- What is the meaning of the sole purpose test?
- How is the sole purpose test administered?
- How does the sole purpose test apply to SMSFs?
- What happens if you fail the sole purpose test?
- How can you ensure your SMSF meets the sole purpose test?
- What are common ways you can breach the sole purpose test?
- Does paying for financial advice through your SMSF breach the sole purpose test?
- The bottom line
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% in Australia (up to certain contribution limits).
What is the meaning of the sole purpose test?
The Australian Taxation Office (ATO) requires super funds to be maintained for the sole purpose of providing retirement benefits to their members (or to their dependants if any of their fund members die before retiring).
Every investment or management decision made by superannuation 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 self-managed super funds (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 that the ATO can apply to fund transactions and the decision-making of fund trustees if necessary.
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.
Any SMSF member 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:
- retiring and reaching their Preservation age. This age depends upon a person’s date of birth
- reaching their preservation age and beginning a transition-to-retirement scheme
- ceasing employment after the age of 60
- reaching the age of 65 (even if still working).
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 outlines 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 of 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 both fund trustees and the ATO.
What happens if you fail the sole purpose test?
Failing the sole purpose test can lead to:
- an SMSF losing its concessional tax treatment (meaning they may need to pay additional tax on their superannuation 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 an overseas 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 to be 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 their advice fees can be deducted from an SMSF member’s accumulation account. However, these SMSF advisers must be licenced by ASIC.
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 of your SMSF will satisfy the test, it’s best to seek independent professional advice before you act. The information contained in this article is general in nature.