THE SUPER BRIEF. UPDATE!!!! ATO knocks back use of SMSF s to fund Buy/ Sell Agreement Life Insurance NEWSLETTER. page 1. ISSUE - October 2014

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1 ISSUE - October 2014 THE SUPER BRIEF UPDATE!!!! ATO knocks back use of SMSF s to fund Buy/ Sell Agreement Life Insurance Clients often use an SMSF to hold life insurance when setting up a Buy Sell Agreement for business succession planning. Buy Sell Agreements are used where co-owners in a business want to plan for an unforeseen event such as death or permanent disability which results in one of the stakeholders of the business needing to leave the business prematurely. Without a documented Buy Sell Agreement such a situation can cause deep financial stress to either the estate of a deceased business owner or to the ongoing owner who has to fund the buyout of the deceased owner s interest in the business. Usually this scenario is managed by each of the proprietors of the business taking out life insurance with a mandated transfer of the ownership interests held in the business in consideration of the receipt by the outgoing owner of the proceeds of the life insurance policy. Offten SMSFs are used as the vehicle to acquire the life insurance policy for a Buy Sell Agreement, particularly if the policy was self owned as the cost of funding the life insurance premiums could be made in pre-tax dollars from concessional contributions being made to the SMSF. There are also tax benefits in structuring the Buy Sell Agreement in an SMSF particularly where there is a dependent spouse member as the proceeds could be received by that spouse tax free in exchange for the transfer of the ownership interests from the deceased business owner to the ongoing business owner. In addition, using an SMSF to fund the insurance in a Buy Sell Agreement was considered permissible under the Sole Purpose test of section 62 of the SIS Act as it was providing the provision of benefits in the event of death of a member. This position now seems to be rejected by the ATO in a private ruling that was handed down on 12th March of this year, where the ATO have stated that the use of an SMSF to fund a Buy Sell Agreement fails the sole purpose test requirements of the SIS Act. In particular, the ATO have said: (a) the sole purpose test requires exclusivity of purpose, particularly in relation to the fund s provision of benefits to members in the event of death, which is regarded as a core purpose ; (b) what is imperative is that all investment decisions and the maintenance of the fund must also meet the overarching sole purpose test requirements at all times, including that investments are made and maintained to provide allowable benefits for members and are not made for any other purposes ; (c) The sole purpose test is breached in circumstances where there is a Buy Sell Agreement because the insurance proceeds and its connection to a Buy Sell Agreement benefits the ongoing co-owner of the business (who is not a member of the fund) who will receive a transfer of the ownership interests of the business under the Buy Sell Agreement. page 1

2 In the circumstances we would recommend that anyone who has effected a Buy Sell Agreement using life insurance through an SMSF should review their current arrangements and should not implement any new arrangements until the ATOID is released. If you have any queries or concerns please do not hesitate to contact our office. Correctly Structuring of Life insurance inside the SMSF (d) The ongoing business owner also obtains the benefit of the life insurance proceeds to the extent that the proceeds are notionally credited to the purchase price of the business because the ongoing purchaser does not have to pay for the business. The existence of the life insurance policy creates a significant benefit to the nonmember ongoing business owner that is not merely incidental remote or insignificant. (e) The life insurance policy was set up for the purposes of the Buy Sell Agreement and for tax deductibility purposes, not for the sole purpose of providing death benefits to the members of the fund. The ATO noted that the policy would not have been established but for the existence of the Buy Sell Agreement. The amount of cover obtained was not structured having any regard to the future needs of the members. (f) The ATO stated that while the deceased member s spouse ostensibly received a death benefit payment from the fund, it is in substance compensation for their expected inheritance from the member s share of the business and from this it is arguable that the contributions received by the fund to enable the premium payments were never intended to produce retirement benefits. (g) The ATO concluded: having regard to all the facts and circumstances, it is reasonable to conclude that when deciding to acquire the death benefit insurance every year, the trustee s sole purpose is not to provide allowable benefits as part of implementing an external business succession and estate planning agreement business succession management motives are far more than incidental to the decision by the trustee While the ruling technically is not binding because it was made as a result of a request for specific SMSF advice it does have significant far reaching implications. Especially to existing Buy Sell Agreements that have structured to date. Because of the significance of this private ruling Hill legal have approached the ATO with regard to whether it will come out with an ATOID on the issue. We have since been advised that the ATO is working on an ATOID with the draft due to be released in the near future. Since the introduction of regulation 4.09(2)(e) of the Superannuation Industry Regulations, each year the trustee of an SMSF has to consider and document as part of the investment strategy of the fund, the needs of the members of the fund to hold life insurance. However, many fund trustees have in ignorance failed to properly structure their life insurance or to consider how their trust deed deals with the insurance proceeds on the death of a member of the fund. This requirement is an operating standard of the fund meaning that its breach will incur a penalty of $3,400. Quite often SMSFs are set up with the purpose of acquiring direct property, particularly under a limited recourse borrowing arrangement. Typically, under this scenario money is rolled over from an existing retail or industry fund into the SMSF for the purpose of funding the deposit on a property with the balance of funds being borrowed from a bank. The fund will either have enough liquidity to meet the loan repayments from rent from the property or from interest income or dividends from other investments held within the fund. page 2

