Edited version of private ruling

Authorisation Number: 1011835267665

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Ruling

Subject: Thin capitalisation

Question 1

Will X Co Pty Limited be regarded as an "outward investing entity (non ADI)" pursuant to subsection 820-85(2) of the Income Tax Assessment Act 1997?

Answer: No.

Question 2

Will X Co Pty Limited be regarded as an "inward investing entity (non ADI)" pursuant to subsection 820-185(2) of the Income Tax Assessment Act 1997?

Answer: Yes.

This ruling applies for the following period

The year ending 30 June 2011

The year ending 30 June 2012

The year ending 30 June 2013

The year ending 30 June 2014

The year ending 30 June 2015

The scheme commenced on

1 December 2010

Relevant facts and circumstances

X Co Pty Ltd (X Co) is an Australian incorporated and tax resident company. It is the head company of an Australian income tax consolidated group ("X Co Group"). The X Co Group has a year end of 30 June for tax purposes. X Co is part of a structure which also comprises an Australian unit trust called X Trust and X Trustee Co. X Trustee Co is the trustee of the X Trust.

X Co and X Trust, along with their subsidiary entities, acquired assets.

Under the structure:

· X Property Trust, which is a wholly owned subsidiary trust of the X Trust, holds a lease in respect of land and fixtures.

· The X Co Group holds other assets and leases the land and fixtures from the X Property Trust.

X Co is held by a consortium of entities.

In summary A and B are Australian resident entities and these entities are not controlled by foreign entities, whereas C and D are foreign controlled.

The consortium entities which have a holding in X Co entered into an Agreement. The Agreement contains the rules relating to various matters in respect of the role and influence of consortium entities including the appointment of directors, the powers of directors, the voting rights and the constraints of Board and management meetings.

For X Co its shareholders are the entities that hold the ordinary shares of the company.

In accordance with the Agreement, most of the decisions in respect of X Co will generally require a Simple Majority as defined in the Agreement.

However, certain limited high level decisions of X Co must be approved by a Special Majority of shareholders and/or a Special Majority of directors as defined in the Agreement.

The matters of X Co that require the approval of a Special Majority of Directors and/or shareholders are limited.

Relevant legislative provisions

Section 6 of the Income Tax Assessment Act 1936 (ITAA 1936)

Subsection 317(1) of the ITAA 1936

Subsection 318(2) of the ITAA 1936

Section 336 of the ITAA 1936

Section 350 of the ITAA 1936

Subsection 820-85(2) of the Income Tax Assessment Act 1997 (ITAA 1997)

Subsection 820-185(2) of the ITAA 1997

Section 820-780 of the ITAA 1997

Subsection 820-785(1) of the ITAA 1997

Section 820-815 of the ITAA 1997

Subsection 820-905(1) of the ITAA 1997

Reasons for decision

Question 1

Summary

In order to answer the question "Will X Co be regarded as an 'outward investing entity (non-ADI)' pursuant to subsection 820-85(2) of the Income Tax Assessment Act 1997?" it has been necessary to examine that provision and related provisions. The details of that examination are set out below. It has been found that X is not an outward investing entity (non-ADI).

Detailed reasoning

Outward investing entity

In terms of the table in subsection 820-85(2) an entity will be an outward investing entity (non-ADI) if it is an outward investor (general) where it comes within Item 1 or Item 3 of the table or if it is an outward investor (financial) where it comes within Item 2 or Item 4 of the table.

Under both Item 1 and Item 2 at column 1 of the table in subsection 820-85(2) an entity will be an outward investing entity (non-ADI) if it is either or both of the following:

(a) an *Australian controller of at least one *Australian controlled foreign entity;

(b) an Australian entity that carries on a *business at or through at least one *overseas permanent establishment

Note that the terms marked * are terms defined in section 995-1 of the ITAA 1997.

X Co does not come within paragraph (a) or (b). You state that X Co is not an Australian controller of an Australian controlled foreign entity and does not carry on a business at or through an overseas permanent establishment. Therefore the essential conditions in Item 1 and Item 2 are not satisfied so it is not an outward investing entity by virtue of those provisions.

