SMSF Specific Advice re Super Buy/Sell Cover and Agreement

On 12 March, 2014, the ATO issued a private SMSF Specific Advice which effectively concludes that the practice known as “Super Buy/Sell” contravenes the Sole Purpose Test under section 62 of the Superannuation Industry (Supervision) Act.

In recent years, it has become increasingly common for:

Public Offer Superannuation Funds to issue Insurance Cover that is intended to be Buy/Sell Cover; or
a Self-Managed Super Fund to own Buy/Sell Cover that is issued by an Insurance Company.

This practice is colloquially known as "Super Buy/Sell".

IGS has always expressed concerns about this practice:

The ATO Advice will require many Insurance Arrangements and Super Buy/Sell Agreements to be terminated, in order to avoid ongoing contravention of the Sole Purpose Test.

What is "Super Buy/Sell Cover"?

Michael and Mark each own ten shares in a Company. It is agreed that the Net Asset Value of the Company is $2M, and that the Purchase Price of a half-share should be $1M.

They agree to obtain an Insurance Policy for $1M each.

Their Insurance Adviser suggests that each Policy be held by the Life Insured’s SMSF, so that the premium will be paid out of their Concessional Contributions (and will therefore effectively be deductible).

Upon the payment of a Claim, the Policy will pay the Insurance Proceeds of $1M to:

the Life Insured/Member;
the Executor of their Estate; or
a Nominated Beneficiary.

The Insurance Adviser recommends that Michael and Mark sign a Buy/Sell Agreement.

The purpose of the Buy/Sell Agreement is to ensure that the deceased Life Insured transfers their shares to the surviving Life Insured upon the payment of a claim.

The Agreement contains a clause that effectively provides that, if the value of the shares is fixed at $1M and the Insurance Proceeds are $1M, then the surviving Life Insured will not be obliged to pay any additional amount for the shares.

Alternatively, if the Purchase Price is subject to a valuation (which determines that the value of the shares is $1.2M), then:

the Insurance Proceeds of $1M will be credited against the Purchase Price of $1.2M; and
the surviving Life Insured will be obliged to pay the balance of $200K.

Buy/Sell Cover Relating to SMSF Assets

Where two or more Lives Insured are Members of an SMSF that owns property or other assets, it might be appropriate to hold Buy/Sell Cover in the SMSF, so that a Member can effectively buy the interest of a deceased Member on their death.

This fact situation is not within the scope of the ATO Advice. There is no suggestion in the ATO Advice that it would contravene the Sole Purpose Test.

Taxpayer’s Contentions

The Taxpayer argued that:

“8. The primary purpose of taking out the life insurance policy is to provide benefits to [Life Insured 1]’s dependants on his death. These benefits may otherwise not be readily available should they have to rely on a physical payment from [Life Insured 2] to pay for [Life Insured 1]’s share of the business.”

Summary of ATO’s Decision

The ATO accepted that the benefits would be paid to [Life Insured 1]’s dependants on his death.
However, it concluded that:

“11. It is not enough to demonstrate that a fund meets the sole purpose test that every other provision of the SISA and the Superannuation Industry (Supervision) Regulations 19934 (SISR) are met in relation to an investment.
“What is imperative is that all investment decisions and the maintenance of the Fund must also meet the overarching sole purpose test requirement at all times, including that investments are made and maintained to provide allowable benefits for members and not made for any other purposes.
“12. In this case, the benefit to be obtained by [Life Insured 2] is not remote or incidental to the Trustee’s decision to purchase a life insurance policy on [Life Insured 1]. Therefore the purpose/s behind the trustee’s decision is not solely to provide allowable benefits to the members.”

Reviewing a Trustee’s Decision

In paragraph 17 and 18, the ATO confirms that:

the Sole Purpose Test requires “exclusivity of purpose”; and
what is relevant is whether the sole purpose of entering into a transaction was to provide allowable benefits.

However, it acknowledges that:

“…the test may still be satisfied where an SMSF provides benefits other than those specified in subsection 62(1), if those benefits are considered incidental, remote or insignificant.”

It adds that:

“17. …all the facts and circumstances associated with the maintenance of the SMSF are relevant in deciding if the trustee has complied with the sole purpose test.
“18. Further, the test “requires a holistic assessment of all the circumstances associated with the maintenance of an SMSF” and the test is “particularly concerned with how a trustee of an SMSF came to make an investment or undertake an activity, which is likely to vary from trustee to trustee”.”

Did the Underlying Purpose of the Buy/Sell Agreement Accord with the Sole Purpose Test?

The ATO considered the underlying purpose or purposes of the Buy/Sell Agreement in its decision.

The Company’s Business Succession Plan

One purpose was the extent to which the Policy and the Agreement formed part of the process of managing the Company’s Business Succession Plan:

“ 22. Under the terms of the agreement, on the death of [Life Insured 1], the policy held by the Fund will be paid out to the trustee of the Fund, who is required to pay this amount in full to [Life Insured 1]’s dependent/s.
“[Life Insured 1]’s dependent/s then relinquish all claims on [Life Insured 1]’s 50% shareholding in [Trading Company Pty Ltd].
“[Life Insured 2] will become the sole director and shareholder of [Trading Company Pty Ltd].
“ 23. There is little doubt the agreement is a major component to [Trading Company Pty Ltd]’s business succession management.
“An important underlying driver in having the life insurance policy is the ability of [Life Insured 2] to gain total ownership and control of [Trading Company Pty Ltd] after [Life Insured 1]’s death without [Life Insured 2] incurring any expenditure on acquiring either the life policy or the share of the business.
It was clear from this analysis that Life Insured 2 was intended to obtain a benefit from the Policy.

