Edited version of private advice

Authorisation Number: 1051673809225

Date of advice: 08 May 2020

Ruling

Subject: Commissioner's discretion and affiliates

Question 1

Will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that Entity A (A) did not control Entity B (B) for the relevant test period during the 20XX financial year?

Answer

No

Question 2

Will the Commissioner determine that A and B are not affiliates under section 328-130 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Year ended 31 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

1.    B is an incorporated entity.

2.    B is an Australian start-up technology company which is focused on the development of a certain technology.

3.    B is a proprietary company limited by shares and owned by the following shareholding percentages:

·         A - 39%

·         C - 29%

·         D - 29%

·         E - 3%

4.    A transferred fully paid ordinary shares, pursuant to the Shareholder Agreement, comprising of 1% of ordinary shares issued, to C and D respectively.

5.    Prior to the transfer of shares, A owned 40% of B during the relevant financial year.

6.    A participated in the initial funding of B in 20XX.This initial investment was exclusively used to accelerate technology development in preparation for revenue raising such that B could enhance product capability through further development and product innovation. This contribution was as a passive investor.

7.    The directors of the Board of B consisted of the following:

·         Mr F, appointed by A (F);

·         Mr G, appointed by C (G); and

·         Mr H, appointed by D (H).

8.    Voting rights for A, C and D were in line with their shareholding.

9.    The B Shareholders Agreement (Shareholders Agreement) provides the following key clauses in respect of Shareholder 1 (A):

·         Clause X Board of Directors. Must be three directors, unless the Shareholders by Unanimous Vote determine otherwise.

o   Current directors as outlined above.

o   A Chairperson of the Board may be selected by the Directors. Chairperson does not have a casting vote.

·         Clause X Board Meetings. Must be at least one Board Meeting per year. They may be conducted by telephone conference, video conference or any other means of audio or audio-visual communication.

o   Each Director on the Board is entitled to 1 vote, regardless of the number of shares held by the Shareholder that appoints that Director,

o   A quorum consists of a minimum of two Directors.

·         Clause X Decision making. All decisions of the Board or the Shareholders must be made by Simple Majority Vote which is defined as 50% or more of the votes cast by Shareholders who are present or vote by proxy.

o   Major business decisions regarding borrowings, change, suspension of business, acquisition of land, guarantees, non-arm's length dealings, outside ordinary business dealings, issue of shares or options in the Company, declaration of Dividends, new contracts, encumbrances by the Company over its assets or property in excess of $500,000, application or sale of shares in the company, execution of any contracts between Company and any Shareholder, any new business commencement, modifications in existing agreements or arrangements, matter regarding funding of the Company and any other matter the Shareholders determine that require a decision require a Super Majority Vote.

o   A Super Majority vote in respect of a resolution by Shareholders, the Board or Directors, must be passed by 75% or more of the votes cast by all Shareholders or Directors present or proxy.

·         Clause X Adoption of Business Plan. The Shareholders must ensure the Board considers and adapts a Business Plan before the commencement of each financial year.

10.  B did not hold any formal Board meetings during the relevant financial year. However, G and H met regularly to discuss strategic and operational matters involving company policy and direction. Samples of management meeting notes were provided in the client representative's email dated 20XX.

11.  Management meetings indicated all decisions for B were made by G and H with no involvement from F or other members of A. Minutes of meetings were not shared with F or required to be approved by F before any action could be taken. F had no involvement in any meetings relating to company policy and direction and leaves this decision making capacity to G and H. This is not intended to ever change. F had never attended any management meetings where key decisions were often made.

12.  F confirmed by letter that they had consulted with G and H where director input is required as they jointly manage the strategic operations and management of B and followed their direction. F has stated this will continue in the future. F has been consulted and engaged in the business but at all times relies on G and H to manage B. If a future super majority vote was required as per B's Constitution, they would consult with G and H and vote according to their direction. F does not foresee any scenario where they would exert any form of control or have any input in the strategy or direction of the B business.

13.  You have stated that during the relevant test period as no Board Meetings were held, any important strategic and operational decisions required to be made were discussed together by G and H collectively. G and H would agree on the best policy direction for B. Any decisions were ultimately agreed to by G and H together.

