Edited version of private ruling

Authorisation Number: 1011592277203

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Ruling

Subject

Capital gains tax - small business concessions - connected entities - control - Commissioner's discretion

For the purposes of the connected entity provisions in section 328-125 of the Income Tax Assessment Act 1997 (ITAA 1997) and the maximum net asset value test under section 152-15 of the ITAA 1997, will the Commissioner determine that the Family Trust (A) does not control the Company (B) in accordance with the discretion provided him under subsection 328-125(6) of the ITAA 1997?

No.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Relevant facts and circumstances

You state that A is a hybrid discretionary investment trust which does not carry on a business. Therefore, it cannot be considered a 'small business entity' for the purposes of Division 328.

B is a company. You advise that its paid in share capital comprises C and E class shares with a value of $1 per share. No other classes of shares have been issued. The total paid in capital of the company is $200.

The constitution of B addresses share rights.

The constitution has been provided and forms part of this ruling.

The shareholders of B are C Pty Ltd (C) and A.

C holds 50% of the C class shares and 60% of the E class shares. C are entitled to 50% of the votes at general meetings of B, the right to 60% of the dividends paid by B and the right to 60% of the distribution of surplus assets on liquidation of B.

A holds 50% of the C class shares and 40% of the E class shares. A is entitled to 50% of the votes at general meetings of B, 40% of the dividends paid by B and 40% of the surplus assets on dissolution of B.

A intends to dispose of its shares in B to C and negotiations are under way.

You provided detailed information about why you believe that C and not A controlled B. The main points have been summarised as follows:

Voting shares are 50/50. These shares are valued at $1 each.

Income/capital shares are 60/40 to C. These shares entitle the holder to dividends and in the case of the company being wound up, the right to participate in the surplus profits and assets of the company.

There are four directors. Two of them are from C and the Shareholders agreement states that in the event of a deadlock a director appointed by C shall have the casting vote.

An individual from A 'manages' the day to day operations of B, including employment of staff, administration, marketing and promotion. However, his autonomy in this regard is subject to any decisions of the Board.

Decisions pertaining to matters outside the day to day operations must be referred to the Board. These include acquisition or sale of assets, borrowings, consolidation or amalgamation, acquisition of share capital or other securities, making loans or advances, creation of shares in the companies capital, payment of share dividends, cessation of business, changing location, reduction of capital, alterations to the rights attached to any class of shares, changes to the constitution, winding up the company, matters involving litigation, matters concerning power of attorney, and adoption of accounts.

Whilst there is no written agreement, you state that the control by C over B is such that A could not sell it's shares to an unrelated third party without prior approval.

C provides the funds for B by way of guarantees for the funding facilities for B.

B is treated as a member of C's extended group by B's bankers.

C owns the trade marks, brand names and marketing collateral.

C owns all customer data bases and manages all debtors of B.

The trademark and brand is wholly owned by the group.

For the purposes of the Corporations Act 2001 and the public financial reporting by the group, B is a subsidiary of the group.

A is unable to make any commitment on behalf of B without the prior approval of the group.

The individual representative of A (X) requires the prior approval of the C group regarding the strategic management of B. X is required to report monthly to C's chief executive officer who, together with its chief financial officer, are the two C group representatives on the B board.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 152-10

Income Tax Assessment Act 1997, paragraph 152-10(1)(c)

Income Tax Assessment Act 1997, section 152-15

Income Tax Assessment Act 1997, paragraph 152-15(b)

Income Tax Assessment Act 1997, section 152-20

Income Tax Assessment Act 1997, section 328-125

Income Tax Assessment Act 1997, paragraph 328-125(1)(a)

Income Tax Assessment Act 1997, paragraph 328-125(2)(b)

Income Tax Assessment Act 1997, subsection 328-125(6)

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Section 152-10 outlines the basic conditions for relief under Division 152. If certain other conditions included under paragraph 152-10(1)(c) are not met you are required to satisfy the maximum net asset value test under section 152-15.

Section 152-15 provides that just prior to the CGT event the net value of your CGT assets must not exceed $6 million. Paragraph 152-15(b) specifically includes in the calculation 'the net value of the CGT assets of any entities connected with you'.

Section 328-125 discusses the meaning of 'connected' and states at paragraph 328-125(1)(a) that 'An entity is connected with another entity if ... either entity controls the other entity in a way described in this section'. With regard to companies, you may establish control via either the right to distribution control rule under paragraph 328-125(2)(a) or the voting power control rule under paragraph 328-125(2)(b).

Paragraph 328-125(2)(a) provides that you control a company if you, your affiliates, or you together with your affiliates beneficially own, or have the right to acquire the beneficial ownership of, interests in the company that carry between them the right to receive a percentage (the control percentage) that is at least 40% of any distribution of income or capital by the company.

Paragraph 328-125(2)(b) provides that you control a company if you, your affiliates, or you together with your affiliates 'beneficially own, or have the right to acquire the beneficial ownership of, equity interests in the company that carry between them the right to exercise, or control the exercise of, a percentage (the control percentage) that is at least 40% of the voting power in the company'.

