“To help manage some of this risk, in particular around the death of a business partner, it is not uncommon for an SMSF to consider taking out a ‘buy/sell’ life insurance policy. The purpose of this policy was to provide the surviving spouse with an equivalent business value through the insurance proceeds in exchange for the shares (or units) in the trading entity,” Mr Dunn said.

“In accordance with the terms of the agreement, the business would pay for the policy as a concessional contribution on behalf of the member, conditional upon that contribution is used to pay for the life policy premiums.”

Late last week, the ATO provided guidance on this issue in ATOID 2015/10, which examines whether such an arrangement breaches the sole purpose test.

“What the ATO has ruled in this situation is that the sole purpose test has been breached because the decision to purchase that life insurance policy was influenced by other factors,” said AMP SMSF’s head of policy, technical and educational services, Peter Burgess.

“And those other [factors] were allowing a non-member to obtain 100 per cent ownership in the relevant company,” Mr Burgess said.

SMSF Adviser has, however, been made aware the ATO had previously issued correspondence suggesting such buy-sell arrangements would not breach the sole purpose test.

While it appears the ATO ID does not expressly address grandfathering arrangements, DBA Lawyers director Daniel Butler said he believes this decision constitutes a new position by the ATO.

It is not guaranteed that SMSFs with these arrangements currently in place will escape penalty, Mr Butler said, so a taxpayer’s safest option is to rectify their arrangements as soon as possible.

“If you do have clients who have structured their buy-sell insurance in a superannuation context, they need to review their decision. If they are under the spotlight of this ATO ID, they need to take professional advice,” Mr Butler said.

“If, however, you persist without taking appropriate action, you could be rendering your fund at a substantial risk of potentially [being] non-compliant and other civil penalties."

Mr Burgess added that a key takeaway for SMSF practitioners and their clients is to take a “very broad picture approach” when applying the sole purpose test.

“In this case, if you had just looked at the trustee’s decision to purchase a life insurance policy over the member, that on its own would not lead you to the conclusion that it breaches the sole purpose test,” Mr Burgess said.

“But when you consider all the other factors, and that it was part of a buy-sell agreement, the ATO has then concluded that this is a breach of the sole purpose test."