The sole purpose test

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1 In this issue: SMSFs and insurance : the new landscape where property and borrowing are involved In recent years 1, we have seen substantial growth in the number of SMSF trustees entering into limited recourse borrowing arrangements in order to buy property. Often the property represents a very substantial part of a fund's assets and the loan repayments are dependent upon a strong contribution cash flow. As a result, there is a growing awareness of the need to consider insurance to protect : the cash-flow and liquidity needs of the fund in order to ensure that loan repayments can be financed, and the assets underpinning the account balances of other 1 Funds have been able to borrow to purchase certain assets under limited recourse borrowing arrangements since 24 September fund members should an event (eg, death / disability of a member) cause a benefit to become payable that requires the sale of the asset. Some questions which naturally arise include: Who should receive the benefit of any proceeds and who should bear the cost (one or more members)? How much insurance cover is required (sum insured)? What insurance premiums are deductible? Before we look at the questions raised above, there are some technical matters which also naturally arise in this context, and which we will consider first. The sole purpose test The sole purpose test 2 prohibits trustees from maintaining a fund for purposes other than for the core purposes of retirement 2 s 62 of the Superannuation Industry (Supervision) Act 1993 (SISA). benefits and death benefits before retirement 3. So how does an insurance policy held by a SMSF fit in with the sole purpose test? Clearly, owning a policy of insurance that provides a benefit on the death or disability of a member will satisfy the sole purpose test if the proceeds are used to provide a death / disability benefit to the member or their beneficiaries. Owning a policy of insurance that compensates the SMSF in the event of the loss or destruction of an SMSF asset will also satisfy the sole purpose test on the basis that the amount of retirement and death benefits are intrinsically linked to members' account balances which, in turn, are dependent on the underlying assets held by the SMSF. But what if a policy of insurance is held over the life of a member, and 3 Note that a fund can also provide ancillary benefits such as death benefits after retirement and permanent and temporary incapacity benefits. 1

2 the proceeds are not intended to form part of that member's account balance (ie, the proceeds will not be paid out to the member or their beneficiaries)? In our view, the sole purpose test will not be breached if the purpose of the insurance cover is to provide benefits 4 to other members of the fund. This was also the view taken by members of the National Tax Liaison Group (Superannuation) (NTLG) [September 2011 meeting]. How are insurance proceeds taxed in the hands of a fund? Insurance proceeds are treated as investment returns of a fund (see 'Dealing with insurance costs and proceeds' below). Generally they are taxable (in a fund's hands) under the CGT provisions of the Income Tax Assessment Act 1997 (ITAA 1997), however a payment received from a policy of life insurance held by a fund trustee as a result of the death or terminal illness of a member is specifically disregarded under s of the ITAA Interestingly, there is currently no corresponding provision in s (or any other section of the 4 i.e. benefits in accordance with the SISA ITAA 1997), in respect of insurance proceeds received in respect of disablement. This anomaly was addressed in the 2012/13 Federal budget and a subsequent consultation paper proposes to also provide an exemption from CGT for disablement insurance proceeds. Once enacted, such proceeds will be disregarded for CGT purposes from 1 July In a practical context, any capital gain arising as a result of a claim under a policy of insurance for death, terminal illness or disablement is disregarded for CGT purposes. Importantly, this is the case regardless of whether the purpose for holding the insurance is to: provide benefits to the insured member or beneficiaries of that member; or to, say provide "asset protection" to other members of the fund (ie, to prevent the sale of an asset that underpins the balances of those members). Dealing with insurance costs and proceeds Investment Return TR 2010/1 (ie, the Taxation Ruling on superannuation contributions) expresses the view that any insurance proceeds received as a result of a claim "... will be treated as income, profit or gain from the use of the fund s existing capital...". In other words, insurance proceeds are by default effectively treated as part of the investment return of a fund. This was reiterated at the June 2012 meeting of the NTLG. It follows then that we need to consider Regulation 5.03 of the Superannuation Industry (Supervisions) Regulations 1994 (SISR), which deals with the allocation of a fund's investment return. Allocation must be 'fair and reasonable' SISR 5.03(2) requires the trustee to "... determine the investment return to be credited or debited to a member s benefits (or benefits of a particular kind) in a way that is fair and reasonable as between: (a) all the members of the fund; and (b) the various kinds of benefits of each member of the fund". The ATO has previously expressed the view [September 2009 NTLG meeting] that 'fair and reasonable' not only means treating different members fairly but also ensuring that where a member has multiple interests within a single superannuation 2

