June 17, 2015

ATO Interpretative Decision – SMSFs & Buy/Sell Life Insurance

The Australian Taxation Office has issued an Interpretative Decision (ATO ID 2015/10, the ID) regarding life insurance held within a self managed super fund (SMSF) as part of a buy-sell agreement.

The ID relates to whether an SMSF contravenes section 62 and paragraph 65(1)(b) of the Superannuation Industry (Supervision) Act 1993 (SISA) by purchasing a life insurance policy over the life of a member of the SMSF, where the purchase is a condition and consequence of a buy-sell agreement members have entered into as co-owners of a business.

A buy-sell agreement is commonly used to deal with the preservation and succession of businesses in circumstances such as death, disability, dispute and departure. It has been a practice when implementing buy-sell agreements for SMSFs to take out buy/sell life insurance, to provide a surviving spouse with an equivalent business value through the insurance proceeds in exchange for the shares in the business.

The specific scenario considered in the ID involved a member of an SMSF and his brother who both own shares in a business. A buy-sell agreement was entered into, where the business is to pay additional contributions to the SMSF, and those contributions are used to pay for a member’s life insurance policy (to the value of that member’s share of the business). If that member dies, the insurance benefit would go to the SMSF, which would distribute a death benefit to the member’s spouse. When this occurs, the buy/sell agreement requires the member’s spouse to then arrange for transfer of the remainder of the business to the living brother, and to relinquish all rights over the business.

It is the ATO’s view in the ID that this arrangement will breach section 62 of SISA (the Sole Purpose Test) and section 65(1)(b) (prohibition on providing financial assistance to fund members or their relatives).

Sole Purpose Test
A SMSF must be maintained for the sole purpose of providing retirement benefits to members.

Although s 62(1) of SISA expressly allows a SMSF to be maintained for the provision of death benefits, in the ATO’s view, the policy must be ‘merely incidental’ to the core retirement income purposes of the SMSF, rather than a major component of the company’s succession management.

When applying the Sole Purpose Test to this scenario, the ATO considered::

  1. the manner and circumstances in which the SMSF came to acquire the life insurance policy
  2. the value of the insurance policy was stipulated by the market value of the member’s share in the company, rather than a genuine analysis of the circumstances and need for insurance;
  3. but for the buy/sell agreement, the SMSF would not have purchased the life insurance policy.

The ATO determined that the policy was not ‘merely incidental’ but a major component of succession management for the company, and accordingly it failed the Sole Purpose Test.

The ID represents the ATO’s view on the Sole Purpose Test. There is a contrary view that the sole purpose test is concerned with financial benefits provided by the superannuation fund, rather then non-financial purposes that might be achieved by the superannuation fund. Notwithstanding that, contrary view, it is prudent to implement these arrangements in a manner that is consistent with the ATO view and will not lead to ATO challenge.

Provision of financial assistance
SISA prohibits the provision of financial assistance to fund members or their relatives. It is important to note that unlike the other investment restrictions in the SIS Act, this prohibition is limited to members and relatives, and does not extend to related parties and trusts.

The ID stated that ‘financial assistance is given to a SMSF’s member, or relative of that member, if some aid or help or benefit is given to that person whether or not such assistance was requested.’

The ATO in these circumstances formed the view that the SMSF is converting a portion of its assets into the insurance policy, precluding its ability to invest those funds elsewhere. As the life insurance policy is designed ultimately to benefit the member’s brother upon the member’s death, the ATO views this arrangement as the provision of financial assistance to the member’s brother.

Buy-sell agreements are entered into, where there is a joint undertaking of a business, whether in partnership, through a company or a trust. In most instances, the ‘business partners’ are not relatives. In that case, this aspect of the ID will not have any application because the benefit the ATO refers to is provided to the continuing ‘partner’, which is not a relative of a member.

Effect of Interpretative Decision 2015/10
If your buy/sell insurance is structured through your SMSF, this approach needs to be reconsidered. By failing to heed the warning in the ATO Decision, an SMSF may be in breach of SISA and the fund at risk of being non-complaint and may face civil penalties. In order to comply with the ATO view for existing arrangements involving an SMSF will require a variation to the arrangement.

Rouse Lawyers can assist in altering existing arrangements to comply with the view set out in this ID.