Turning to Item 3 and Item 4 at column 1 of the table in subsection 820-85(2) an entity will be an outward investing entity (non-ADI) if:

(a) the entity (the relevant entity) is an *Australian entity throughout a period that is all or part of an income year; and

(b) throughout that period the relevant entity is an *associate entity of another Australian entity; and

(c) that other Australian entity is an *outward investing entity (non-ADI) or an *outward investing entity (ADI) for that period.

Australian entity

The term Australian entity has the meaning given by section 336 of the Income Tax Assessment Act 1936 (ITAA 1936). As X Co comes within paragraph 336(c) because it is an entity other than an Australian partnership or an Australian trust it is necessary to consider whether X Co is a Part X Australian resident as defined in subsection 317(1) of the ITAA 1936.

That Part X Australian resident definition includes a resident within the meaning of section 6 of the ITAA 1936 and as X Co is an Australian incorporated company it is a resident in terms of section 6. Thus X Co is a Part X Australian resident and consequently an Australian entity which means X Co satisfies the condition at paragraph (a) of Item 3 and Item 4 at column 1 of the table in subsection 820-85(2) immediately above.

Associate entity

It is therefore necessary to consider paragraph (b) of Item 3 and Item 4 at column 1 of the table in subsection 820-85(2) to determine whether X Co is an associate entity of another Australian entity. The meaning of associate entity is given by section 820-905 of the ITAA 1997.

Subsection 820-905(1) reads as follows:

An entity (the first entity) that is not an individual is an associate entity of another entity at a particular time if, at that time, the first entity is an *associate of that other entity and at least one of the following paragraphs applies:

(a) that other entity holds an *associate interest of 50% or more in the first entity [see subsections (4) to (8)];

(b) the first entity is accustomed or is under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the other entity in relation to:

i. the distribution or retention of the first entity's profits ; or

ii. the financial policies relating to the first entity's assets, *debt capital or *equity capital;

where those directions, instructions or wishes are, or might reasonably be expected to be communicated directly or through interposed entities.

However, this subsection does not apply to the first entity in its capacity as the *responsible entity of a *registered scheme [see subsection (2A)].

In this case X Co is the first entity.

You submit that X Co is not an "associate entity" of either a controller of an Australian controlled foreign entity or an entity which carries on a business through an overseas permanent establishment. That is, the conditions in Item 3 and Item 4 of the table in subsection 820-85(2) are not satisfied.

Section 995-1 of the ITAA 1997 defines "associate to have the meaning given in section 318 of the ITAA 1936. Of particular relevance is subsection 318(2) which deals with associates of a company.

You do not address the specific terms of subsection 318(2) of the ITAA 1936 as to their application to X Co.

Instead you confine your argument to the secondary tests in paragraphs 820-905(1)(a) and (b) of the ITAA 1997.

You submit that paragraph 820-905(1)(a) is not satisfied by any entity that is a member of the consortium that has an interest in X Co because no member holds a 50% or more direct control interest in X Co.

Further you argue that the conditions in paragraph 820-905(1)(b) also are not met for the reasons set out below.

You consider the members of the consortium which are the shareholders in X Co are not able to direct, instruct or control the actions of X Co in relation to the matters identified in paragraph 820-905(1)(b). This is because no consortium member has an interest of 50% or more which is required to achieve the necessary degree of control. Each of these entities is taken to be independent of one another.

Consequently neither of the secondary tests in subsection 820-905(1) is met and thus X Co is not an associate entity.

Thus for Item 3 and Item 4 at column 1 of the table in subsection 820-85(2) paragraph (b) which relates to an associate entity is not satisfied.

It is not necessary to consider paragraph (c) of Item 3 and Item 4 at column 1 of the table in subsection 820-85(2) because paragraph (b) has not been met.

Therefore the conclusion drawn from this examination of subsection 820-85(2) is that X Co is not an outward investing entity (non-ADI) because it does not meet the requirements of any of the four items in the table in that subsection.