3 fund (say several pensions), any allocation is shared equitably between each interest. This view may well be based on the requirement in 5.03(2)(b) above to treat the various kinds of benefits of each member of the fund fairly and equitably. In other words, the ATO's current position is that where SIS prescribes any particular treatment of "members" or members kinds of benefits, it should be interpreted as requiring that treatment be applied to all superannuation interests for each member. What determines what is a fair and reasonable distribution of insurance proceeds between superannuation interests? In a nutshell, it is determined by which interest funds the premium. The ATO's views on this were discussed at the September 2009 NTLG meeting and can be summarised as follows. If an insurance premium is debited from a particular fund account balance, it would generally be 'fair and reasonable' to credit any corresponding insurance proceeds to that account. The account in question could be a member accumulation or pension account, or it could be a reserve account (see below). What about if premiums are not debited to a specific account, but rather debited out of a fund's gross investment return (i.e. before allocation to members)? In this case, insurance proceeds should be allocated to all account balances in the same manner as the fund's other net investment returns (which generally is in proportion to the size of members' balances). What choice does a trustee have in deciding how to debit insurance premiums? SISR 5.02(2) allows a trustee to debit insurance premiums 'against a member's benefits'. This means premiums can be debited from any account held by the member irrespective of whether it is a pension or accumulation account. Importantly, this Regulation does not require the premium to be debited from a member's account balance - the trustee is able to debit the premium from a reserve account (if one exists), or out of the gross investment return of the fund. Having said that, it is obviously important to have regard to a fund's trust deed to see if it prescribes where premiums are to be debited from and insurance proceeds are to be allocated, or if this is at the discretion of the trustee. Assuming that the deed doesn't fetter a trustee's discretion in this regard, then the choice will be driven by the purpose of the insurance. If, for example, the purpose is to provide protection for a member and their family, it would be usual to debit the premium from an account of that member so that the insurance proceeds are allocated to that account and are therefore available exclusively for the member and their dependants. On the other hand, if the purpose was to protect fund assets underpinning account balances of the other fund members, the cost would typically be borne by the members seeking the protection. Thus the debiting of the costs of insurance 'mirror' the crediting of the insurance proceeds. This balance of debit and credit is important because SISR 5.02(3) requires that costs (like investment returns discussed above) be distributed in a fair and reasonable manner as between all members and the various benefits of members. In this regard it is worth observing that where a cost is debited from gross investment returns, and the net investment return (including any insurance proceeds) is distributed in a fair and reasonable manner (as discussed above), the cost is effectively also distributed 3

4 in a fair and reasonable manner by default. Reserve accounts If a fund has a reserve account, and if an insurance premium is debited from that account, then it follows from the discussion above, that any insurance proceeds should be credited to that account. If insurance proceeds are credited to a reserve account, this potentially raises contribution cap issues if, and when, allocations are ultimately made out of the reserve to one or more members. Specifically, an allocation made to a member may be counted as a concessional contribution for the year in which the allocation is made unless certain criteria are met, ie: the allocation is fair and reasonable to each member and each account balance and the amount allocated over a year is less than 5% of a member's account balance at the time of allocation. Note both limbs must be met in order for a reserve allocation to not count towards a member's concessional contribution cap. In this context, it is important to make a distinction between reserve allocations made to members' account balances and reserve allocations made directly to a member / beneficiary (ie, bypassing an account balance altogether). In ATO ID 2012/32, the ATO expressed the view that reserve allocations made to members' account balances will be counted as concessional contributions (unless the criteria referred to above are met), and also inferred that if an amount is paid from a reserve directly to a member / beneficiary (ie, bypassing any account balance of fund member), that it will not count as a concessional contribution, but rather be treated as a benefit payment to the member / beneficiary. If premiums are instead debited from the fund's gross investment return, it is important to note that any insurance proceeds received do not automatically form part of a reserve account. Rather, the trustee would have to make a decision (in accordance with the fund reserving strategy) to actually set aside some or all of the proceeds (via the investment return) and allocate these to a reserve. How much insurance is needed and who should bear the cost? That will depend on what you're trying to achieve. We illustrate this by considering the following examples. Example 1 Suppose we have a two member fund with assets of: Property $1,200,000 Liquid assets $200,000 $1,400,000 Loan ($600,000) Net assets $800,000 Member 1 (M1) $500,000 Member 2 (M2) $300,000 If M1, say, were to die or become disabled, unless we have the ability to pay the benefit in pension form, the fund will have to pay the benefit as a lump sum. The fund would therefore be forced to sell the property to fund a benefit payment of $500,000 (unless it wanted to pay the benefit 'in kind' which would be doable but impracticable given it would require a tenants in common arrangement over the property). But what if the trustee took out $300,000 of insurance cover on M1's life and debited the premium from M2's account balance? The rationale here is that $300,000 of insurance together with the fund's $200,000 of liquid assets would be sufficient to pay 4

