In August, the full Federal Court handed down an appeal decision on the application of the sole purpose test that has important ramifications for Self Managed Super Funds (SMSFs) entering into related-party transactions. In the decision, the Court confirmed that an SMSF had not breached the sole purpose test where it had entered into an arrangement that resulted in a residential property being leased to a related-party at market rate.
The case involved the corporate trustee (Aussiegolfa Pty Ltd) of a single member SMSF (the Benson Family Super Fund (the SMSF)) investing in a Managed Investment Scheme (MIS). Under the arrangement the SMSF, along with some relatives of the member, acquired units in a sub-fund of the MIS which then acquired a residential property (the property). The investors in the sub-fund were then entitled to distributions equivalent to any net rent or capital gains derived from the property.
After being acquired the property was then leased to a number of different unrelated individuals over a two year period prior to being leased to a related party of the fund (the member’s daughter) for the same rent paid by the previous unrelated tenants.
In the initial Federal Court case the judge ruled the trustee of the SMSF had breached both:
• the in-house asset test – as the units in the sub-fund constituted an investment in a related trust which exceeded the 5% in-house asset limit, and
• the sole purpose test – as the fund was being maintained in part for the non-incidental purpose of providing accommodation to a relative of a member.
In response, the trustee appealed, arguing there was no breach of either provision as:
• the investment in the MIS constituted an investment in a widely held trust which is exempt from the 5% in-house asset limit, and
• the fund’s decision to acquire the property was to gain exposure to a real property investment and that there was no evidence the decision related to the desire to provide accommodation to a relative.
Findings of Appeal Court
The full Federal Court confirmed the original judge’s finding the SMSF had breached the 5% in-house asset limit. This finding was based on the sub-fund being found to be a distinct trust and since the sub-fund (as a distinct trust) was controlled by Mr Benson and his Part 8 associates, it was also a related trust.
However, the Court ruled the fund had not breached the sole purpose test on the basis the lease to the daughter was on arm’s length terms. Specifically, the Court was not satisfied that the member or their daughter had obtained any financial or other non-incidental benefit from the property being leased to the daughter as opposed to some other unrelated tenant. In addition, the Court found that any comfort or convenience derived by either the daughter or the member from the leasing arrangement was only an incidental benefit.
In contrast, the judge noted that in other cases where it had been found that the sole purpose test had been breached, these cases all exhibited two features:
• Either payments were made to members otherwise than upon retirement, or
• Benefits were provided on non-arm’s length terms.
Circumstances which may have changed the outcome
As part of the ruling, the Court specified that this outcome would have been different if the lease was not for market rent, or if the investment strategy for the fund had been affected by the leasing of the property to the daughter. That is, indicating the SMSF was being maintained for the purpose of providing discount accommodation to a relative rather than to provide retirement benefits.
It should also be noted that it is unclear whether the Court may have reached a different conclusion if the property had initially been leased to the daughter rather than to unrelated parties as this may have indicated the investment decision was not based upon gaining exposure to real property as an asset class but for some other collateral reason. For example, the Court may have reached a very different conclusion if there was evidence the investment did not correspond with the fund’s existing investment strategy or if the trustee had amended its investment strategy to facilitate the acquisition.
Implications of the case
The case is useful as it provides judicial guidance on the application of the sole purpose test and confirms that arm’s length arrangements entered into for the legitimate, objective reason of providing retirement benefits may not contravene the sole purpose test just because they involve related parties. However, like any arrangement, this will be dependent on the specific facts and circumstances and any SMSF clients wishing to enter into any such arrangements with a related party should seek expert legal opinion.
Finally, it is also critical to recognise that the superannuation rules contain a number of other provisions that may apply to prohibit or restrict any such arrangements, such as the in-house asset rules and the prohibition on trustees acquiring assets from related parties.
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Disclaimer and Warning
The information above is of a general nature only. It should not be used as a source to make financial decisions. It’s also important to note that the legislation and figures related to this topic tend to change regularly and therefore the information above may not reflect the current status. We recommend that if you are looking for advice on this matter, you should contact us.