Edited version of private ruling

Authorisation Number: 1011804244838

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Ruling

Subject : Capital gains : small business CGT concessions - entity controlling another entity

Question 1

For the purposes of working out whether Discretionary Trust (DT) satisfies the basic conditions for relief under paragraph 152-10(c) of the Income Tax Assessment Act 1997 (ITAA 1997); does the Commissioner determine that DT does not control Trading Co Pty Limited (Trading Co), throughout the period that DT held greater than 40% of the shares on issue in Trading Co, under subsection 328-125(6)?

Answer

Yes.

This ruling applies for the following period:

Period 1 July 1995 to 30 June 2011.

The scheme commences on:

1 July 1995

Relevant facts and circumstances

Trading Co operates a business which is co-owned between Other Shareholder Co Pty Ltd (OS Co) and DT.

Mr X and Mr A are the directors and shareholders of Trustee Pty Ltd (TPL), who is the Trustee for DT. They are also the joint appointors of DT.

OS Co and DT entered a shareholder agreement (the agreement), which was in place and effective the entire time that DT held greater than 40% of the ordinary shares in Trading Co.

Trading Co's articles of association (the articles) set out that those shareholders holding 'Ordinary Class Shares' possess the following rights and privileges:

· voting rights,

· rights to dividends, and

· rights to capital on winding up.

The agreement also determined the weight of voting rights.

The board of directors meets frequently as business arises and in accordance with the agreement.

The agreement set out the general terms of the operation of the company, including the requirement for Trading Co to make available various financial reports concerning the operation of the business to all directors and shareholders of Trading Co. Further, parties to the agreement are bound by certain restraint clauses and are limited in respect of disposing of their shares in Trading Co.

Mr X and Mr A are employed by Trading Co in an operational capacity and are responsible for the day to day business decisions of the company in accordance with the agreement and separate employment contracts.

DT controls Trading Co under strict application of subsection 328-125(2) of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Section 152-15

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 Subsection 328-125(6)

Income Tax Assessment Act 1997 Section 328-130

Income Tax Assessment Act 1997 Subsection 328-130(1)

Income Tax Assessment Act 1997 Subsection 328-130(2).

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Detailed reasoning

General discussion of the law

Small business relief

Section 152-10 of the ITAA 1997 sets out the basic conditions for relief, which an entity must meet in order to access certain Capital Gains Tax (CGT) concessions. This section provides that:

152-10(1) A *capital gain (except a capital gain from *CGT event K7) you make may be reduced or disregarded under this Division if the following basic conditions are satisfied for the gain:

(a) a *CGT event happens in relation to a *CGT asset of yours in an income year;

Note: This condition does not apply in the case of CGT event D1: see section 152-12.

(b) the event would (apart from this Division) have resulted in the gain;

(c) at least one of the following applies:

(i) you are a *small business entity for the income year;

(ii) you satisfy the maximum net asset value test (see section 152-15);

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership;

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

Note: For determining whether an entity is a small business entity, see Subdivision 328-C (as affected by section 152-48).

(d) the CGT asset satisfies the active asset test (see section 152-35).

Note: This condition does not apply in the case of CGT event D1: see section 152-12.

In working out whether you are a small business entity, or that you satisfy the maximum net asset value test, under paragraph 125-10(1)(c) of the ITAA 1997, you are required to identify which entities you are 'connected with' or those that are your 'affiliate'.

Meaning of 'connected with'

Section 328-125 of the ITAA 1997 provides the meaning of 'connected with' an entity, this section reads in part as follows:

328-125(1) An entity is connected with another entity if:

(a) either entity controls the other entity in the 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 entity other than a discretionary trust

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 beneficially own, or have the right to acquire the beneficial 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 beneficially own, or have the right to acquire the beneficial ownership of, *equity interest 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.

Commissioner may determine that an entity does not control another entity

328-125(6) 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 entity is controlled by an entity other than, or by entities that do not include, the first entity or any of its *affiliates.

This means that an entity is connected to another entity if either entity controls the other entity or both entities are controlled by the same third entity. It also means that another entity is connected with an entity, if the entity, its affiliates or both of them beneficially own, or have the right to acquire the beneficial ownership of interests in the other entity that give them the right to receive at least 40% of the distribution of income or capital by the other entity.

For the Commissioner to make a determination under subsection 328-125(6), he must be satisfied that the entity is controlled by an entity other than, or by entities that do not include, the first entity or any of its affiliates.

Meaning of 'affiliate'

Section 328-130 of the ITAA 1997 provides the meaning of 'affiliate' as follows:

328-130(1) 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.

328-130(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.

Note: For small business relief purposes, a spouse or a child under 18 years may also be an affiliate under section 152-47.

Example:

A partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could reasonably be expected to act, in accordance with the directions or wishes of the second partner, or in concert with the second partner, in relation to the affairs of the partnership.

Directors of the same company and trustees of the same trust, or the company and a director of that company, would be in a similar position.

It is necessary to determine whether an entity is an affiliate of the first entity for the purposes of working out whether the first entity 'controls' another entity.