14.  B was registered for the R&D Tax Incentive in respect of the 20XX financial year and wishes to claim a refundable tax offset in respect of its expenditure on R&D during the 20XX financial year. B's eligibility to obtain a refundable tax offset is dependent on the Commissioner exercising their discretion pursuant to section 328-125(6) of the ITAA 1997.

15.  The relevant "test time" is during the year 20XX during which the Commissioner can consider if A does not control B because another entity or entities that do not include A, actually controlled B under subsection 328-125(6).

16.  You state that the day to day operations of B were controlled and directed by G and H.

17.  You provided the following as examples of business decisions which were made in their respective roles and how they affected the strategic direction of B:

·         Key decision making was made by both G and H in their key employment roles. G and H collectively made decisions relating to the partners B will work with, the scope of the work and future projects, as well as selection of the team that implement that work.

·         G and H brought different skill sets to the company, with G bringing strong entrepreneurial skills in building the business and liaising with partners and clients. H brought a strong technical background with sound knowledge in understanding the client's needs. G and H acted in concert to ensure the success of B.

·         Consistent with their work in concert with one another, G and H always voted together on issues of control and management of B. Any disagreements were resolved by collaborative discussion about all possible benefits and positions regarding a proposal. However, through this active discussion, G and H would ultimately agree on a strategy that was in the best interests of B.

·         There was never any "deadlock" in their voting during the 20XX financial year. If such a hypothetical situation arose, B would engage its advisors to determine the correct course of action and G and H would then vote together on the path suggested by the expert advisor.

·         Decisions involving head count and next hire requirements are made jointly by G and H. Additionally, the technology roadmap and future planned developments would be decided jointly.

·         Each minor change in ownership of B during the 20XX year was decided by G and H. These changes did not require a formal board meeting as the company is still a small start-up business focussed on research and development of its technology and learning from its technical failings. Strategic decisions can and have been made through informal joint meetings with G and H such as management meetings.

18.  As a "channel partner", A is a supplier of technical hardware. It does not develop software. A was interested in B's plans to develop software that would work in its hardware and its investment was designed to allow for future growth of its hardware business. A will continue to use other software and B software will function on an unlimited range of hardware. They will continue to act independently but occasionally provide a combined end-to-end solution.

19.  You also provided details of the relationship between A and related A entities operating from the same premises as B.

20.  F was a director on the Board of B as the representative of A. Their total involvement in Board decisions and operations of B was as follows:

·         F was the CEO and Director of A, therefore a representative of A on the B Board of Directors. However, F was not involved in any meetings or discussions that occurred between G and H in regard to the strategic, operational and policy decisions that dictated the direction of B.

·         F did not attend any management meetings where certain decisions were made. As all strategic decisions were made by G and H, F does not have any formal proxy vote. F had no involvement in decision making of B. All voting was conducted by G and H, collectively.

·         You have stated that in a hypothetical scenario where a Super Majority Vote was required per the Shareholders Agreement, A, through their representative director F would seek the direction of both G and H jointly and vote in concert with them. However, at no stage has F ever had any input into key business and strategic decisions and it is not ever intended that this will change.

·         Going into the future, A will not hold more than its current 39%. It is not planned for them, nor do they wish for, to have any input into key business and strategic directions of B.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 325-125

Income Tax Assessment Act 1997 subsection 325-125(1)

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

Income Tax Assessment Act 1997 subsection 325-125(3)

Income Tax Assessment Act 1997 subsection 325-125(4)

Income Tax Assessment Act 1997 subsection 325-125(6)

Income Tax Assessment Act 1997 section 325-130

Reasons for decision

Question 1

Summary

Based on the facts and circumstances, the Commissioner cannot form the view that control rests with another entity or entities during the test period. Therefore, the Commissioner will not exercise the discretion under subsection 328-125(6) to determine that A did not control B during the relevant test period.

Detailed reasoning

1.    Section 328-125 of the ITAA 1997 provides several control tests which govern when an entity will be deemed to be "connected with" another entity. Subsection 328-125(1) states that:

An entity is connected with another entity if:

(a)  either entity controls the other 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 [emphasis added].