Question 2

Summary

In order to answer the question "Will X Co be regarded as an 'inward investing entity (non-ADI)' pursuant to subsection 820-185(2) of the Income Tax Assessment Act 1997?" it has been necessary to examine that provision and related provisions. The details of that examination are set out below. It has been found that X Co is a foreign controlled Australian company and consequently X Co is an inward investing entity non-ADI.

Detailed reasoning

Inward investing entity

In terms of the table in subsection 820-185(2) an entity will be an inward investing entity (non-ADI) if it is an inward investment vehicle (general) or an inward investment vehicle (financial) where it comes within Item 1 or Item 2 respectively of the table or it will be an inward investor (general) or an inward investor (financial) where it comes within Item 3 or Item 4 respectively of the table.

Under both Item 1 and Item 2 at column 1 of the table in subsection 820-185(2) an entity will be an inward investing entity (non-ADI) if it is a foreign controlled Australian entity and also meets the relevant conditions in column 2.

Australian entity

The term Australian entity has the meaning given by section 336 of the ITAA 1936. As X Co comes within paragraph 336(c) because it is an entity other than an Australian partnership or an Australian trust it is necessary to consider whether X Co is a Part X Australian resident as defined in subsection 317(1) of the ITAA 1936. That definition includes a resident within the meaning of section 6 of the ITAA 1936 and as X Co is an Australian incorporated company it is a resident in terms of section 6. Thus X Co is a Part X Australian resident and consequently an Australian entity.

Foreign controlled Australian entity

Section 820-780 divides foreign controlled Australian entities into three categories of which X Co falls for consideration under paragraph 820-780(a) which relates to a *foreign controlled Australian company. This latter term has the meaning given by section 820-785.

Subsection 820-785(1) reads as follows:

A company (except a *corporate limited partnership) is a foreign controlled Australian company (or a FCAC) at a particular time if, at that time, it is an *Australian entity to which at least one of the following applies:

(a) not more than 5 *foreign entities (each of which holds a *TC control interest in the company that is at least 1%) hold a total of TC control interests in the company that is 50% or more;

(b) a foreign entity holds a *TC control interest in the company, that is 40% or more, and no other entity or entities (except an *associate entity of the foreign entity or entities including the foreign entity or its associate entities) control the company;

(c) not more than 5 foreign entities control the company (whether or not with associate entities and whether or not any associate entity is a foreign entity).

Note: A corporate limited partnership that is an Australian entity may be a foreign controlled Australian partnership, see section 820-795.

With respect to a *TC control interest section 820-815 contains a general rule about the thin capitalisation control interest in a company, trust or partnership however that section is also affected by sections 820-820 to 820-835 which set out special rules to avoid double counting.

Briefly stated subsection 820-815(1) provides that a thin capitalisation control interest (or TC control interest) that an entity holds in a company is the total direct and/or indirect interest held by the entity or the entity's *associate entities in the company.

Section 350 of the ITAA 1936 defines the direct control interest of an entity in the company as the percentage the entity holds or is entitled to acquire in:

· the total paid up capital;

· the rights to vote; or

· the rights to a distribution of capital or profits.

In the case of X Co two foreign entities hold an interest in the company. Those entities are C and D.

These interests total less than 50%.

Note that A and B are Australian resident entities. These entities are not controlled by foreign entities.

Returning to a consideration of the tests in each paragraph of subsection 820-785(1) it is found as follows:

(a) the foreign entities that hold an interest in X Co do not hold a TC control interest of more than 50%;

(b) neither of the foreign entities that holds an interest in X Co separately holds a TC control interest of 40% or more;

(c) this paragraph requires further examination with respect to the meaning of "control" and this examination appears below.

The term "control" is not defined in the ITAA 1997. However in the Explanatory Memorandum to New Business Tax System (Thin Capitalisation) Act 2001 which introduced Subdivision 820-H into the ITAA 1997 the following appears in Chapter 7 titled "Control of entities" in respect of subsection 820-785(1):

7.33 The third test concerning control by 5 foreign entities does not require a calculation of TC control interests, but is instead directed towards an examination of facts relevant to the circumstances of each case. The term control is not defined for these purposes, but will include situations where foreign entities are capable of exercising control.

