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Ruling

Subject: Connected entities - Commissioner's discretion

Question

Will the Commissioner's discretion be exercised under subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that Company X will not control Company Z if the option is exercised?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

An agreement was executed between Company X and the existing shareholders of Company Z (the applicant). The agreement provided Company X with shares in Company Z and Company X's CEO became a director of Company Z.

The agreement included an option enabling Company X to increase its shareholding to more than 40% by investing further in Company Z. Under this option, Company X has the right but not the obligation to further invest in Company Z.

If the option was to be exercised, none of the remaining shareholders, other than Company X, would hold an interest in Company Z of 40% or more in their own rights.

All shares carry the same voting rights.

The CEO of Company X has expressed on a number of occasions via correspondence to Company Z that they are not interested in taking control of the company or its day to day operations and is happy for the management team to determine Company Z's business objectives.

Company X is based abroad with offices worldwide.

There has been limited business dealings between Company X and Company Z to date and Company Z has not been given any preferential treatment by Company X.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 328-125

Income Tax Assessment Act 1997 Subsection 325-125(2)

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

Income Tax Assessment Act 1997 Subsection 328-125(6)

Income Tax Assessment Act 1997 Subsection 328-130(1)

Income Tax Assessment Act 1997 Subsection 328-130(2)

Reasons for decision

Detailed reasoning

The meaning of a connected entity is defined under section 328-125 of the ITAA 1997 which states as follows:

An entity is connected with another entity if:

(a) either entity controls the other entity in the way described in this section; or

(b) both entities are controlled in a way described in this section by the same third entity.

Direct control of a company

Paragraph 328-125(2)(b) of the ITAA 1997 provides that an entity controls a company if the entity, its affiliates, or the entity together with its affiliates beneficially own 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.

In this case, if the option is exercised by Company X to increase their shareholding, Company X will hold a control percentage of more than 40% but less than 50%. Accordingly, Company X will control Company Z in accordance with subsection 325-125(2) of the ITAA 1997.

Commissioner may determine that an entity does not control another entity

If an entity's control percentage in a company is at least 40% but less than 50%, the Commissioner may determine under subsection 328-125(6) of the ITAA 1997 that the first entity does not control the other entity if the Commissioner thinks that the entity is controlled by a third entity (other than an affiliate of the first entity).

For the Commissioner to be able to consider the exercise of discretion in subsection 328-125(6) of the ITAA 1997 there must be a single, identifiable third entity that has a control percentage of at least 40% of the company. In working out the third entity's control percentage, the interests of any affiliates of the third entity are taken into account. The third entity must control the company in the way described in subsection 328-125(2) of the ITAA 1997. Unless the conditions of subsection 328-125(2) of the ITAA 1997 are met the Commissioner cannot determine that the first entity does not control the company.

If there was a third entity with a control percentage of 40% or more it would then be necessary to consider additional factors such as who is responsible for the day to day and strategic running of the company to determine if the third entity controls it. It is possible that both of the entities having a control percentage of at least 40% may control the company if such responsibilities are shared.

In this case, for the Commissioner to consider the exercise of the discretion contained in subsection 328-125(6) of the ITAA 1997 there would need be a single, identifiable third entity that would have a control percentage (including the interests of its affiliates) in Company Z of more than 40% following the increase in Company X's shareholding. None of the shareholders other than Company X will hold a control percentage of 40% or more in their own right. Accordingly, we must consider if there is an affiliate relationship between any of the remaining shareholders.

Affiliates

An affiliate is an individual or a company that, in relation to their business affairs, acts or could be reasonably expected to act in accordance with your directions or in concert with you (subsection 328-130(1) of the ITAA 1997). The Advanced guide to capital gains tax concessions for small business 2011-12 (NAT 3359), provides a number of relevant factors that may support a finding that a person is an affiliate of a taxpayer in accordance with subsection 328-130(1) of the ITAA 1997:

· the existence of a close family relationship between the parties

· the lack of any formal agreement or formal relationship between the parties dictating how the parties are to act in relation to each other

· the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements or legal or fiduciary obligations, and

· the actions of the parties.

However, subsection 328-130(2) of the ITAA 1997 points out that an individual or company is not your affiliate merely because of the nature of the business relationship. For example, companies and trusts are not affiliates of their directors and trustees respectively and vice versa, merely because of the positions held.

You have provided information regarding the relationships between the remaining shareholders. You have argued that all but one of the remaining shareholders, are affiliated with the management team of Company Z. However, the relationships between the remaining shareholders are based on formal business relationships and agreements. You have not provided any evidence of a family or other personal relationship between the parties.

You have provided evidence to show that these shareholders have previously supported the business strategies implemented by the management team and have injected further funds into the business when asked. However, there is no indication that these shareholders would act in concert with the management team based on any personal relationships they share. They simply share a business relationship that has been created by their common financial interests in the company. These factors alone do not support the finding that these entities are affiliates of the management team.

Accordingly, we do not consider that the remaining shareholders are affiliates of the management team.

Conclusion

As explained above, the key requirement to enable the consideration of the discretion is the existence of a single, identifiable third entity that has a control percentage (including the interests of its affiliates) of more than 40%.

As the affiliate relationships between the remaining shareholders have not been established, there will not be a third entity that holds a control percentage of more than 40%. Although we accept the evidence you have provided to indicate that the controller of Company X is not interested in being involved in the day to day management of Company Z, the Commissioner is not satisfied that there is a third entity that could be taken to control Company Z.

Accordingly, the Commissioner cannot exercise his discretion under subsection 328-125(6) of the ITAA 1997. If the option is exercised, and Company X's control percentage increases to Y%, Company X will control Company Z in accordance with section 325-125(2) of the ITAA 1997.

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