Edited version of your written advice

Authorisation Number: 1013019784045

Date of advice: 18 May 2016

Ruling

Subject: Connected entities and affiliates

Question 1

Did Company B satisfy the control test set out in subsection 328-125(2) in relation to Company A during the Relevant Period?

Answer

Yes

Question 2

Was Company B an affiliate of one or more of the other shareholders of Company A during the Relevant Period?

Answer

No

Question 3

Will the Commissioner exercise his discretion found in subsection 328-125(6) to determine that Company B did not control Company A during the Relevant Period?

Answer

Yes

Question 4

Are Company A and Company B affiliates as defined in section 328-130?

Answer

No

This ruling applies for the following period:

1 July 201X to 30 June 201Y

The scheme commences on:

1 July 201Y

Relevant facts and circumstances

The scheme that is the subject of this Ruling is described below. The description is based on the provided documents.

Company A is an incorporated Australian company providing engineering services.

The issued share capital of Company A consists of ordinary shares only. All shares have equivalent rights in respect of voting, income and capital distributions. The current shareholders and ownership percentages since late 2012 are as follows:

Brief descriptions of the current shareholders in Company A:

• Company B is an Australian company and is represented on the Board of Directors of Company A by Y;

• X is the spouse of X (General Manager and Director);

• Z is a senior employee and Director of Company A;

Management of Company A

The composition and operation of the Board of Company A ('Board') are governed by the Shareholders Agreement. The Shareholders Agreement dictates that the number of Directors (including alternate Directors) shall be three unless the Shareholders of Company A unanimously determine otherwise. Further, each shareholder who holds at least 30% of the capital of Company A is entitled to appoint one Director.

The Chairman of the Board shall be a Director appointed by the other Directors. The chairman of the Board does not have a casting vote as chairman.

The General Manager of Company A is appointed and removed by the Board of Company A. The appointment of General Manager of Company A requires unanimous consent of the shareholders.

The General Manager is required to draft the annual business plan of Company A. This business plan then needs to be considered and approved by the Board. Decision to approve the business plan requires a simple majority.

Where the Board fails to adopt a new business plan, the business of Company A will be conducted in accordance with the business plan of the previous financial year.

Shareholders and relationships between shareholders

Z is a senior employee of Company A and part of the management team led by X.

X and Z, as senior employees of Company A, enjoy a family and commercial relationship with each other.

X's spouse is employed by the company in an administrative role with no managerial or technical responsibilities.

None of the shareholders of Company A or members of its Board, aside from Y, have commercial or family relationship with those of Company B and vice versa. The two companies do not offer their services jointly, are not answerable to one another, and have no common employees or bank accounts.

Relationship between Company A and Company B

Company B's legal and practical involvement in the operations of Company A is limited to Y's influence on decisions made by Company A's Board of Directors, which is required to meet at least twice a year and does not have responsibility to the day-to-day management of the company.

The commercial relationship between Company A and Company B is as follows:

• Company A does not consult with Company B regarding its day-to-day operations and vice versa,

• No family or other personal relationship exist between Company A and Company B, their directors or shareholders,

• The individual directors of Company A enjoys equal voting power and seniority,

• Company B is not obliged to purchase service from Company A and vice versa,

• Company A and Company B have never jointly offer their services for commercial purposes,

• There are no common employees providing services to both Company A and Company B,

• Company A and Company B conduct their businesses at separate premises,

• Company A and Company B use different management accountants, accounting systems and are audited separately, and

• Company A and Company B, maintain different bank accounts.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 328-125,

Income Tax Assessment Act 1997 - Section 328-130

Reasons for decision

Issue 1

Question 1

Section 328-125 of the Income Tax Assessment Act 1997 ('ITAA 1997') sets out the meaning of 'connected with an entity'. Specifically, subsection (1) states:

'(1) An entity is connected with another entity if:

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

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

Subsection (2) then sets out the criteria to determine when an entity directly controls another entity, other than a discretionary trust. As Company A is a company, the relevant control test is in paragraph 328-125(2)(b), which states:

'(2) An entity (the first entity) controls another entity if the first entity, its affiliates or the first entity together with its affiliates:

….

(b) if the other entity is a company - own or have the right to acquire the 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.'

As Company B controlled 43.75% of the issued share capital of Company A during the relevant period, Company B satisfied the requirement in paragraph 328-125(2)(b).

Company B directly controls Company A for the purposes of section 328-125.

Question 2

Section 328-130 of the ITAA 1997 provides the definition of 'affiliate':

'(1) An individual or company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of the individual or company.

(2) However, an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.'

Taxation Ruling 2002/6 Income tax: Simplified Tax System: eligibility - grouping rules (*STS affiliate, control of non-fixed trusts) ('TR 2002/6') sets out the Commissioner's views on the meaning of 'STS affiliate' for the purposes of determining whether an entity satisfies the eligibility rules in Subdivision 328-F. The provision has since been repealed.

Although the STS no longer operates for the 2007-08 and later income years, the definition of 'STS affiliate' under the former subdivision 328-F is closely aligned with the requirements set out in section 328-125. As such, the Commissioner's guidelines in TR 2002/6 are relevant to the meaning of affiliates for the purposes of section 328-130.

TR 2002/6 sets out a number of factors to be taken into account when determining whether two entities are acting in accordance with another's direction or wishes or acting in concert with each other.

None of the shareholders of Company A have any existing relationships with Company B outside of their participation in Company A as shareholders.

Furthermore, from the facts provided, there are no circumstances that would indicate that the remaining shareholders in Company A could be expected to act in accordance with the directions or wishes of, or in concert with, Company B in relation to Company A's business.

Therefore Company B and other shareholders of Company A, are not affiliates of each other in relation to Company A's business.

Question 3

Subsection 328-125(6) provides that:

'If the control percentage referred to in subsection (2) or (4) is at least 40%, but less than 50%, the Commissioner may determine that the first entity does not control the other entity if the Commissioner thinks that the other entity is controlled by an entity other than, or by entities that do not include, the first entity or any of its affiliates.'

While this subsection refers to 'control by entities', it does not indicate that those entities must be affiliates.

Discussion of the Commissioner's discretion under this subsection is found in paragraph 2.60 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Act 2007, which states:

'The Commissioner may think that another entity controls the entity either based on fact or on a reasonable assumption or inference. Whether or not the third entity or entities has a control percentage of at least 40% may assist in determining whether the third entity or entities control the other entity, but not decisive.'

In Company A's circumstances, Company B has a control percentage of 43.75%, worked out under subsection 328-125(2) of the ITAA 1997.

The Commissioner has considered the facts provided in the private binding ruling request specific to Company A's circumstances and thinks that a group of entities, not including Company B or its affiliates, control Company A.

Therefore the Commissioner will exercise his discretion under subsection 328-125(6) and determine that Company B does not control Company A for the purposes of this section.

Question 4

Section 328-130 states the meaning of 'affiliate' as follows:

'(1) An individual or company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of the individual or company.

(2) However, an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.'

In considering the relationship between Company A and Company B, we again refer to the factors provided in TR 2002/6.

In the facts provided, there is nothing to suggest that either Company A or Company B will act in accordance with the other's wishes or act in concert with each other. The only relationship the entities have is that Company B has a shareholding in Company A. The two companies operate independently of each other and do not co-operate in the provision of their services.

Company A and Company B are not affiliates of each other for the purposes of section 328-130.

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