When a proper diagnosis is needed

A recent legal case and its subsequent appeal highlight the importance of many SMSF compliance requirements. SMSF Association head of technical Mary Simmons acknowledges the lessons learned from this episode.

Tax planning for interrelated family structures often requires the same precision and planning as a medical procedure.

Just as one wouldn’t expect a surgeon to operate without first conducting the necessary tests and thoroughly reviewing a patient’s file, tax planning similarly requires an understanding of the tax affairs of the broader family group and each of the steps of a transaction where an SMSF is involved. Otherwise there is a risk a routine procedure, or transaction in this case, could turn into a compliance nightmare.

Before a surgeon picks up a scalpel, we’d expect that they need to know a patient’s medical history and have a clear diagnosis and a treatment plan in place. Similarly, SMSF trustees must ensure every transaction is well documented and aligns with superannuation law, the fund’s investment strategy and the sole purpose test. Jumping in without due diligence can lead to regulatory complications, financial penalties and potentially trustee disqualification.

When it comes to structuring tax-effective transactions for interrelated entities, the case of Merchant and Commissioner of Taxation [2024] AATA 1102 is a stark reminder: jumping in without a full diagnosis can be disastrous.

This case is an example of what can happen when a trustee undertakes a transaction without properly assessing the broader interrelated family group. The case involved a seemingly simple share transfer, but beneath the surface it raised issues concerning investment strategy compliance, the sole purpose test and the provision of financial assistance to a member.

The result was a tribunal decision that reaffirmed the fundamental obligations of SMSF trustees and provides a strong warning against structuring transactions for tax benefits without due consideration of the superannuation law.

The transaction: a high-risk operation?

Gordon Merchant, the founder of Billabong, entered a transaction where his SMSF bought $5.8 million worth of Billabong Limited shares (the company is no longer listed on the Australian Securities Exchange) from his family trust (MFT) in 2014 at market value.

At first glance the standalone transaction complied with section 66(2) of the Superannuation Industry (Supervision) (SIS) Act, which allows SMSFs to acquire listed shares from a related party at market value.

So why did the scalpel slip? The real issue lay beneath the surface. It was held the transaction was strategically designed to crystallise a capital loss in the family trust to offset the expected gain from the impending sale of another investment, Plantic Technologies Ltd, while retaining ownership of Billabong shares in the broader Merchant group – which raised immediate red flags.

Much like a patient concealing a preexisting medical condition before surgery, the broader tax strategy was not aligned with the SMSF’s core obligations. The commissioner of taxation argued the transaction was primarily undertaken to benefit the family trust, not the SMSF – an assertion that ultimately led to a breach of multiple SIS provisions and the ruling was subsequently contested via the Administrative Appeals Tribunal (AAT).

Investment strategy: the missing medical chart

A properly documented and implemented investment strategy is as essential to an SMSF as a patient’s pre-operation instructions are to their procedure. It provides the framework for investment decisions, ensuring trustees act prudently and in the best interests of members.

In this case, the AAT heavily scrutinised the SMSF’s investment strategy. Under section 52B(2) of the SIS Act and SIS Regulation 4.09, SMSFs must have an investment strategy that considers diversification, liquidity, risk and the ability to meet member benefits.

While Merchant’s SMSF did have an investment strategy in place, the tribunal identified significant flaws.

Firstly, the strategy was signed by Merchant’s assistant under a power of attorney. Merchant could not recall approving the investment strategy.

Secondly, the strategy inaccurately reflected the fund’s asset allocation, listing property holdings at 0 per cent when, in fact, the fund owned direct property.

Finally, the share purchase caused a concentration risk with 74 per cent of SMSF assets invested in a single listed company, which was far outside the investment strategy’s prescribed limit of a maximum of 40 per cent to be held across multiple listed companies.

Merchant argued the SMSF’s investment strategy did not require every individual investment to adhere to its stated parameters. He also contended purchasing the shares was itself a de facto revision of the investment strategy.

The AAT rejected these claims, stating an SMSF trustee must “give effect to” its investment strategy, meaning investment decisions must align with a pre-existing, wellconsidered strategy rather than retrospectively adjusting it to justify decisions.

Notably, the AAT found no evidence Merchant or his representatives sought investment advice on the purchase from an SMSF compliance perspective. The lack of documentation about how this acquisition served the SMSF’s best interests contributed to the finding there had been a breach of section 34(1) of the SIS Act.

This case serves as a reminder that an investment strategy is not just a box-ticking exercise. It must be well documented, tailored to the fund’s objectives, regularly reviewed and consistently followed when making investment decisions.

In medical terms, this is akin to a surgeon operating without reviewing a patient’s charts. The AAT concluded that failure to formally assess the risks, diversification and liquidity implications of the Billabong share purchase was a key concern.

The sole purpose test: treating the wrong condition

At the heart of SMSF compliance is the sole purpose test under section 62 of the SIS Act, which broadly requires the fund exists solely to provide retirement benefits to its members or provide benefits to dependants in the event of a member’s death.