The online version of the Macquarie Dictionary defines the verb "control" as:

· to exercise restraint or direction over; dominate; command.

· to hold in check; curb.

· to test or verify (a scientific experiment) by a parallel experiment or other standard of comparison.

You state that the Oxford English Dictionary defines the word "control" as:

"The fact of controlling, or of checking and directing action, the function or power of directing and regulating; domination, command, sway. A method or means of restraint; a check."

You submit that given the above Oxford English Dictionary definition, the non-resident shareholders do not control X Co for the purposes of the thin capitalisation rules, either separately or together. That submission is made by you on the following basis:

1. Whether control achieved through direct interest in X Co

C holds an interest in X Co while D holds an interest. These interests do not provide either entity with control of X Co. It is also contended by you that given that the investors all have the same rights there is no justification for finding that the non-residents have control of X Co on the basis of their respective interests.

This argument is accepted, the non-residents do not achieve control through their direct interest in X Co.

2. Whether control achieved by the shareholder approvals regarding meetings and resolutions

The Special Majority provision in the Agreement which requires that shareholders achieve a specified majority on specified issues gives any shareholder the power to veto the decision or resolution. You submit that this does not provide any shareholder with control over X Co. Instead it is reasoned that the rights only allow the shareholder to block or veto certain high level decisions and resolutions related to the corporate governance and capitalisation policies of X Co Group.

In addition you argue that:

· Of the present shareholders the power to veto a decision is possessed equally by the Australian shareholders and the foreign shareholders. It is said therefore to the extent that such power to veto places control in the hands of the shareholder which exercises that right to veto it does not provide the foreign shareholders with rights to "control" X Co that are any different from the rights of the Australian shareholders.

· The rights are claimed to be standard commercial rights that protect the interests and value of the third party or arm's length shareholders that have an interest. It is said that there is no intention for the rights to provide any entity with control over X Co.

· The rights are not sufficient to provide the shareholders in X Co with control for accounting purposes. Thus no shareholder is able to include it in a consolidated account.

· The rights are merely blocking rights over certain corporate governance and capitalisation aspects of X Co. Those rights do not allow the shareholders to direct or instruct the company in relation to its activities.

The meaning of "control" in subsection 820-785(1) has not been the subject of judicial consideration. However the meaning of "control" has been considered in other statutory contexts.

In Re News Corporation Ltd (1987) 15 FCR 227; (1987) 70 ALR 419, which was in the matter of a reference to the Federal Court of Australia by the Australian Broadcasting Tribunal pursuant to Section 22B of the Broadcasting and Television Act 1942 in relation to applications to the Australian Broadcasting Tribunal for approval of transactions relating to the ownership and control of radio and television licences by The News Corporation Limited, Network Ten Holdings and others,

Bowen CJ said (at 243):

"The second argument advanced by counsel for both groups of applicants was that, even if control of the board of directors be relevant, TNCL's power was only to appoint half of the board of NTHL and did not put it in a position to exercise control of that company. It was argued that a power of veto does not constitute control in the relevant sense. Control, it was said, exists only where there is a power to get one's own will.

I do not agree that the concept of control is so limited.

The Oxford English Dictionary defines 'control' as 'to exercise restraint or direction'. A power to veto is a power to restrain, and hence to control."

The CHH Australian Corporations Commentary states that these remarks by Bowen CJ were cited by the Full Federal Court in Canwest Global Communications Corporation v Australian Broadcasting Authority (1998) 82 FCR 46; (1998) 153 ALR 47. When considering the meaning of the word "control'' in the context of the Broadcasting Services Act 1992, the Court in that case said that to be in a position to exercise control within the meaning of the Act one must have the power to direct or restrain what the company may do on any substantial issue, the extent of that power being determined by practical commercial considerations rather than highly refined legalistic tests. It does not necessarily require the ability to direct or restrain founded on a right or power sourced in an agreement, arrangement, understanding or practice. Further, the ability to direct or restrain compliant directors within lawful limits is sufficient to constitute control within the meaning of the Act.

