Believe it or not, one of the more obscure and less well-known parts of the superannuation legislation is the sole purpose test.

In my opinion, the sole purpose test has two arms, which are interlinked. The first relates to the benefits provided by the fund and the second relates to the manner in which the fund makes its investments.

The first arm of the sole purpose test is about the provision of benefits to members and their dependants. This is covered by section 62 of the Superannuation Industry (Supervision) Act (SIS Act). The types of benefits that can be provided by the fund are divided into core purposes and ancillary purposes. One core purpose is required to be satisfied, such as retirement, meeting a specified age (65) or death. A fund may choose to provide one or more ancillary benefits but there is no obligation on the fund to have any ancillary benefits.

Examples of ancillary purposes include benefits for ill-health, disability and those approved by the Regulator, such as hardship or compassionate grounds. The governing rules of most superannuation funds will be established with powers to provide all of the core and ancillary benefits.

These benefits link broadly with the preservation standards in Regulation 6 and conditions of release in Schedule 1 of the SIS Regulations.

While the purpose of the superannuation fund to provide various types of benefits may seem relatively clear, there’s a catch. That catch is the second arm of the sole purpose test, which relates to the provision of indirect benefits to members, dependants and others who usually have some relationship with the superannuation fund. A fund that provides these indirect benefits or uses the fund for purposes other than the sole purpose of providing superannuation benefits will place itself at risk in gaining the relevant taxation concessions.

A breach of the sole purpose test would include funds making investments, loans or leasing assets to anyone who has a direct or indirect relationship with the fund trustees or members. These transactions then have a link to whether the particular transaction is commercial and the taxation implications for the fund where it is not on a commercial basis. In addition to the sole purpose test, the SIS legislation imposes standards on arrangements that are considered not to be at arm’s length. For example, benefits must be paid strictly in accordance with the preservation rules, loans cannot be made to members or their relatives and the in-house assets must be limited to no more than 5% of the fund’s assets.

Case law

In the modern context, we have seen a number of court cases where the majority of the fund’s money found its way back to the contributing sponsor with no intention of providing any benefits to members. During the last decade, we have seen a number of cases where trustees and members of SMSFs stripped money from the fund with reckless abandon to support a business, helping to settle a divorce or pay for mortgages.

In many of these cases, the desperate attempt to pay a personal or business expense has seen good money go after bad and be lost forever. The courts and the Australian Taxation Office have taken a dim view of any trustee who takes money or investments from the fund well in advance of the time permitted by the legislation and penalties have been imposed, ranging from financial penalties to disqualification as a trustee. We are yet to see any gaol sentences imposed but it seems only a matter of time, as one case in the past two years came very close to a trustee going to prison.

The payment of a benefit to a member before time or a superannuation fund set up for the purpose of never paying benefits to members is a clear illustration of a breach of the sole purpose test. In addition, actions that may not be as clear could pose a compliance risk to the fund because of the link between the superannuation fund and its investment strategy.

Re-thinking the investment strategy

There are many things surrounding the fund’s investment strategy that need to be understood and whether particular investments will result in the fund being maintained solely for superannuation purposes. All superannuation funds are required to have an investment strategy, which takes into consideration the risks associated with the fund’s investments, their returns, diversification, liquidity, taxation consequences and the need for insurance to name but a few of the requirements.

Many trustees may couch the wording of the fund’s investment strategy very widely and allow for a very broad range of investments, however, they need to understand that some of these investments may provide indirect benefits to members that could result in a breach of the sole purpose test.

One example is the fund acquiring shares in a public company where discounts are provided to shareholders. This is not a problem if the discounts are offered to fund members for no cost to the fund. However, if the fund is required to pay for the discount card to enable the purchase to take place the sole purpose test could be breached as members are receiving a benefit that is not solely for superannuation purposes.

The sole purpose test requires that any investments that the trustees make on behalf of the superannuation fund must be used exclusively, absolutely and solely directed towards providing benefits to members or their beneficiaries.

It should be ensured that the investment strategy of the fund takes into account the risks, returns, diversification etc. as well as ensuring that the investments made by the trustees are consistent with the investment rules of the legislation, as well as the strict requirements of the sole purpose test.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.