2.    In relation to entities other than discretionary trusts, the relevant control test is stated in subsection 328-125(2):

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

(a)  except if the other entity is a discretionary trust - own, or have the right to acquire the ownership of, interests in the other entity that carry between them the right to receive a percentage (the control percentage) that is at least 40% of:

(i) any distribution of income by the other entity; or

(ii) if the other entity is a partnership - the net income of the partnership; or

(iii) any distribution of capital by the other entity; or

(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.

3.    There are two separate control tests for discretionary trusts - under subsections 328-125(3) & (4). Subsection 328-125(3) adopts an 'actual control' test by stating:

An entity (the first entity) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates or the first entity together with its affiliates.

4.    The other control test is in subsection 328-125(4), which states that if an entity, its affiliates, or the entity with its affiliates, receives 40% or more of the trust's income or capital in any of the last four income years, then the entity is deemed to "control" that discretionary trust.

5.    Apart from the 'actual control' test in subsection 328-125(3) - all other control tests in section 328-125 deems an entity to control another entity - regardless of whether they in fact control the entity or not.

6.    The Commissioner's discretion in subsection 328-125(6) states:

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.

7.    In the Commissioner's view, the discretion in subsection 328-125(6) of

8.    the ITAA 1997 adopts the ordinary meaning of 'controlled', i.e. it is not equivalent to 'control' for the purpose of subsection 328-125(1) or 'controls' for the purpose of the statutory tests set out in subsections 328-125(2) and (4).

9.    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 has a 40 per cent interest may assist in determining whether the third entity controls the other entity, but is not determinative.

Ordinary meaning of 'Control'

10.  "Control" is undefined and takes its ordinary meaning. The term 'control' is defined in the Macquarie Dictionary Online Edition to include:

                    (i)        To exercise restraint or direction over, dominate; command.

                   (ii)        To hold in check; curb.

11.  Thus, it is considered that the Commissioner may, in determining whether a third entity (or entities) control the other entity for the purposes of subsection 328-125(6), consider the third entity's (or entities') ability to, for example, command the other entity to undertake/not undertake actions, and other relevant facts and evidence. This would include where the third entity (or entities) have less than a majority shareholding, or even no shareholding, in the other entity. The term 'controlled' is to take its ordinary meaning.

12.  In determining the controlling entity/entities of B, the Commissioner will give consideration to who is responsible for the strategic decision making on behalf of the company as well as the day-to-day management of the company.

13.  Taxation Ruling TR 2018/5 Income tax: central management and control test of residency (TR 2018/5) provides some guidance on what to consider when determining control of an entity.

14.  Paragraphs 11-12 state that:

11. The key element in the control and direction of a company's operations is the making of high level decisions that set the company's general policies, and determine the direction of its operations and the type of transactions it will enter.

12. The control and direction of a company is different from the day-to-day conduct and management of its activities and operations. The day-to-day conduct and management of a company's activities and operations is not ordinarily an act of central management and control. Nor is the management of day-to-day activities under the authority and supervision of higher-level managers or controllers.

15.  Paragraph 14 of TR 2018/5 states:

14. Merely because a person is a majority shareholder, or has the power to appoint those who control and direct a company's operations does not, by itself, mean the person controls and directs a company's operations and activities.

16.  Paragraph 15 of TR 2018/5 defines decision making as:

15. A person, or group of people, make a decision if they actively consider and decide to do, or not do something based on it being in the best interests of the company. It does not include the mere implementation, or rubberstamping, of decisions made by others (see paragraphs 26 to 29 of this Ruling).

17.  Paragraph 16 of TR 2018/5 outlines acts that would indicate the exercise of central management and control of a company. These include setting investment and operational policy including deciding to buy and sell significant assets of the company, appointing company officers and agents (and revoking such appointments), overseeing and controlling those appointed and matters of finance including how profits are used and the declaration of dividends.