Under section 328-125 the Commissioner may also determine that you do not control the company, and under subsection 328-125(6) he provides that if the control percentage referred to in subsection 328-125(2)(a) or subsection 328-125(2)(b) is at least 40%, but less than 50%, he may determine that you do not control the company if he thinks that the company is controlled by an entity other than, or by entities that do not include, you or any of your affiliates.

We have established that subsection 328-125(2) deals with control percentages and for a company these can be in terms of income, or capital, or voting shares. In the event that these percentages differ, the highest percentage would be considered for the purposes of determining access to subsection 328-125(6). If the highest percentage is not 'less than 50%' you cannot access the Commissioner's determination provisions.

With regards to subsection 328-125(6) the Advanced guide to capital gains tax concessions for small business (NAT 3359) (the Guide) states that 'it is possible that both of the entities with a control percentage of at least 40% may control the company if such responsibilities are shared.' This confirms the Commissioner's view that control of a particular entity may in fact rest with more than one connected entity.

Application to your circumstances

The shares that are the subject of this ruling request are held by A in the company referred to as B. You submitted the constitution of B.

The constitution discusses the rights, privileges and conditions attached to "K" class shares and provides, in part, that 'they shall confer on the holders the right to receive notice of meetings and shall confer upon any holder thereof, when present in person or by proxy or by attorney at any general meeting of the Company, the right to cast one (1) vote for each share held.'

In accordance with the constitution, other share classes with voting rights attached are "A", "B", "C" and "D" class shares.

In your application you state that B's paid in share capital comprises only "K" and "E" class shares and that in accordance with the constitution the holders of "E" class shares have the right to receive dividends and to participate in any surplus profits or assets, but they do not have any voting rights.

B issued 100 "K" class shares and 100 "E" class shares.

You state that A holds 50% of the "K" class shares and 40% of the "E" class shares. Another company, C holds 50% of the "K" class shares and 60% of the "E" class shares.

As A holds 40% of the "E" class shares to which income and capital rights are attached, it follows that for the purposes of paragraph 328-125(2)(a), A controls B and is therefore connected to it.

As A holds 50% of the "K" class shares to which voting rights are attached, it follows that for the purposes of paragraph 328-125(2)(b), A controls B and is therefore connected to it.

The construction and interaction of subsections 328-125(2) and 328-125(6) are such that once a control percentage of 50% is established in either paragraph (a) or (b) of subsection 328-125(2), access to the Commissioners determination in subsection 328-125(6) is denied.

Whilst A's control percentage under paragraph 328-125(2)(a) in relation to income and capital is only 40%, it's control percentage under paragraph 328-125(2)(b) by way of its voting power rights is 50%.

Recalling the Commissioner's position that more than one entity can control and be connected to a third entity it is irrelevant whether C maintains a greater level of control over B because the fact remains that A's highest control percentage must be considered and their voting power percentage of 50% is not 'less than 50%' as is required under subsection 328-125(6). As such, A is denied access to these provisions and the Commissioner is unable to determine that it does not control B.

If the current 50/50 ratio of class "K" share holdings held by A and C is maintained up until just before the sale by A of its total share holdings in B, then for the purposes of the $6 million maximum net asset value test under section 152-15, A will be required to include in its calculation the net value of (i) its own shares in B and (ii) any of B's CGT assets that are caught under section 152-20.

If A's net asset value exceeds $6 million and it does not pass any of the other tests contained within paragraph 125-10(1)(c) then it will not satisfy the basic conditions for relief and will not be eligible for any of the concessions under Division 152.

Additional basic conditions for shares under paragraph 152-10(2)(b)

You have not specifically included this issue as a question to be answered in your ruling application, and in accordance with our response to the maximum net asset question above it may no longer be relevant. However, you refer to it in your 'references' and 'arguments' and to that extent we have provided our position for your information.

With regard to this provision you forwarded the following information:

A is a discretionary trust which is dealt with under item 3 of the table in subsection 152-70(1). In the relevant year of income distributions from the trust would be made to Individual X (60%) and Individual Y (40%). The direct small business participation percentages of both of these individuals would therefore also reflect these percentages.

In terms of item 1 of the table in subsection 152-70(1) A is entitled to 40% of the distributions of income and capital from B and therefore has a direct small business participation percentage in that company of 40%.

Under section 152-75, the indirect small business participation percentages of X and Y in B would be 24% (60% x 40%) and 16% (40% x 40%) respectively.

For the purposes of section 152-60, X is a CGT concession stakeholder in B because his small business participation percentage (24%) is greater than 20%. Y is a CGT concession stakeholder in B because she is a spouse of X who has a small business participation percentage of greater than zero.

Providing the above information is accurate for the year in which the trust distributions are expected to occur, both X and Y would be considered CGT concession stakeholders of B and their combined small business participation percentages in A would be greater than 90% (that is, 100%). Accordingly, the additional basic condition outlined under paragraph 152-10(2)(b) would be met for the disposal of the shares held in B.

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