Edited version of private advice

Authorisation Number: 1052002114587

Date of advice: 4 July 2022

Ruling

Subject: Commissioner's determination - control over an entity

Question

Will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that XYZ does not control the Company?

Answer

No.

This ruling applies for the following period:

1 October 20XX to 30 September 20YY

Relevant facts and circumstances

The Company registered with the Australian Securities and Investments Commission in June 20ZZ and is a boutique fund manager exclusively focused upon investing in small Australian companies.

A Shareholders Agreement was executed in August 20ZZ to record an agreement between the Company, 'Investment Team Members' and shareholders in relation to the ongoing control, management and funding of the Company, and rights and obligations of the shareholders as members of the Company.

A, B and C are Investment Team Members under the terms of the Shareholders Agreement, as well as 'Relevant Employees' of the Company, defined in the Shareholders Agreement as an employee who has a 'Nominated Holder' which holds shares in the Company on their behalf.

As the Nominated Holder for A, AAA Pty Ltd in its capacity as trustee of the AAA Trust (a family trust of A) is an 'Investment Team Shareholder' in the Company.

As the Nominated Holder for B, BBB Pty Ltd in its capacity as trustee of the BBB Trust (a family trust of B) is an Investment Team Shareholder in the Company.

As the Nominated Holder for C, CCC Pty Ltd in its capacity as trustee of the CCC Trust (a family trust of CCC) is an Investment Team Shareholder in the Company.

The Company has 1,000,000 ordinary shares on issue held by the three Investment Team Shareholders and XYZ as follows:

All ordinary shares on issue carry equal rights to vote, income and capital distributions.

The Company's Board must be comprised of five directors, one of whom was required to be appointed (as an 'Investment Team Director') by each Investment Team Shareholder and two of whom were required to be appointed by XYZ (in accordance with the Shareholders Agreement).

In their capacity as Investment Team Shareholders, AAA Pty Ltd, BBB Pty Ltd and CCC Pty Ltd appointed A, B and C respectively as an Investment Team Director of the Company.

The two directors/Board members appointed by XYZ are D and E.

Subject to the Corporations Act, a director may only be removed by their appointing shareholder.

A director appointed by a particular shareholder may have regard to, act in the interests of, and participate in Board decisions relating to, its appointing shareholder, except where in so doing the director is not acting in the best interests of the Company as a whole.

A quorum for a meeting of directors is three directors or any greater number determined by the Board, of whom at least one director must be appointed by XYZ and two appointed by the Investment Team Shareholders. At a meeting of directors, each director has one vote.

Pursuant to the Shareholders Agreement, the Company and the Business is managed on a day-to-day basis by the Investment Team Members in accordance with the Business Plan and Budget, and the Investment Team Members report, and are responsible, to the Board which is responsible for the overall direction and management of the Company and the formulation of the policies to be applied to the Company and the Business.

Role of the Board

The Board is responsible for the overall direction and management of the Company and the formulation of the policies to be applied to the Company and the Business. This clause applies subject to any matters requiring Shareholder approval under this agreement and the Corporations Act.

Day to day management

The Company and the Business is to be managed on a day-to-day basis by the Investment Team Members or any other person approved by the Board in accordance with the Business Plan and the Budget. The Investment Team Members (and any other person approved by the Board under this clause) report, and are responsible, to the Board.

The role and responsibility of the Board is subject to any specific matters requiring shareholder approval, including the matters listed in Schedules 1 and 2 of the Shareholders Agreement.

Except for the matters specifically requiring either a 'Special Shareholders' Resolution', a 'Shareholder Representation Directors' Resolution' or a 'Shareholder Majority Representation Directors' Resolution', all other directors' resolutions must be decided by 'Ordinary Directors' Resolution', defined in the Shareholders Agreement to mean:

... a resolution of the Directors ... which is approved by the Directors ... present and voting (who are not disqualified from voting on that resolution) who between them hold more than one half of the total number of votes that may be exercised by all of the Directors... who are not disqualified from voting on that resolution and who are present and voting on that resolution.

The Special Shareholders' Resolution is defined in the Shareholders Agreement to mean:

... a resolution of the Shareholders which is approved by Shareholders who between them hold more than 50 percent of the total number of Shares held by all of the Shareholders who are not disqualified from voting on that resolution and provided that:

(i)    the majority of the Investment Team Shareholders; and

(ii)   [XYZ]

vote in favour of the resolution.