Tax Deductibility of Premium

The ATO then considered the role of the tax deductibility of the premiums in the decision:

“24. Presumably, there exists no impediment to having the policy held outside the Fund (say, by [Trading Company Pty Ltd] or by [Life Insured 2]).
“However, the parties have chosen to structure their affairs in a very specific manner, and it would be reasonable to say that a significant motivating factor would be the perceived tax advantages of the arrangement.”

Commercial Implications for Life Insured 2 (the Purchaser)

The ATO also considered the implications of the Cover for the Purchaser:

“25. However, as well as these anticipated tax advantages, the scheme effectively relieves [Life Insured 2]’s obligation to either provide money to purchase [Life Insured 1]’s share of the business or to pay insurance premiums for a policy on which he will derive a significant, albeit indirect, benefit.
“The ‘buy-sell’ agreement was entered into with a specific purpose of obtaining this particular benefit.
“This benefit certainly cannot be described as something that is incidental, remote or insignificant: a benefit is not incidental if it is one of the objects or purposes of the trustee to provide that benefit.”
The ATO describes the “crediting” of the Insurance Proceeds against the Purchase Price that the Purchaser will have to pay as an “indirect” benefit of the Policy as far as the Purchaser is concerned.
However, it confirms that the benefit is “significant”.
It is not merely “incidental, remote or insignificant”.

SMSF was a “Conduit”

The ATO drew an adverse inference from the fact that the SMSF was a conduit for the funds in a broader commercial transaction (paragraph 26).

Even though it was not a party to the Buy/Sell Agreement, it still participated in the transaction, by being the vehicle by which the Insurance Policy was maintained.

Opportunity Cost to the SMSF

The ATO considered that:

the SMSF was required to use contributions made to it in a manner that may not accord with its investment strategy, which leads to the question of opportunity cost to the Fund; and
The Trustee was essentially directed or obliged to invest contributions made to it in an asset it may not otherwise hold, or hold at the value chosen (paragraph 26).

In effect, but for the Buy/Sell arrangements, the Fund might not have obtained:

this amount of Insurance Cover; or
any Insurance Cover at all.

In other words, it might have invested the contributions in an accumulation or investment strategy for retirement purposes.

The payment of the premium by the Fund detracts what might otherwise have been a more appropriate investment strategy.

Method of Determination of the Sum Insured

When considering the investment strategy of the Fund, the ATO drew an adverse inference from the fact that the Sum Insured:

was not determined by having regard to the future needs of the Member’s dependants; but
was determined by reference to the value of the Member’s shares in the Company (paragraph 28).

“Compensation for Expected Inheritance”

The ATO also drew the following conclusion from the Buy/Sell Agreement:

“What [Life Insured 1]’s dependent/s receive from this agreement, whilst ostensibly a death benefit payment from the Fund, is in substance compensation for their expected inheritance from the member’s share of the business.
“From this, it is arguable that the contributions received by the Fund to enable the premium payments were never intended to produce retirement benefits. (paragraph 28)”

Collateral Benefit to the Purchaser

The ATO expressly recognised the extent of the benefit obtained by the Purchaser as a result of the Insurance Cover:

“The collateral benefit to a person who is not a member of the Fund is at least equal to what is being characterized as a future death benefit payment to the member’s dependant.
“This is a sought-for benefit that certainly isn’t a mere incidental benefit.
“There is a deliberateness and purposefulness to this course of action which is difficult to reconcile with the underlying intention of the sole purpose requirements under section 62.”

ATO’s Conclusions on Purpose

In paragraph 27, the ATO concluded that:

“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, but is a part of the implementation of an external business succession and estate planning agreement.
“Business succession management motives are far more than incidental to the decision by the Trustee.

Evidence Relied on by ATO

In this case, the SMSF applied for Specific Advice from the ATO.

Thus, it would have been the source of all of the documentation and information upon which the ATO made its decision.

However, it is clear from the ATO’s conclusions that it was prepared to draw alternative inferences from the circumstances than those that were submitted by the SMSF.

It was not prepared to accept that:

there was only one purpose underlying the Cover; or
any other purpose was merely incidental, remote or insignificant.

In practice, it has always been necessary for a Super Buy/Sell Arrangement to be documented in an Agreement, so that there is a legally binding arrangement to give the Purchaser “credit” for the Insurance Proceeds.

It is inevitable that the terms of the Agreement will assist the ATO draw its inferences about the true purpose of the Cover.

The ATO’s Advice does not mention the Insurance Adviser’s Statement of Advice.

However, if the Statement of Advice identified the purpose of the Cover as Buy/Sell Cover, then it to would be fatal to the Fund’s attempt to argue that it had complied with the Sole Purpose Test.

If the Statement of Advice attempted to conceal the real purpose of the Cover, then it is likely that it would at least breach the compliance provisions of the Corporations Act applicable to the Adviser.

Conclusion

Many Advisers and Lawyers have willingly contributed to the breach of the Sole Purpose Test by their Clients.

In many cases, it could be argued that there has not been an adequate consideration of how the ATO would apply the Sole Purpose Test.

The ATO Advice will require many Insurance Arrangements and Super Buy/Sell Agreements to be terminated, in order to avoid ongoing contravention of the Sole Purpose Test.

Because the Advice is specific to a particular Fund, it is not clear how the ATO will deal with historical breaches.

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