5 M1's benefit without needing to sell the property. But why debit the premium from M2? Debiting the premium from M2 means that it is fair and reasonable to credit the $300,000 insurance proceeds to M2's account (increasing it to $600,000) on the death / disablement of M1. Note that M1's benefit entitlement remains fixed at $500,000. The financial position of the fund (after all transactions) then becomes: Property $1,200,000 Loan ($600,000) Net assets $600,000 Member 2 (M2) $600,000 Applying this concept of 'cross insurance" has enabled the trustee to: pay out the death / disability benefit to M1 / their dependants; whilst protecting the assets underpinning the balances for M2. In this example, the loan balance has not been reduced. Flowing from this, there may now be a cash flow problem for the fund if it previously relied on contribution cash flow in respect of M1 to meet its loan commitments. If this is the case, what could be done? Example 2 Let's suppose that the loan balance would need to reduce by $300,000 in order for the fund to be able to service it. This could be achieved if the trustee took out $600,000 of insurance (instead of $300,000) on M1's life and debited the premium to M2. The financial position of the fund (after all transactions) then becomes: Property $1,200,000 Loan ($300,000) Net assets $900,000 Member 2 (M2) $900,000 Example 3 Returning to the original scenario, what if a lump sum was to be paid, and the objective was to pass the property to the member / beneficiary (ie, pay the benefit 'inspecie')? M1's current account balance is $500,000, so it would need to increase to $1.2m (the market value of the property) in order to enable an in-specie payment of the property. In addition, as the property is subject to a limited recourse borrowing arrangement, the debt would need to be repaid in full before the asset could be paid inspecie to the member / beneficiary. This could be achieved by taking out $700,000 of insurance cover on M1's life and debiting the premium from M1's own account balance (note no cross insurance is involved in this case). The financial position of the fund (after all transactions) then becomes: insurance proceeds received benefit payment made Property $1,200,000 $Nil Liquid assets $900,000 $300,000 $2,100,000 $300,000 Loan ($600,000) ($Nil) Net assets $1,500,000 $300,000 M1 $1,200,000 $Nil M2 $300,000 $300,000 The $700,000 of proceeds have been used to pay out the loan ($600,000) and increase the fund's liquid assets ($100,000). Are insurance premiums deductible (to the fund) if the trustee is "cross insuring"? Superannuation funds are able to claim a deduction for the full amount of any premiums paid on insurance policies held for the purposes of providing benefits to a 5

6 member (or their beneficiaries) upon death, terminal illness, and permanent or temporary incapacity [s of the ITAA 1997]. In other words, in order for a premium to be deductible, there must be a connection between that premium payment and a current or contingent liability of the SMSF to provide a benefit referred to in s of the ITAA 1997 to members (ie, death, terminal illness, and permanent or temporary incapacity). Where 'cross insurance' is taken out to protect the assets underpinning other member balances, a deduction under s of the ITAA 1997 will not be available. This is not because of the purpose of the insurance, but rather because there is no connection between the premium payment and a current or contingent liability of the SMSF to provide a benefit for the insured life. If cross insurance is involved, could the premium be deductible under s 8-1 of the ITAA 1997 instead? S 8-1 of the ITAA 1997 allows a deduction for expenses to the extent they are "incurred in gaining or producing assessable income and are not of a capital, private or domestic nature". To date we have not received any guidance from the ATO on whether premiums are deductible under s 8-1 of the ITAA 1997 when "cross insurance" is in place. We feel that it is prudent for trustees not to claim a deduction for such insurance premiums until the ATO provides some guidance. What if insurance premiums were debited from gross investment income? Let's return to example 1 and let's suppose that the purpose of the insurance is to increase the fund's liquid assets just enough to enable the payment of M1's death / disablement benefit without needing to sell the property. We saw previously that this could be achieved by taking out $300,000 of insurance on M1's life funded from M2's account balance, where $300,000 was simply the 'gap' between the fund's liquid assets ($200,000) and M1's account balance ($500,000). If the premium were instead debited from gross investment return, however, substantially more than $300,000 of insurance would be required. Here's why. As the premium is debited from the gross investment return, the insurance proceeds (via the investment return) must be distributed in a fair and reasonable manner to all (ie, both) members' accounts. This means that if the level of insurance taken out over M1's life was $300,000, each of M1 and M2's account balances would receive a proportional share of the $300,000 insurance proceeds. Consequently, a higher level of insurance cover will be needed in order to ensure that M2's 'portion' of the net investment return is enough to ensure that their account balance equates to the net value of the property ($600,000). In this example, the level of insurance would need to be $800,000, and the financial position of the fund (after all transactions) then becomes: insurance proceeds received benefit payment made Property $1,200,000 $1,200,000 Liquid assets $1,000,000 $Nil $2,200,000 $1,200,000 Loan ($600,000) ($600,000) Net assets $1,600,000 $600,000 M1 $1,000,000 $Nil M2 $600,000 $600,000 6

7 The level of insurance would need to be even higher, if the purpose was to also extinguish the debt on the property. Conclusion Cross insurance can be a powerful and efficient way for trustees to protect against the forced sale of assets underpinning the balances of other SMSF members, and to protect the fund's on-going cash flow requirements, following the death / disablement of fund members. Disclaimer Heffron Super News is an electronic newsflash which highlights important events in the superannuation arena. If you are not already on our mailing list and would like to subscribe, please contact us on or by heffron@heffron.com.au. Alternatively, if you do not wish to receive future editions, please heffron@heffron.com.au to be removed from the distribution list. While Heffron believes that the information contained herein is reliable, no warranty is given to the accuracy and persons who rely on it do so at their own risk. This publication is intended to provide background information only and does not purport to make any recommendation upon which you may reasonably rely without taking specific advice. In particular, it should not be considered financial product advice for the purposes of the Corporations Act