Matters listed in Schedule 1 of the Shareholders Agreement requiring a Special Shareholders' Resolution relate to:

• any corporate action which alters the equity structure of the Company
• changes to the Constitution
• merging or amalgamating with any other entity
• winding-up the Business
• an alteration to rights attaching to shares
• the appointment or removal of the Company auditor
• a change of the Company's name
• a significant disposal of Company assets or of a part of the Business
• the issue price of a new share.

The Shareholder Representation Directors' Resolution is defined in the Shareholders Agreement to mean:

... a resolution at a Board meeting which is approved by Directors (who are not disqualified from voting on that resolution) who together comprise more than half of the Directors who are not disqualified from voting on that resolution, and who are present and voting on that resolution and provided that at least one [XYZ] Director and one Investment Team Director vote in favour of the resolution.

Matters listed in Schedule 2 of the Shareholders Agreement requiring a Shareholder Representation Directors' Resolution relate to:

• the distribution of profits, declaration of dividends etc.
• the Board fees payable
• variation of the terms of an Investment Team Member's employment
• the engagement of key employees
• entry into settlement of any material litigation, dispute or regulatory investigation
• proposals to change the composition of the Board
• amendments to the Distribution Agreement
• the Company's entry into or becoming liable under a guarantee or indemnity
• the adoption of, and amendment to, any risk management procedures.

The Shareholder Majority Representation Directors' Resolution is defined in the Shareholders Agreement to mean:

... a resolution at a Board meeting which is approved by Directors (who are not disqualified from voting on that resolution) who together comprise more than half of the Directors who are not disqualified from voting on that resolution, and who are present and voting on that resolution and provided that at least one [XYZ] Director and two Investment Team Directors vote in favour of the resolution.

Matters listed in Schedule 2 of the Shareholders Agreement requiring a Shareholder Majority Representation Directors' Resolution relate to the termination of an Investment Team Member's employment and incurring any financial indebtedness.

It is submitted that:

• as part of their day-to-day management of the Company, all operational matters are handled by the Investment Team Members personally, without the requirement of a Board meeting or any involvement by the two XYZ directors;
• the XYZ directors are not involved in the day-to-day or strategic decision-making of the Business;
• XYZ has two votes at most, and as such holds no power to initiate or pass resolutions in its own right;
• all resolutions passed since inception at Board level by way of Ordinary Directors' Resolution, Shareholder Representation Directors' Resolution or Shareholder Majority Representation Directors' Resolution, have been 'rubber stamped' by the XYZ director or directors in attendance as a formality as the three Investment Team Directors exert sufficient control;
• all resolutions passed since inception by way of Special Shareholders' Resolution have been 'rubber stamped' by XYZ as a formality as the three Investment Team Shareholders exert sufficient control; and
• at no time has XYZ or an XYZ director voted differently to that of the Investment Team Shareholders or Directors, as applicable.

None of the Investment Team Members is an affiliate of another in accordance with subsection 328-130(1) of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 paragraph 328-115(2)(b)

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 subsection 328-125(1)

Income Tax Assessment Act 1997 subsection 328-125(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)

Reasons for decision

Detailed reasoning

Taxpayers need to determine their aggregated turnover for many reasons under taxation laws, including access to concessions. An entity's aggregated turnover includes the annual turnover of entities connected with it: subparagraph 328-115(2)(b).

Section 328-125 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.

In relation to entities other than discretionary trusts, the relevant control test is stated in subsection 328-125(2). Pursuant to paragraph 328-125(2)(b), an entity (the first entity) controls a company if the first entity, its affiliates or the first entity together with its affiliates 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.

The Commissioner's discretion, as set out in subsection 328-125(6) states the following:

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.

In the Commissioner's view, the discretion in subsection 328-125(6) adopts the ordinary meaning of 'controlled'. The term 'controlled', for the purposes of subsection 328-125(6), is undefined.

The Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (the EM) states:

2.59 Where an entity's interest in another entity is at least 40 per cent but less than 50 per cent, Commissioner may choose to ignore the interest of that entity in the other entity if the Commissioner determines that a third entity actually controls the other entity.

2.60 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 it is not decisive.

Thus, it is actual control that is taken into account.