3 From our experience however, many transactions of this nature require the fund s borrowings to be supported by way of contributions from the member. Many clients who establish a limited recourse borrowing arrangement do not contemplate the cash flow impact on the fund as a result of the death of a member when the loan is outstanding. This is particularly acute for singlemember funds but also funds with two or more members. The difficulty in these situations is that Members may have policies of life insurance in their own names but outside of the fund or life cover through a retail or industry fund. In many situations members who rollover their superannuation balances from say a retail fund to their SMSF leave a small amount within the fund in order to meet the cost of life insurance. This is the case because often the premium cost for life cover is cheaper by staying with the original fund or because of exclusions that prevent the member obtaining life insurance within the SMSF. Either way the following scenarios emerge: - 1. The Member has no life insurance cover or inadequate life insurance cover as a result of the limited recourse borrowing. 2. The Member has adequate life insurance, but this is held in their own names and outside of the SMSF, or 3. There may be adequate cover, but it is held in a retail or industry super fund and not in the SMSF. Unwittingly, this creates a number of problems for the SMSF when a member dies, or becomes incapacitated. Further, problems arise when the trust deed of the fund states that the life insurance proceeds of the member forms part of the member s death benefit. A member s death benefit has to be paid out of the fund either as a lump sum or as pension if there is a tax spouse member dependant within the fund. All of these circumstances create potentially disastrous circumstances when there are assets within the fund the subject of a limited recourse borrowing arrangement. Consider, for example, the following scenarios. Scenario 1- single member fund - No Life Insurance John Matthews is the sole member of the Matthews SMSF. John is single, aged the 45 with two children from a former relationship aged 12 and 14. John recently established his SMSF from money that he rolled over from his Host Plus superannuation fund. The SMSF has a factory that is been rented out to an unrelated party valued at $850,000 and subject to a loan from the NAB of $595,000. Other assets of the fund comprise cash of about $15,000 and shares of $100,000. Rent from the factory is approximately $51,000pa and principal and interest loan repayments on the NAB loan is approx. $95,000 pa. John makes up the short fall in the loan payments by concessional contributions to the fund. John has a death benefit nomination leaving his super to his estate which holds the money in trust until his two children are aged 21; John left $20,000 in his host plus fund to cover the cost of life cover of $800,000 because the premiums were cheaper. John tragically dies from motor vehicle accident. Consequences: 1. John s death results in a default in loan repayments due to the shortfall in the cash flow of the fund; 2. The bank take possession of the property and exercise a mortgagee sale, and sell the property for $680,000; 3. The life insurance proceeds of $800,000 held with host plus get paid to the estate. They are not capable of being transferred or rolled over to the SMSF because John has passed away and the insurance proceeds are part of John s death benefit and are required to be paid out of the Host super fund as a death benefit payment. 4. The life insurance proceeds could not be used to pay off the NAB debt because the debt is a debt of the SMSF and there is no way of getting the proceeds into the fund when there are no members of the fund. page 3

4 5. The children could not become members of the SMSF and use the insurance proceeds as a contribution since their estate benefits do not vest until they reach aged The SMSF suffers a capital shortfall of $170,000 Note: If John had effected life insurance inside of his SMSF, his trust deed as with most trust deeds state that the life insurance proceeds forms part of his death benefit. This would be automatically paid out of the fund to the estate and could not be used to pay off the National Australia Bank debt. The deed would need to be updated in these circumstances. Scenario 2- Joint members - Life Insurance in the wrong name Peter and Janet Johnson are members of the Johnson SMSF; Peter is aged 58 and Janet is aged 65; Peter works part time as a consulting engineer The Johnson SMSF has the following assets: - Cash and TD $50,000 - Shares $285,000 - Real estate $1,500,000 - Total Assets $ 1,835,000 - Debt (LRBA) $ 950,000 - Net Assets $ 885,000 Life insurance Peter s name $500,000 Both members are in accumulation mode Peter has a reversionary pension which leaves his accounts based pension to Janet upon his death; Peter and Janet thought that the life insurance would cover the fund s debt in the event of death of either of them Peter dies of a sudden heart attack Consequences: 1. Peter and Janet thought that the life insurance was held within the fund or otherwise would be available to the fund pay the debt; 2. Because Peter was nominated as the policy owner and the life insured it is considered to be a policy held outside of the fund; 3. The life insurance proceeds of $500,000 get paid to Peters estate; 4. Janet cannot use the proceeds to pay off the super fund debt. Because of her age she can only contribute $180,000 as a concessional contribution and use this amount to pay down part of the fund s debt; 5. If Janet was to pay off the debt with the insurance proceeds this would be regarded as an excess contribution and subject to excess contributions tax; 6. Depending on the loan commitments, the fund may not be able to pay Janet a tax free pension. Peter s plans of leaving the property rental as a retirement income for Janet upon his death will have been thwarted; 7. There is insufficient life insurance proceeds and they should have been correctly structured inside of the SMSF and available to pay out the fund s debt. The need to review Super fund trustees need to be aware that in reviewing the life insurance needs of members is part of the mandatory annual review of the fund s investment strategy and they need to be aware of the following issues: The ownership structure of the policy; The amount of cover required; The provisions of the fund s trust deed; If insurance is to be retained in the fund, the purposes of the cover needs to be carefully minuted and documented and in some cases the premiums cross debited to the member accounts to allow flexibility in the use of the proceeds. If you require any assistance in this area please do not hesitate to contact us to make sure your insurance policies are adequate and correctly structured within your fund. Remember, for a husband and wife SMSF it is more tax effective to pay for life insurance through the super fund from tax deductible ( concessional ) contributions than outside of the fund with after tax money. This is a smart way to effectively lower the premium cost. page 4

5 Disclaimer The material contained in this publication is general reading only information and does not constitute advice on the subject matter. While every effort has been made to ensure accuracy you should not rely on the information provided without seeking professional specialist SMSF advice on your individual needs and circumstances and the relevance and appropriateness of the ideas and strategies mentioned. No representation is given, warranty made or responsibility taken as to the accuracy, timeliness or completeness of any information or recommendation contained in this publication and Hill Legal, lawyers and consultants will not be liable to the reader in contract or tort (including for negligence) or otherwise for any loss or damage arising as a result of the reader acting upon any such information or recommendation. page 5

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