Life of buy-sell in super

Dimitri Diamantes canvasses how the Government should approach buy-sell in super and how the industry may respond.  

Some recent rumblings from the Australian Taxation Office (ATO) about funding a buy-sell agreement with an insurance policy held in superannuation ('buy-sell in super’) have some concerned that the arrangement may breach the sole purpose test under the Superannuation Industry Supervision Act (SIS). Whether or not the Government, as a matter of policy, should allow buy-sell in super is discussed below.  

Buy-sell in super 

Before we delve deep, we’ll look at some basics of buy-sell in super. What is buy-sell in super? In a nutshell, it means: 

•  A policy (e.g. term life and/or permanent incapacity) over the life of a business principal is owned by their super fund and backs the member’s account; 
•  On an insured event happening, the trustee receives the proceeds and pays them into the member’s account; 
•  There is a valid 'binding death benefit nomination’ in place - broadly, the trustee of the super fund is bound to pay to a nominated beneficiary the value of term life insurance proceeds as a death benefit; 
•  The member may withdraw the value of total and permanent disability (TPD) insurance proceeds as a disability benefit; 
•  There is a buy-sell agreement providing for the principal’s interest in the business to be given up to the remaining owners upon certain conditions being met (e.g. death or permanent incapacity; receipt - or deemed receipt - of the value of the insurance proceeds, as a death/disability benefit; and the exercise of a put or call option by the parties to the agreement) 
•  The death or disability benefits are credited towards the amount required to be paid by the remaining owners under the buy-sell agreement. 

Sole purpose test 

What is the sole purpose test? This test requires that each trustee of a super fund ensures the fund is maintained solely for purposes prescribed in SIS. In Self-Managed Superannuation Fund Ruling (SMSFR) 2008/2, the ATO provides a non-exhaustive list of factors - in relation to a benefit - that suggest a self managed superannuation fund (SMSF) is not being maintained solely for the purposes prescribed in the legislation. These factors are:  

•  The trustee negotiated for or sought out the benefit; this is the case even if the additional benefit is negotiated for - or sought out - in the course of undertaking other activities that are consistent with the sole purpose test; 
•  The benefit has influenced the decision-making of the trustee to favour one course of action over another; 
•  The benefit is provided by the SMSF to a member or another party at a cost or financial detriment to the SMSF; 
•  There is a pattern of events that amounts - or the number, quantity or importance of events amount - to a non-prescribed benefit being provided. 

A non-exhaustive list of factors - in relation to a benefit - that indicate that an SMSF is being maintained solely for prescribed purposes - despite the provision of non-prescribed benefits includes:  

•  The benefit is an inherent or unavoidable part of other activities that are consistent with providing prescribed benefits; 
•  The benefit is remote or isolated, or is insignificant; 
•  The benefit is provided by the SMSF on arm’s length commercial terms, consistent with the financial interests of the SMSF and at no cost or financial detriment to the SMSF; 
•  All of the activities of the trustee are in accordance with the covenants set out in section 52 of SIS; 
•  All the SMSF’s investments and activities are undertaken as part of - or are consistent with - a properly considered and formulated investment strategy. 

A possible concern with buy-sell in super is that, in substance, it is to provide compensation for the business interest - or an expected inheritance - rather than to provide death/disability benefits. Another possible concern with the arrangement is that one purpose is to relieve the surviving business principals of the need to pay for the departing principal’s interest in the business. Factors which might support a conclusion that providing these benefits are objects of the fund include:  

•  The buy-sell agreement provides a means to ensure that, if an insured event happens, the life insured or their beneficiaries receive cash for the life insured’s interest in the business and the other business principals acquire the life insured’s interest; 
•  The cost of premiums reduces the fund’s capital, which may mean less capital is invested in line with a properly formulated investment strategy of the fund; 
•  Tax deductibility of premiums would influence the trustee to provide the non-prescribed benefit; and  
•  The value of the insurance cover is determined not by the life insured’s personal/family needs, but by the value of their interest in the business. 