Further, the use of the words 'a reasonable assumption or inference' indicates the intention of the legislation was to give the broadest powers possible to the Commissioner. Example 2.10 in the EM states:

Chandra owns a restaurant with a turnover of less than $2 million and has inherited his father's 42 per cent interest in a software company. The other 58 per cent of the software company is owned by the manager of the company, and Chandra has had no dealings with the manager whatsoever.

The turnover of Chandra's restaurant will not be aggregated with the turnover of the software company if the Commissioner thinks that the software company is actually controlled by the other person with the 58 per cent interest.

Example 2.10 suggests that in considering whether 'the software company is actually controlled by the other person with the 58 per cent interest' the Commissioner turns his mind to who controls the software company in the ordinary sense, regardless of the percentage interest held.

To determine whether the third entity controls the other entity in the ordinary sense of that term, all relevant facts and evidence will be considered to determine actual control. The Commissioner is not restricted by an entity's legal ownership interest.

The Commissioner may think that an entity has actual control based either on fact or on a reasonable assumption or inference. The exercise of the discretion will turn on the facts and circumstances of any case.

Application to your circumstances

Under subsection 328-125(2), XYZ will be deemed to control the Company for the 2022 income year on the basis that XYZ owns shares in the Company that carry between them the right to exercise or control the exercise of at least 40% of the voting power in the Company.

However, the Commissioner may exercise his discretion under subsection 328-125(6) to make a determination that XYZ does not control the Company for the 20YY income year if:

(1)  XYZ's control percentage (as referred to in paragraph 328-125(2)(b)) is less than 50% for the year; and

(2)  the Commissioner thinks that the Company is controlled by an entity other than XYZ or any of its affiliates, or by entities that do not include XYZ or any of its affiliates.

As a result of its holding of 40% of the shares issued in the Company, XYZ controls the exercise of 40% of the voting power in the Company (i.e. a control percentage of at least 40% but less than 50%), and satisfies the first requirement.

It is therefore necessary to determine if the Company is controlled by a third entity other than XYZ or any of its affiliates, or by entities that do not include XYZ or any of its affiliates.

Does another entity, or entities, control the Company?

Relevantly:

• the Board, comprised of three Investment Team Directors and two XYZ directors, is broadly responsible for the overall direction and management of the Company;
• the quorum for a meeting of directors is three, of whom at least one must be a XYZ director and two an Investment Team Director;
• at a meeting of directors, each director has one vote and all directors' resolutions require approval by all directors present and voting;
• all matters specified under Schedule 1 of the Shareholders Agreement requiring Special Shareholders' Resolution require the vote of at least two Investment Team Shareholders, in addition to the vote of XYZ;
• all matters specified under Schedule 2 of the Shareholders Agreement requiring Shareholder Representation Directors' Resolution require the vote of at least one Investment Team Director, and at least three directors in total (one of whom includes a XYZ director); and
• all matters specified under Schedule 2 of the Shareholders Agreement requiring Shareholder Majority Representation Directors' Resolution require the vote of at least two Investment Team Directors, and at least three directors in total (one of whom includes a XYZ director).

Except for the matters specified under Schedule 1 of the Shareholders Agreement which are determined by the shareholders, the Board determines a broad list of topics central to many operational or management decisions relevant to running the Company. Therefore, the Board broadly has the authority to operate or manage the Company.

For the Commissioner to think that an entity or entities control the Company, that entity or entities would need to be able to determine Board decisions, either directly, or indirectly through its right to appoint or remove directors. An entity will not be able to demonstrate control of the Company if it cannot determine important matters relating to policy and strategic direction of the Company in its favour without the support of other parties. In other words, if entity A cannot determine a decision or resolution on such matters if entity B disagrees with it, entity A does not control the Company.

From the current shareholding and Board composition, no single Investment Team Director (or their associated Investment Team Shareholders) considered independently, would be able to carry a motion without the support of other directors (or shareholders). Therefore, it cannot be said that any Investment Team Director or Investment Team Shareholder, taken independently, can demonstrate the power to control the Company.

While subsection 328-125(6) clearly contemplates the possibility that multiple entities could, in some circumstances, exercise collective control, it would not be appropriate for the Commissioner to treat multiple entities as a collective unless they have a relationship which clearly demonstrates a common identity or collective interests that would mean they do together have actual control of the business (for example, they are affiliates). Although shareholders might have some common identity or collective interests (for example, a common desire for the entity to generate profits), something more than this would be needed to show that the entities could be considered collectively as a group having control of the entity. We do not consider it appropriate to regard multiple unrelated entities as a collective simply where their combined votes, if they agreed, would carry a shareholder or board resolution.