Taxation Determination TD 2006/79 outlines the Commissioners view regarding whether an entity's 'controller' is necessarily an 'affiliate'. While TD 2006/79 refers to section 152-25 of the ITAA 1997, which was the law at that time, however that section now forms part of new provisions under section 328-130. The same principles apply under the new provision.

The Commissioner explains in TD 2006/79 that a person is a small business CGT affiliate of a taxpayer if the person 'acts, or could reasonably be expected to act, in accordance with (the taxpayer's) directions or wishes, or in concert with (the taxpayer)'. However in determining whether a person acts in such a manner, the actions of the parties need to be considered.

Further, the Commissioner states that the definition of affiliate does not include the relationship between the 'controller' of an entity and the entity itself. The relationship in these situations is considered to be dictated more by obligations imposed by law, formal agreements, fiduciary obligations and the like.

Accordingly, companies, trusts and partnerships are not considered to be affiliates of the various officers, persons or entities (and vice versa) that are related to the company, trust or partnership in various capacities merely because of that relationship. In other words, it is not automatically concluded an affiliation exists because of that relationship. However this does not preclude an entity from being an affiliate where such a relationship exists, the facts and circumstances must be examined in each case.

Application of the law

In your circumstances, in order to determine whether DT controls Trading Co, it is necessary to examine DT's relationships with other entities and whether those entities are in-fact affiliates.

Both Mr X and Mr A operated Trading Co prior to its acquisition under the terms of the agreement with OS Co. From the time of making the agreement they were appointed as directors. Further, each became employees of Trading Co to manage the day to day operations. However each became restricted under the operation of the agreement.

Mr X and Mr A are both appointors of the DT. In addition they are directors of TPL as trustee for the DT. However it is noted that any action of the trustee for the DT would be limited to that which is allowable in accordance with the trust deed. Further, under the agreement the trustee is prevented from varying the trust or changing the beneficiaries unless consent is obtained as prescribed. However, as the issue in question relates to the control of Trading Co, it is considered unnecessary in this circumstance to determine whether Mr X and Mr A are affiliates of each other or of DT and who of them may control DT.

DT owns greater than 40% of the shares on issue in Trading Co. Based on this fact you state that, in the first instance, DT controls Trading Co under strict application of subsection 328-125(2) of the ITAA 1997. Therefore is connected with Trading Co under subsection 328-125(1).

However it is noted that as a shareholder of Trading Co, DT is bound by the conditions of the agreement in respect of transfer or disposal of those shares.

The directorship of Trading Co is set out in the agreement to include more OS Co directors than the number who represent DT. It is noted that under the agreement, notwithstanding the number of directors attending a meeting, those directors representing OS Co have a weighted vote of greater than 50% within a meeting of directors. Such weighting appears to impede Mr X and Mr A together from controlling the outcome of such meetings.

Given the contractual obligations of Mr X, Mr A, DT and OS Co under this scheme, even if it were assumed that Mr X and Mr A were in-fact affiliates of DT and held control of the trust, it is considered that either Trading Co or OS Co could not reasonably be expected to act in accordance with DT's directions or wishes, or in concert with DT, in relation to the affairs of the business of the Trading Co. Therefore, consistent with the Commissioner's view in TD 2006/79, it is considered that Trading Co and OS Co are not affiliates of DT.

In considering the extent of control that DT has over the operation of Trading Co, it is apparent that the contractual obligations, including regular financial reporting to stakeholders; and, OS Co's level of involvement in the ongoing business of Trading Co under this scheme, act to support OS Co's position as majority shareholder and stakeholder in relation to the business operations.

Further, it is evident from the facts of this scheme that OS Co has control over the business operations of Trading Co such that DT can not hold majority vote in relation to decisions of the board of directors or meetings of shareholders. Notwithstanding that Mr X and Mr A are employed to manage the day-to-day operations of the business in accordance with the direction of the board. Therefore it is considered that OS Co is the controlling entity of Trading Co, not DT.

Therefore, for the purposes of working out whether DT satisfies the basic conditions for relief under paragraph 152-10(c) of the ITAA 1997; the Commissioner finds it reasonable to determine that DT does not control Trading Co, throughout the period that DT held greater than 40% of the shares on issue in Trading Co, under subsection 328-125(6).

Further issues for you to consider

There may be related issues to consider, including:

Small business relief - eligibility

The Commissioner has not considered whether the trust is eligible to access small business CGT concessions set out within the Small business relief provisions under Division 152 of the ITAA 1997.

Small business relief - extra basic conditions

You may need to consider whether you are required to satisfy extra basic conditions under subsection 152-10(2) of the ITAA 1997. This subsection applies if the CGT asset is a share in a company or an interest in a trust and examines the existence of certain circumstances just before the CGT event.

Connected with an entity - additional considerations

Where the trustee has elected to nominate a beneficiary to be a controller of the trust for an income year, you must consider the affect of section 152-42 of the ITAA 1997, as this may impact upon whether an entity is 'connected with' you for the purposes of determining whether a CGT asset is an 'active asset' under section 152-40.

In particular, section 152-42 of the ITAA 1997 relates to the application of subparagraph 152-40(1)(a)(ii) and paragraph 152-40(1)(b). A nomination under subsection 152-42(2) has effect as if each nominated beneficiary controlled the trust for the relevant income year in a way described in section 328-125.