The sole purpose test — a new way to answer an old problem

Could I be controversial? If dealings are at arm’s length, the sole purpose test will be met.

This is not how most people think of or explain the sole purpose test. Indeed, this is not how the ATO in SMSFR 2008/2 approach the sole purpose test. Also, it is not how courts or the AAT approach the test.

Nevertheless, for the busy adviser, I think there is a lot of merit to approaching the sole purpose test this way.

Here’s why.

What the sole purpose test says

The sole purpose test provides that super fund trustees must ensure that the fund is maintained for certain purposes. Naturally, such purposes are things like the provision of retirement benefits.

For full details see s 62 of the Superannuation Industry (Supervision) Act 1993 (Cth).

How to work out purpose

How should the ‘purpose’ in the sole purpose test be measured? What if someone genuinely believes that their SMSF investing in a Swiss chalet is a great way to generate funds for retirement benefits? Further, what if that someone also believes that getting their family and friends to stay there is a great way to achieve that goal because family and friends can be trusted to pay rent on time and to take care of the chalet?

That actual purpose inside that person’s head — their subjective purpose — may well be to provide retirement benefits.

However, does a person’s subjective purpose matter?

The short answer is no. The ATO state in SMSFR 2008/2:

Determining the purpose for which an SMSF is being maintained requires a survey of all of the events and circumstances relating to the SMSF’s maintenance. This enables an OBJECTIVE assessment of whether the SMSF is being maintained for any purpose other than those specified by subsection 62(1). [Emphasis added]

Similarly, the AAT have stated in Montgomery Wools [2012] AATA 61:

Whether a fund complies [with the sole purpose test] will depend on the facts of each case and will be assessed by the OBJECTIVE facts, not the subjective views of trustees or, in the case of the corporate trustees, the directors. [Emphasis added]

In short, you work out someone’s purpose by looking at the concrete facts and seeing what those facts suggest their purpose is.

How to objectively work out someone’s purpose

It is easy to say that purpose should be worked out objectively, but what does this mean in ‘hands on’ practical terms?

Here’s where I get a bit controversial.

I think that the most important fact is whether all dealings are at arm’s length.

I have conducted what I believe is an exhaustive search of every court case and AAT decision considering the sole purpose test or its predecessors. (I won’t list them all here, but if anyone’s interested, email me at [email protected] and I’ll send the list to you.)

Without exception, in every court case and AAT decision where dealings were not at arm’s length, the sole purpose test was held to be contravened. The flip side is also true: where dealings were at arm’s length, the sole purpose test was held to have been complied with.

If anyone has an instance where dealings were at arm’s length but the sole purpose test was held to have been contravened, please let me know. However, to the best of my knowledge such an instance does not exist.

Examples

Consider the following real life examples.

Montgomery Wools

In Montgomery Wools [2012] AATA 61, an SMSF bought all the units in a unit trust. The unit trust used the SMSF’s money to acquire real estate and then the unit trust allowed the real estate to be used as security in respect of a related business’ loans. The real estate was sold and the proceeds used to repay the related business’ debts. The unit trust, and therefore the SMSF indirectly, was left with a loan investment that existed on paper but realistically it had lost its money.

Naturally, in allowing its assets to be used as security, the unit trust was not acting at arm’s length. The ATO held that the SMSF failed the sole purpose test and the AAT agreed.

On an interesting side note, the SMSF met the arm’s length rules in the SIS Act as the SMSF itself had not engaged in the non-arm’s length dealings. Rather, the unit trust had had the non-arm’s length dealings and the unit trust is not regulated by the SIS Act. That being said, the ATO in their decision impact statement said that they might dispute this point if it ever arises again.

I use Montgomery Wools to illustrate that when I say all dealings should be at arm’s length, I do mean all dealings. Consideration should be given not just to the SMSF’s dealings but to the dealings of all parties who directly or indirectly have involvement with the SMSF.

AAT Case 6059 (1990) 21 ATR 3477

A small super fund was by run by Mr D. Mr D had a ‘penchant, indeed [a] positive zeal for investing a considerable part of the trust funds in a manner not normally adopted by trustees’. This included investing in a real estate development unit trust. Once the fund was invested in these investments, the fund felt compelled to make a number of interest free loans to the investment entities (eg, the unit trust). The ATO took issue and said that the fund failed the then equivalent of the sole purpose test.

However, the AAT ultimately found that ‘the non-payment of interest on monies loaned in all these instances, arose from practical commercial considerations in each case and not from any desire … of benefiting the entities to whom the funds were loaned’. That is, at the risk of putting words in the AAT’s mouth, the interest free loans were held to be at arm’s length and the then sole purpose test equivalent was met.

Conclusion

The sole purpose test is crucial and funds that do not comply with it can risk serious penalties. However, so long as care is taken to ensure that dealings are at arm’s length, I dare say there is an extremely strong chance that the sole purpose test will be complied with.

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.