The sole purpose test requires that the fund be maintained exclusively for prescribed purposes. Providing compensation for the life insured’s business interest and relieving the surviving business principals of the need to pay for the departing principal’s interest in the business is not a prescribed purpose and, therefore, unless the non-prescribed benefit is remote or insignificant, the fund breaches the sole purpose test. Note that by characterising the provision of a non-prescribed benefit as a purpose or object of the fund, providing the non-prescribed benefit isn’t merely incidental to prescribed purposes.  

The non-prescribed benefit is made significant by the provision (in the buy-sell agreement) to credit the value of the death/disability benefit against the amount the remaining principals owe for the departing owner’s share of the business. It has been reported that the above approach has been taken in a private binding ruling issued by the ATO. 

Would an alternative approach be possible?  

Consider the following suggestion:  

•  In substance, the purpose of the cover is to provide permissible death/disability benefits to the life insured/their beneficiaries in the form of compensation for a non-superannuation retirement nest egg;  
•  The provision of a collateral benefit to the other business principals is simply an unavoidable (as opposed to purposeful or deliberate) consequence of pursuing the object of providing permissible benefits; 
•  There is no extra cost - above what the fund’s already paying to provide the insured death/disability benefit - for the collateral benefit; 
•  While the value of insurance cover is determined by reference to the value of the business interest, this represents the life insured’s non-superannuation nest egg of permissible benefits (including death and disability benefits); 
•  Providing cash flow benefits to the member may be an unavoidable consequence of ensuring - through access to Superannuation Guarantee (SG) contributions or accumulated superannuation savings to pay for insurance premiums - the provision of death/disability benefits; and 
•  Tax deductibility of premiums may have influenced the fund, but is also an unavoidable consequence of providing death/disability benefits with the high confidence that having access to SG contributions and accumulated savings affords. 

Beyond SMSFs 

Another question is, does it matter whether the super fund is an SMSF or another fund? Could a public offer fund that allows a member to hold insurance in the fund breach the sole purpose test if the insurance is for buy-sell (or other non-prescribed) purposes, and; 

•  The fund’s trustee is willing to provide a member with insurance where the insurer has underwritten the policy on the basis that the cover is to fund a buy-sell agreement 
•  The member doesn’t sign a sole purpose declaration or, for example, the sum insured is a lot higher than the average level of personal insurance for their demographic? 

Where to from here? 

So, should the Government allow buy-sell in super? Let’s look at the pros and cons. On the positive side: 

•  The practical effect of buy-sell in super is to ensure the insured business owner’s business interest can be received as cash on the member’s death or disability - this seems consistent with a broad objective of superannuation: to provide benefits to members or their beneficiaries on the member’s death or disability 
•  Superannuation provides business owners who may not otherwise be able to access insurance with the opportunity to take out cover through automatic acceptance 
•  Superannuation helps business owners fund premiums even when cash flow is tight 

On the negative side: 

•  In relation to TPD, from 1 July 2014 no new policies that aren’t consistent with the 'permanent incapacity’ definition in SIS are allowed in super - a product solution for TPD may be split TPD, where that part of the cover to provide a benefit in circumstances beyond permanent incapacity are owned by a non-superannuation entity 
•  There may be tax on death or disability benefits from super - a solution is to gross up the sum insured, and any tax savings from holding insurance in super may offset the extra premium cost 
•  Retirement savings can be depleted - a solution is to make extra contributions to cover the premiums; even where the member has already reached their concessional contributions cap, the fund could claim a deduction for the premiums and may be able to pass that benefit into the member’s super account 

Conclusion 

If you do take the view that the Government should allow buy-sell in super, what would need to be done? We await guidance, beyond private rulings, from the regulators. Short of a broader interpretation of the sole purpose test being adopted, SIS may need to be amended. Such reform has the potential to draw a clear line between acceptable and unacceptable buy-sell in super. 

Dimitri Diamantes is technical services manager at Asteron Life.