The ATO’s view on the sole purpose test is detailed in SMSF Taxation Ruling (TR) 2008/2, which confirms the test requires exclusivity of purpose, a higher standard than the maintenance of an SMSF for a dominant or principal purpose.

Essentially, where transactions provide a current-day financial benefit to a member or related party, the fund is at risk of failing the sole purpose test even if the transaction is executed at market value.

Transactions can become problematic when SMSF trustees also hold other roles within the family group, such as in businesses or other controlled entities. If they cannot demonstrate their investment decisions are made solely to serve the fund’s retirement purpose, and not influenced by other business or personal objectives, compliance risks arise.

In the Merchant case, due to the lack of evidence at the time of the transaction, the AAT determined the dominant purpose of the share acquisition was to generate a capital loss in the family trust and to enable the Merchant group to retain a significant shareholding in Billabong. Neither of these reasons aligned to the core purpose of providing retirement benefits to the fund member.

Merchant’s justifications, such as his belief in Billabong’s recovery and his desire to show confidence in the company, did not change the underlying intent.

The transaction resulted in a situation where MFT reduced its tax liability, while the SMSF took on significant concentration risk and encountered difficulty with cash flow and its ability to maintain the payment of a pension to Merchant, forcing the fund to commute the income stream.

The sole purpose test is not concerned with whether a particular transaction is permissible in isolation, but rather why it was undertaken. In this case, the AAT concluded the SMSF was effectively used as a vehicle to facilitate a broader tax strategy for MFT, that is, the SMSF was used to solve MFT’s tax problem rather than fulfilling its duty to the fund’s member.

This serves as another important lesson. Just because an investment is made at market value does not automatically mean it is in the best interests of a fund’s members. Trustees must be able to demonstrate, with objective evidence, SMSF assets are not being misused for personal or business purposes unrelated to the provision of retirement benefits.

Financial assistance to members: a risky side effect

Under section 65 of the SIS Act, an SMSF must not provide financial assistance to its members or their relatives. This prohibition extends beyond direct loans to indirect benefits derived through related-party transactions.

The ATO successfully argued that by acquiring the shares the SMSF indirectly provided financial assistance to Merchant. The purchase enabled MFT to realise a tax-saving capital loss – an advantage that would not have existed but for the SMSF’s involvement.

Merchant claimed any financial benefit to MFT was incidental rather than intentional. The AAT disagreed, ruling the transaction provided a clear, measurable benefit to MFT, bringing it within the scope of section 65.

The AAT decision was not negated by the fact the ATO was successful in applying Part IVA of the Income Tax Assessment Act to deny MFT the capital loss, which ultimately resulted in no financial assistance being provided. The tribunal was of the view the later cancellation of the tax benefit did not undo the breach, stating the breach had already occurred at the time of the transaction.

Just as doctors must consider side effects when prescribing medication, SMSF trustees must evaluate whether a transaction directly or indirectly benefits fund members or relatives. In this case, the SMSF bore all the risk while the family trust, and its beneficiaries, stood to reap the rewards. A clear regulatory breach.

Trustee disqualification: the risk of permanent suspension

In 2020, the commissioner disqualified Merchant from acting as an SMSF trustee under section 126A(2) of the SIS Act, citing serious compliance breaches.

However, although the tribunal acknowledged the seriousness of the contraventions, it determined Merchant was a fit and proper person to continue as a trustee, overturning the disqualification.

In making the decision, the AAT considered his reliance on professional advice, the fact the breaches arose from a single transaction and his commitment to appointing an independent director to strengthen future SMSF governance.

While Merchant avoided permanent trustee disqualification, the case demonstrates trustees who fail to exercise independent judgment and due diligence are at serious risk of regulatory action.

By contrast, Coronica and Commissioner of Taxation [2024] AATA 2592 reinforces the AAT’s willingness to uphold trustee disqualifications where there is a pattern of non-compliance and a failure to acknowledge serious breaches.

Coronica’s persistent contraventions, including unauthorised loans to members and in-house asset breaches, demonstrated an ongoing disregard for SMSF obligations. The tribunal ultimately ruled Coronica was not a fit and proper person to act as an SMSF trustee and disqualification was necessary to protect the integrity of the SMSF system, highlighting that individuals who repeatedly fail to meet compliance standards risk permanent removal.

Conclusion: the right diagnosis saves lives and SMSFs

The Merchant case is a timely warning for trustees and SMSF professionals alike.

Just like surgery, tax planning requires precision. There is no room for trial and error. A misstep, whether from poor documentation, non-compliance with SIS rules or a failure to prioritise retirement benefits over taxdriven motives, can prove fatal for an SMSF’s compliance status.

Poor trustee decisions can also have far-reaching personal consequences. Trustee disqualification by the ATO is publicly available information and can result in irreparable damage to one’s reputation, professional standing or business.