we’re getting and the fact that we’re getting this question a lot suggests there is still some confusion around the sole purpose test. So hopefully I can assist with that confusion. What I’ve given you here are two very separate ATO regulator references for you. And this pretty much sums up the issue.

So, I just want to take you through these two things. The first one is taken directly from the ATO website, which says “Your self-managed super fund (SMSF) needs to meet the sole purpose test to be eligible for the tax concessions normally available to super funds. This means your fund needs to be maintained for the sole purpose of providing retirement benefits to your members or their dependents if a member dies before retirement”.

It doesn’t say, and the legislation doesn’t say, that your fund needs to be maintained for the sole purpose until you start paying pensions. It’s throughout that as well. Otherwise, if you think about this, you could start using tax concessioned assets held in superannuation like a property where, for instance, if you’re in pension phase, all the income is tax free. You could start living in it and not charging rent, giving it benefit to members with your retirement savings. It’s not really what the sole purpose test is for.

The sole purpose test applies whilst your fund is still in existence. And in fact, if we go to an SMSF ruling (these are the ATO specific legal rulings) relevant to, in this case, SMSF. SMSFR 2008/2 sets out that “A trustee must maintain an SMSF in a manner that complies with the sole purpose test at all times while the SMSF is in existence. This extends to all activities undertaken by the SMSF during its life cycle”. So really, to answer your question, the sole purpose test needs to be adhered to throughout the entire life of the fund. You need to ensure that those strict compliance obligations, including the solve purpose test, are adhered to at all times.

Whilst the property is still held inside the fund, if you then lease the asset, putting a residential property to a member or a related party, it will result in that property becoming an in-house asset and being included in the 5% test. So you don’t get out of the in-house assets test. You don’t get out of the sole purpose test, merely because we’ve entered into retirement phase or we’re all in pension phase. It still needs to be met.

The one other point I want to make here is I mentioned that whilst the asset, whilst the property is an asset of the fund, any lease or lease arrangement (what I mean by that is you would usually see a written lease in place that covers the terms of the lease) the super rule suggests that even if there isn’t a lease in place, there’s a lease arrangement in place. So the sole purpose test still needs to be adhered to at all times, while it’s an asset of the fund.

Transcript

Q: During our working lives, we’ve made tax deductible charity donations and claimed the tax deduction against personally generated and other income. Most of our SMSF is now in pension mode, but we still have some in accumulation. Can the SMSF make charity donations in its own name and claim the deduction against any income earned by the fund?

A: Okay, surprisingly, this is a question that I get asked a lot. Really, the answer comes down to what we always go back to, and it’s called the sole purpose test. The sole purpose test applies to the fund, to all the transactions of the fund and all the activities that the trustees carry out. All of those activities need to be maintained or carried out for the sole purpose of providing retirement benefits to the fund members or to their dependents if they pass away before retiring. All things that are done by the fund must satisfy the sole purpose test.

Now, the question which gets raised is, is making a donation, is your SMSF making a donation going to pass that sole purpose test? Is a donation going to be giving retirement benefits to the members, or is it really giving benefits to someone else, and therefore be in breach of the sole purpose test? I would say questions would be raised as to why the fund is doing it, and I would suggest that it’s going to create a sole purpose test issue. If that’s the case, and we are deemed to have failed the sole purpose test, we can lose the tax concessional treatment for our fund. So essentially earnings are taxed at 45% rather than 15% or 0%. It could render the trustees disqualified. They can never be a member of a fund again or act as a trustee. And it can be fines or imprisonment.

I don’t think you’re going to get to that level if it was a donation being made, but they are outcomes from breaching the sole purpose test. So in my view, I don’t think donations are going to work through an SMSF. Based on the purpose of the sole purpose test. If you’re really looking to do that and eligible, it might be worth, we’re allowed to withdraw money and get a tax deduct in your own name by making the contribution personally. But for the fund, I know, I think you’ve got a sole purpose test issue.

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About the author

Barbara Drury
Barbara Drury
Barbara is a financial journalist and author with over 30 years’ experience in Australia and the UK. She is a contributor to The Sydney Morning Herald and The Age Money section, and has worked for the Australian Financial Review and The Australian. Barbara is the author of Alan Kohler’s Eureka Report Guide to Personal Investing, Sorting Out Your Finances for Dummies and Personal Finance for Dummies and co-author of Investing for Dummies with James Kirby.
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