Further, a habit or established practice of acting together, or conducting the business on a 'consensus basis', would not necessarily demonstrate that multiple unrelated entities can be considered as a group, or collective controllers for the purpose of establishing whether they have control of the business, for the purposes of determining whether the discretion in subsection 328-125(6) is available. This is because unrelated parties would normally only agree where they have determined that collective action was in their individual interests. The relationship would not offer any guarantee or reasonable certainty that they would continue to act collectively, or make consensus decisions where their interests ceased to coincide. Once two independent, unrelated entities had conflicting interests about a company matter, they would be unlikely to vote together. Given that possibility, we could not be satisfied that unrelated entities could be a group which exercises control.

There is no explicit requirement in subsection 328-125(6) that multiple entities must be 'affiliates' or 'connected entities' to exercise collective control. However, we consider that these are examples of circumstances in which it may be appropriate for the Commissioner to think that they exercise collective control. If entities are connected, they would most likely have common ownership and/or a common controlling mind. If entities are affiliated, one would either act in accordance with the directions or wishes of the other, or they both act in concert, in relation to any business they separately carry on. When considering control of a company, it would usually be reasonable to expect that two connected or affiliated shareholders or directors would always vote together in any shareholder or director resolution. They would be unlikely to have conflicting interests, and even if their personal interests sometimes diverged, their close relationship might override those interests to ensure agreement.

It is considered unlikely that a relationship between entities, where they were not affiliated or connected, and each exercises independent judgment, would provide the Commissioner with assurance that they would continue to act collectively in the future. Therefore, the Commissioner would be unlikely to think that those multiple entities held control.

The Investment Team Directors cannot be connected entities because they are all individuals, and no information has been provided to the Commissioner to suggest that:

• the Investment Team Shareholders are connected under any of the relevant control tests in section 328-125; or
• any of the Investment Team Directors are connected with any Investment Team Shareholders (other than the one they have elected as Nominated Holder).

While the Investment Team Directors have never voted against each other in practice, this is presumably because each, exercising their own independent judgment, have concluded that the resolution or decision supported their interests or the interests of their associated Investment Team Shareholder. A mere history of voting together does not justify treating multiple unrelated entities as exercising collective control. Rather, this simply evidences that the Investment Team Directors have a style or preference for running the Business on a consensus basis, as they consider this achieves the best results for the Business. If this was enough to treat multiple entities as having collective control, it would mean that a diverse group of unrelated parties with small shareholdings could be treated as 'controlling' another entity for the purposes of subsection 328-125(6). This seems an unlikely result.

If the interests of the Investment Team Directors did not align, or ceased to align, we expect that they could exercise their vote as a director to vote against a resolution advanced by another. Their history of having run the Business on a consensus basis up until now would not ensure that they would continue to do so if their interests ceased to align; and disagreement over a significant business decision could arise. Therefore, we do not see any compelling reason why they should be treated as a collective or group when determining whether they have control of the Company for the purposes of determining the subsection 328-125(6) discretion.

Even if the Investment Team Directors could be treated as a collective or group when determining whether they have control of the Company for the purposes of determining the subsection 328-125(6) discretion (which is not conceded), they are unable to determine many operational or management decisions relevant to the running of the Company without the approval of one (if not two) XYZ directors.

The fact that a XYZ director has never voted against any decision made by an Investment Team Director, or that XYZ has never voted against any decision made by an Investment Team Shareholder, is also not determinative of collective control. If a history of voting together is enough for multiple entities to establish collective control for the purposes of the Commissioner's discretion under subsection 328-125(6), there would seem no reason to include the Investment Team Directors from the relevant group of entities but exclude the XYZ directors.

It is concluded that the Investment Team Directors (and/or the Investment Team Shareholders) should not be treated collectively when determining whether they control the Company. Since no one Investment Team Director can demonstrate individual control, and it is not considered appropriate to treat them as a group exercising collective control, it follows that no other entity or entities controls the Company in the sense required by subsection 328-125(6), and the Commissioner's discretion is not available.

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