Edited version of private advice

Authorisation Number: 1052257912191

Date of advice: 18 June 2024

Ruling

Subject: CGT - small business concessions

Question 1

Would Company A and Entity B be connected for the purpose of the $6,000,000 maximum net value asset test as outlined in section 152-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

If yes, can the Commissioner exercise his discretion to disregard this connection pursuant to section 328-125(6) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Income year ended 30 June 2024

The scheme commenced on:

1 July 2023

Relevant facts and circumstances

Company A is a trading entity that runs an XXXXXXX business.

Entity B owns 49% B class shares in Company A.

Company A also has 51% of A class shares on issue to a third party.

The A and B class shares have equal rights in terms of voting at general meetings, receiving dividends and capital distributions upon the company winding up.

When Company A was originally created it was the understanding between all the shareholders that Entity B and Individual B would purely be silent investors and take no part in the actual running of the business.

Individual B has never been a director of Company A and has never taken any part in the running of the business.

The shareholders agreement outlines the responsibilities of all parties involved:

•         The Board is responsible for the direction and control of Company A.

•         The Board consists of one director, Individual A.

•         Individual A holds the power to appoint, remove and replace that director.

•         Individual A is the initial sole director and managing director responsible for the day-to-day operations of Company A.

Individual B is and has been a silent investor since the inception of the company as outlined by the company constitution and shareholders agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-125(2)

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

Reasons for decision

Question 1

Subsection 328-125(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that:

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.

Direct control of an entity other than a discretionary trust, such as a company, is defined in subsection 328-125(2) of the ITAA 1997.

Under paragraph 328-125(2)(b) of the ITAA 1997, an entity controls a company where the entity and/or 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 at least 40% of the voting power in the company (the control percentage).

Paragraphs 2.46 and 2.47 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 provide:

2.46 An additional test applies for the control by entities of companies. If either this test, or the 40 per cent ownership test is satisfied, then that entity controls the company.

2.47 Control of a company will be established if an entity alone or together with affiliates beneficially own, or has the right to acquire beneficial ownership of, interests in the company with at least 40 per cent of the voting power in the company.

Application to your circumstances

The ordinary shares that constitute the issued capital of John & James Insurance Services Pty Ltd have equal rights to voting and the distribution of income and capital. Entity B has shareholding of more than 40% but less than 50% in Company A and it satisfies the control percentage requirement in paragraph 328-125(2)(b) of the ITAA 1997. As such Entity B satisfies the direct control test contained in subsection 328-125(2) of the ITAA 1997 and is therefore taken to be connected with Company A for the purposes of the maximum net value asset test.

Question 2

Where the first entity has a control percentage of at least 40% but less than 50%, subsection 328-125(6) provides the Commissioner with a discretion to determine that it does not control the test entity (the Commissioner's discretion). To make that determination, the Commissioner must think the test entity is controlled by an entity or entities (the third entity or entities) that is not, or does not include, the first entity or any of its affiliates.

The statutory condition for exercising the Commissioner's discretion requires that the Commissioner positively conclude that there is actual control by a third entity or entities. It is not sufficient to merely show that the first entity is not a controller.

Taxation Determination TD 2023/5 Income tax: aggregated turnover and connected entities - Commissioner's discretion that an entity does not 'control' another entity provides guidance on particular issues that have emerged from the administration of the discretion in subsection 328-125(6) of the ITAA 1997 to determine that an entity does not "control" another entity. The relevant paragraphs from TD 2023/5 are presented and discussed in more detail below.

Sole or primary responsibility for the day-to-day management of the affairs of the test entity, while not irrelevant to the question of who controls that entity, does not of itself constitute control for the purposes of the Commissioner's discretion in subsection 328-125(6). The context of the aggregated turnover rules in Subdivision 328-C, and the concept of 'control' that underpins the primary control tests, support this view.

Having regard to the statutory context, the nature of control relevant for the Commissioner's discretion is control over those matters typically associated with ownership of a business entity. That is, entitlements to income and capital of the entity as well as participation in decision making on key matters affecting the entity's constitution, funding, structure and management. The latter would ordinarily include matters such as:

•         decision making on the composition and oversight of the management team

•         amending the entity's constituent documents

•         deciding on capital and entity restructuring proposals, the issue of new ownership interests or winding up, and

•         authorising significant changes in the direction of the entity's business operations.

Other ways in which an entity may be said to be 'controlled', such as the control exercised by managers with responsibility for the day-to-day conduct of the business of the entity, do not of themselves constitute control of the entity in the sense contemplated by the aggregation rules. It is necessary to distinguish control of an entity from powers in respect of the conduct of an entity's business.

Managers or directors with responsibility for the day-to-day conduct of a company's business may have considerable autonomy in making significant business decisions, but this of itself is not considered relevant 'control' of the entity for the purposes of subsection 328-125(6).

Example 2.10 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (EM) illustrates when the discretion might be exercised to disregard a control percentage interest of between 40% and 50% on the basis of a conclusion that a third entity controls the test entity. The example refers to a manager of the test entity with a 58% shareholding in that entity, and another person with a 42% shareholding who has no dealings at all with the manager.

We consider that, in these circumstances, the significance of who manages the business of the test entity stems from the relative ownership interests which dictate who has the power to determine who performs the managerial function. The identity of who actually performs the managerial function is generally of limited relevance to the question of control of the test entity. The manager in Example 2.10 of the EM, with the 58% shareholding, would not cease to control the test entity merely because they decided to appoint a new manager with full responsibility for the day-to-day conduct of the business of the entity.

We also consider that Example 2.10 of the EM illustrates circumstances in which we would be likely to conclude that the test entity is controlled by a third entity (the 58% shareholder) and exercise the discretion to disregard the 42% shareholding accordingly. The holding of interests carrying rights to more than 50% of the income, capital and voting power in a company is consistent with control of the company for the purposes of subsection 328-125(6). Assuming that the majority ordinary shareholding is sufficient to carry the vote on most or all of the fundamental matters relating to the test entity, we would think there is control by the third entity unless the third entity's control through its majority shareholding is in some way qualified or compromised by other circumstances or arrangements.

Application to your circumstances

Entity B has at least 40%, but less than 50% of control in the Company A. Therefore, the first condition set out in subsection 328-125(6) is satisfied.

In addition, over 50% of shares held by the other entity allow to control Company A by this other entity in a way presented in the example 2.10 of the EM. The day-to-day operation of Company A is controlled by its sole director, Individual A. Consequently, the second condition set out in subsection 328-125(6) is also satisfied..

Accordingly, the Commissioner will exercise the discretion contained in subsection 328-125(6) of the ITAA 1997 to determine that the Entity B does not control Company A for the relevant ruling period.

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