18.  Paragraphs 20-23 outline what is the starting point in considering control. It states:

A starting point

20. Normally, where a company is run by its directors in accordance with its constitution and the company law rules applicable to that company, which give its directors the power to manage the company, the company's directors will control and direct its operations. It follows that ordinarily it is a company's directors who exercise its central management and control.

21. However, the actions of a company's directors, or others with the legal power and authority to control and manage the company, are not the end of the enquiry as to who exercises central management and control. There is no presumption that the directors of a company will always exercise its central management and control.

22. When determining who exercises a company's central management and control, all the relevant facts and circumstances must be considered. Facts and circumstances to be considered in determining who exercises a company's central management and control include the role of anyone who assumes the role of the directors' role in managing and controlling the company's affairs or has a role in the decision-making processes or governance of the company.

Mere legal power or authority to manage a company is not sufficient to establish exercise of central management and control

23. A person who has legal power or authority to control and direct a company, but does not use it, does not exercise central management and control. For example, in Bywater, the court disregarded the role of those directors who were formally appointed but did not play any real role in the affairs of the company.

19.  Paragraph 24 of TR 2018/5 states:

24. A person may control and direct a company without actively intervening in the company's affairs on an ongoing basis provided they have appointed agents or managers whom they tacitly control to conduct the company's day-to-day business,· tacitly control and regularly exercise oversight of the affairs of the company, including monitoring the company's performance, and do not need to actively intervene because the company's affairs are running smoothly and in the manner they desire.

Application to your circumstances

20.  Pursuant to the statutory control test under subsection 328-125(2) and in accordance with Annexure A at paragraph 25 of the facts, A controlled B where it had ownership interests in B that carried the right to exercise, or control the exercise of, a percentage (the control percentage) that was at least 40% of the voting power of B during the relevant test period. During other periods in the 20XX financial year, A did not hold the requisite 40% interest.

21.  Therefore, the period from during the year 20XX is the relevant "test time" during which the Commissioner can consider if A does not control B because another entity or entities that do not include A, actually controlled B under subsection 328-125(6).

Your Contentions

22.  You contend that B was controlled during the relevant test time by C which owned 28.5% of B together with D which also owned 28.5% of B. In summary, the applicant contends that the following facts support this conclusion:

·         B has three directors with each director having one vote on decision making issues,

·         Normal operational matters of B require the approval of at least 50% of the votes cast by directors

·         Major strategic issues require the approval of at least 75% of the votes cast by directors

·         The appointed directors are G (C), H (D), and F (A)

·         G and H meet regularly to discuss operational and strategic matters - with F merely following the direction of G and H on both operational and strategic matters.

As such, it is contended that B was controlled by G and H during the relevant test time as they meet and agree on all operational and strategic matters - and F has always just followed their direction.

ATO position

23.  C (through G) did not control B as it has only one of the three possible director votes as per the Shareholders Agreement. As such, G has no capacity to approve decisions relating to B in the absence of support from either H or F.

24.  Similarly, D (through H) does not control B as it too only has one of the three possible director votes. As such, H has no capacity to approve decisions relating to B in the absence of support from either G or F.

25.  It is your contention that this is still evidence of control as G and H have a practice of discussing operational and strategic matters and reaching agreement on the decision in question. However in order for the Commissioner to exercise his discretion under

26.  subsection 328-125(6), there must be evidence of actual control of the company. We consider that actual control requires more than being able to demonstrate a pattern of being able to discuss operational and strategic matters with other arm's length directors and reach agreement on the particular decisions in question.

27.  Rather, we consider that actual control requires one to demonstrate that they can approve a decision even in circumstances where agreement cannot be reached with other arm's length directors. The Shareholders' Agreement does not entitle any director to have a casting vote in decision-making of the Board.

28.  It is considered that the fact that Board decisions involving a super majority vote have never happened to date with B is irrelevant - as the actual control test in subsection 328-125(6) is a hypothetical test that requires the Commissioner in forming his view to have regard to the full range of possible facts and circumstances including the outcome that would arise where agreement cannot be reached between the directors.

29.  There has been insufficient evidence provided to indicate that C (through G) would always support operational and strategic matters put forward by D (through H), including in circumstances where they were clearly not in the best interests of C. Similarly, insufficient evidence has been provided to suggest D (through H) would do likewise in relation to matters put forward by C.

