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Edited version of your written advice
Authorisation Number: 1012826465685
Date of advice: 24 June 2015
Ruling
Subject: Application of paragraph 102N(1)(b) of the Income Tax Assessment Act 1936 ( ITAA 1936)
Question
Will paragraph 102N(1)(b) of the ITAA 1936 apply to X Trust?
Answer
No
This ruling applies for the following periods:
• Year ending 30 June 2016
• Year ending 30 June 2017
• Year ending 30 June 2018
• Year ending 30 June 2019
• Year ending 30 June 2020
Relevant facts and circumstances
1. OpCo is carrying on a trading business.
2. The three shareholders of OpCo are Y Co, X Trust and Z Co. Y Co and X Trust each hold greater than 40% of the ordinary shares in OpCo while Z Co is the minority shareholder.
3. The constitution of OpCo provides that the directors have decision-making power in respect of most aspects of the affairs and operations of the trading business.
4. The shareholders agreement among Y Co, X Trust and Z Co provides additional rights to the shareholders and directors.
Relevant legislative provisions
Income Tax Assessment Act 1936 paragraph 102N(1)(b)
Reasons for decision
Subsection 102N(1) of the ITAA 1936 provides that a unit trust is a trading trust in relation to a year of income for the purposes of Division 6C, if at any time during that year the trustee:
(a) carried on a trading business, or
(b) controlled, or was able to control, directly or indirectly, the affairs or operations of another person in respect of the carrying on by that other person of a trading business.
Under paragraph 102N(1)(b) of the ITAA 1936, X Trust would only be a trading trust in relation to a year of income, if it was considered to control, or be able to control, directly or indirectly, the affairs or operations of OpCo in respect of OpCo's carrying on of its trading business.
The term 'control' or 'controlled' is not defined for the purposes of Division 6C of Part III of the ITAA 1936. Accordingly, its meaning must be construed by reference to its normal meaning.
'Control' is defined in the Macquarie Dictionary, 2001, rev. 3rd edn, the Macquarie Library Pty Ltd, NSW:
1) To exercise restraint or direction over; dominate, command;
2) To hold in check, curb.
Therefore, the concept of 'control' encompasses both the positive aspect of directing or commanding and the negative aspect of restraining. The view that power of veto constitutes control for the purposes of paragraph 102N(1)(b) of the ITAA 1936 is adopted in ATO Interpretative Decision ATO ID 2003/162 Public trading trust - meaning of control and ATO ID 2011/11 Trading trust: meaning of 'control' and 'affairs or operations' of another person.
The control of a company may operate at both the shareholder and director level. Shareholders exercise control by means of majority voting rights as well as negative control. Mahoney JA in North Sydney Brick & Tile Co Ltd v. Darvall & Anor (1986) 10 ACLR 837 at 844 commented on a shareholder's negative control:
The part that a shareholder plays in the restrictions imposed by these articles is, in a sense, negative rather than positive: they empower him to prevent … but do not authorise him to permit … But a power to prevent, in this sense, may constitute a power to control within the section
The respective roles played by shareholders and directors were summarised by Stephen, Mason and Wilson JJ in FCT v. Commonwealth Aluminium Corporation Ltd (1980) 143 CLR 646 at pp 659-60:
… Important decisions, whether involving questions of policy or not, are invariably taken by the directors who are ultimately responsible to the company in general meeting for the conduct of the business operations. The shareholders, through their power to control the company in general meeting and perhaps through their power to elect directors, may be said to control the company, but as a general rule they do not exercise de facto control of the company's business.
The words 'able to control' require a present ability to control, whether or not that ability is exercised, but does not include a power by some means or other to obtain the ability to control if that power is not exercised. In WP Keighery Pty Ltd v FC of T (1959) 100 CLR 66 at pp 86-87, Dixon CJ, Kitto and Taylor JJ said:
But to describe a company as capable of being controlled by a person or group of persons is to attribute to that person or group a presently existing power of control. 'Capable of being controlled' in this context cannot be interpreted so widely as to be satisfied whenever a possibility of obtaining control over a company exists by reason of something in its constitution or its special circumstances … The truth is that 'capable of being controlled' connotes the existence of either one person whose enforceable and immediately exercisable rights enable him to control, or a number of persons whose enforceable and immediately exercisable rights enable them, if they act in concert, to control
The effect of the words 'directly or indirectly' imply that although the trustee may not, in fact, control or be able to control the affairs or operations of another person, they do so or may do so through their control of an interposed entity (British American Tobacco Co Ltd v. Inland Revenue Commissioners (1943) AC 335). In this case, there is no interposed entity between X Trust and OpCo.
The terms 'affairs' and 'operations' are not defined in the legislation. The Macquarie Dictionary, [online], viewed 24 March 2015, www.macquariedictionary.com.au , relevantly, defines 'operation' as follows:
• A course of productive or industrial activity;
• A particular course or process;
• A business transaction, especially one of a speculative nature or on a large scale.
Therefore, the meaning of 'operations' is quite narrow. We regard it as a reference to the day-to-day business of the company.
The term 'affairs' has a much broader meaning. Winn J in R v. Board of Trade, ex parte St Martin Preserving Co Ltd [1964] 2 All ER 561 AT 568, said:
… the phrase "affairs of the company" comprises all its business affairs, interests or transactions, all its investment or other property interests, all its profits and losses, and its goodwill.
For the purposes of Division 6C of Part III of the ITAA 1936, it is reasonable to adopt this broad meaning, given the context within which the provision is intended to operate, as evidenced from the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 4) 1985 (which introduced Division 6C):
Paragraph (b) of section 102N is a safeguarding provision against arrangements to circumvent the operation of Division 6C by having activities that would constitute a trading business of a public trust carried on by an associated entity. By taking income from the associate in the form of eligible investment income, the trust could otherwise ensure that the relevant trust did not qualify as a trading business and so avoid the operation of Division 6C.
This broad meaning of 'affairs' is adopted in ATO Interpretation Decision ATO ID 2011/11. In ATO ID 2011/11, it was held that 'affairs or operation' encompass structure, scope and management of the company. However, the relevant affairs and operations to which paragraph 102N(1)(b) are concerned are those that go to the trading business actually being carried on.
A trading business is a business that does not consist wholly of eligible investment business, which includes, relevantly, investment in land primarily for the purpose of deriving rent (section 102M of the ITAA 1936). OpCo will be carrying on a trading business.
The additional rights provided in the shareholders agreement do not affect the trading business of OpCo. Based on the facts provided, X Trust does not have positive or negative control over OpCo in respect of the carrying on by OpCo of its trading business.
Accordingly, paragraph 102N(1)(b) of the ITAA 1936 will not apply to X Trust by virtue of its proposed investment in OpCo.
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