Accordingly, it is considered that the power to veto certain high level decisions and resolutions in relation to the corporate governance and capitalisation policies of X Co which the foreign shareholders possess in terms of the Agreement constitutes control of X Co.

As the foreign shareholders possesses the power to veto decisions and resolutions this means that the control test in paragraph 820-785(1)(c) is met and therefore X Co is a foreign controlled Australian company.

However, in the event of such a view being reached by the Commissioner you presented additional arguments to be considered by the Commissioner.

Those additional arguments are that:

Such "control" as is possessed by the foreign members of the consortium is also obtained by the Australian members of the consortium who are investors of the company. In this respect it is contended that it would not seem to be the intention of the thin capitalisation rules for an Australian controlled entity to be regarded as an "inward investing entity (non-ADI)".

There is no agreement or understanding for any of the shareholders in X Co to act in concert when making any decisions in relation to the matters set down in the Agreement. Each shareholder will act and vote independently.

This first argument you put is that because both the foreign shareholders and the Australian shareholders posses the same power to veto and hence control the company this means that it is simultaneously foreign controlled and Australian controlled. The Explanatory Memorandum to New Business Tax System (Thin Capitalisation) Act 2001 which introduced Subdivision 820-H into the ITAA 1997 has been examined and it is found to be silent on such a situation. The control tests are designed to determine whether the company is foreign controlled and it has been found to be so by virtue of the restraint exercisable by the power of veto. The control tests do not provide for the situation claimed to exist here of simultaneous foreign control and Australian control. The control tests are designed to determine if the entity is a foreign controlled Australian entity and if it is such then in terms of the legislation it will be an inward investing entity. There is no provision under the law which applies here for any other outcome.

The final argument regarding the absence of agreement or understanding for any of the shareholders in X Co to act in concert has no bearing on the finding that the foreign members of the consortium which are shareholders in X Co control X Co for the purposes of the thin capitalisation control test.

Therefore it is concluded that X Co is a foreign controlled Australian company. Consequently X Co is an inward investing entity that is not an approved deposit-taking institution (non-ADI) in terms of subsection 820-185(2) of the ITAA 1997.

3. Whether control achieved by Special Majority for Board Decisions

With respect to the Special Majority for Board Decisions you acknowledge that the Agreement can provide directors of X Co with rights that veto the decisions. However, you assert that these rights do not provide the directors with control over X Co. It is said that the rights only allow the directors to block or veto certain decisions and policies in relation to the strategies and objectives of X Co.

Your argument that the power to veto or block decisions does not constitute "control" is not accepted. The reasons for our view are as stated above and are made in reliance upon the judgement of Bowen CJ in Re News Corporation Ltd (1987) 15 FCR 227; (1987) 70 ALR 419.

It is necessary however to consider the specific voting power of the directors.

The Special Majority for Board decisions is set out in the Agreement as requiring approval of Directors that were appointed by the shareholders that hold an aggregate voting interest of more than a specified percentage.

You contend that based on the existing shareholder percentages in X Co, neither of the non-resident shareholders should be able to satisfy the relevant thresholds to exercise the veto right under the Agreement. This is because currently D has not appointed a director. It has the power to appoint a director and should it do so, neither the C directors nor the D director could alone veto any decision.

It is considered that the power in terms of the Agreement to veto decisions and resolutions of the board of X Co which the foreign shareholder possess through the directors it has appointed to the board of the company constitutes control of X Co.

As there is one foreign shareholder which possesses the power to veto decisions and resolutions this means that the control test in paragraph 820-785(1)(c) is met and therefore X Co is a foreign controlled Australian company.

Consequently X Co is an inward investing entity that is not an approved deposit-taking institution (non-ADI) in terms of subsection 820-185(2) of the ITAA 1997.