30.  You have stated that there was never any "deadlock" in voting during the 20XX financial year. If such a hypothetical situation arose, B would engage its advisors to determine the correct course of action and G and H would then vote together on the path suggested by the expert advisor. It is not considered that this demonstrates "control" as there is no evidence that any one director or directors have actual control over B.

31.  For these reasons, the Commissioner cannot form the view that during the relevant test time control rests with either C or D, and nor can he form the view that control rests with C and D jointly.

Question 2

Summary

B and A are not considered to be affiliates pursuant to section 328-130.

Detailed reasoning

Meaning of affiliates

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

An individual or a 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.

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.

33.  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 been repealed).

34.  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.

35.  The scope of the affiliate definition is described in TR2002/6 as follows:

The *STS affiliate definition in subsection 328-380(8) does not apply where the potential *STS affiliate acts or could reasonably be expected to act as another directs or wishes, or in concert with it, only in relation to isolated transactions or on an irregular, ad hoc basis. For the definition to apply, the potential *STS affiliate must act in accordance with the entity's directions or wishes or in concert with it, or could reasonably be expected to so act, in relation to all or a substantial part of the affairs of the potential *STS affiliate's business.

Meaning of 'could reasonably be expected'

36.  The Full High Court, in FC of T v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344, held that the phrase 'might reasonably be expected' requires more than a possibility.

37.  An entity, the first entity, 'could reasonably be expected' to act in accordance with another entity's, the second entity's, wishes where the second entity has a relationship of control or influence over the first entity. Such a relationship can be evidenced by the entities' behaviours and the presence of any influential relationships, such as:

(a) family or other close personal relationships;

(b) financial relationships and dependencies; and

(c) relationships created through links such as common directors, partners or shareholders.

Conversely, the entities' behaviours, obligations to each other and external parties, and their own interests may evidence a lack of such a relationship.

For a company, this relationship depends on whether the majority shareholders and/or directors of the company can reasonably be expected to act in accordance with another entity's directions.

Meaning of in 'concert'

38.  TR 2002/6 explains, at paragraph 59, that entities will only be regarded as acting 'in concert' with each other where:

(a) it is acting together with the other entity in pursuit of a common goal or objective; and

(b) that common goal or objective is the carrying on of a business by the potential *STS affiliate with a substantial degree of connection with or dependence on the business carried on by the other entity.

39.  TR 2002/6 details a number of factors to take into account when determining whether two entities are acting in concert with each other. These include:

·         the nature and extent of commercial dealings between the two entities;

·         common resources, facilities or services;

·         involvement in managerial decisions and day to day management;

·         financial interdependencies;

·         common flow of profits;

·         common ownership/capital;

·         shared purchasing of goods or services;

·         common customers; and

·         similar kind of business

40.  Whether an entity is an affiliate will be a question of fact and degree in relation to which an exercise of judgement is necessary, which involves a process of evaluating and weighing a range of factors for the particular circumstances.

Application to your circumstances

41.  There is no evidence to suggest that there is any family or close personal relationships, financial relationships or dependencies between A and B. Whilst there are common directors and shareholders, there is nothing to suggest that either entity will act in accordance with the other's wishes or act in concert with each other. F is a Director of A and B but has never participated in any B management or board meetings. The only relationship the entities have is that A holds a substantial shareholding in B. There are no other routes of control by one entity over the other and no routes of common control of both companies by any third parties.

42.  On the facts, it does not appear that A and B were acting in concert with one another. The following factors support this conclusion:

·         Involvement in managerial decisions and day to day management was conducted by G and H as representatives of C and D respectively. They also managed all day to day decision making of B.

·         Financial interdependencies - there was no sharing of loans or guarantees.

·         Common flow of profits - there was no common flow or shared profits.

·         Sharing purchase of good and services - purchase of goods and services was not shared.

·         Common customers - they each had their own different clients.

43.  Thus, B and A are not considered to be affiliates pursuant to section 328-130 of the ITAA 1997.

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