Edited version of your private ruling

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Subject: Connected entities- refundable tax offsets - research and development

Question 1

For the purposes of calculating the aggregated turnover of Company Z under section 328-115 of the Income Tax Assessment Act 1997 (ITAA 1997) and accessing the research and development (45%) refundable tax offset provisions under section 355-100 of the ITAA 1997, will the Commissioner exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Company X does not directly control Company Z for the purposes of section 328-125 of the ITAA 1997?

Answer

Yes.

Question 2

For the same purpose as Question 1, in terms of subsection 328-125(6) of the ITAA 1997 will the Commissioner determine that Company X does not indirectly control Company Z via an affiliate relationship with Company Y in accordance with section 328-130 of the ITAA 1997?

Answer

Yes.

Question 3

Also for the purposes of calculating the aggregated turnover of Company Z under section 328-115 of the ITAA 1997, will the Commissioner determine that Company X is not an affiliate of Company Z under section 328-130 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The rulee, Company Z is a company which was incorporated as a joint venture between Company X and Company Y.

Company Z intends to apply for a research and development (R&D) tax offset for certain R&D expenditure incurred.

Under the R&D provisions, only certain entities with an aggregated turnover of less than $20 million are eligible for a full 45% refundable tax offset, and to determine whether the annual turnover of Company X is included in the aggregated turnover of Company Z it must first be determined whether Company X controls and is therefore connected with Company Z, or alternatively is an affiliate of Company Z.

Company Y is an Australian publicly listed company.

Company X is an overseas registered company.

Commercial objective of Z

The Company Z joint venture company was established in the year ended 30 June 2011 in order to continue the research and development of Company Y patented technology with the aim of commercialising it and bringing it to market.

Structure of Company Z

In accordance with the Joint Venture Agreement, Company Y holds 51% of the total number of issued shares in Company Z and Company X holds the remaining 49%. There is only one class of shares in Company Z and all shares have the same rights.

Governance of Company Z
The board of directors of Company Z is made up of a total of six directors, comprising three directors who are appointed by Company Y and three directors who are appointed by Company X.

The Joint Venture Agreement sets out that as Company Y holds 51% of the total number of issued shares it is entitled to appoint one of its nominee Directors as chairman of the Board. This power is ongoing.

Under the Joint Venture Agreement the company secretary of Company Y was also appointed as company secretary of Company Z.

Voting power of Company Z

The voting powers of the directors are determined by the proportion of equity held by their respective nominating shareholders. Therefore, the three directors nominated by Company Y hold a combined voting power of 51%, whereas the three Company X nominated directors hold a combine voting power of 49%.

The Chairman of the Board does not have a casting vote in addition to any votes he may be entitled to as director.

Board Meetings of Company Z
To date all board meetings have been held in Australia at the offices of Company Y or Company Z/Company Y's secretary. The overseas based directors from Company X have either attended via phone hook up or travelled to Australia. Company Z board meetings are normally held after Company Y board meetings.

Intellectual property
The owner of the core intellectual property is a company which is a wholly owned subsidiary of Company Y. In the year ended 30 June 2011 this subsidiary entered into a licensing arrangement with Company Z under which Company Z is permitted to modify, develop and commercialise the core intellectual property for the purposes of bringing it to market. In return the subsidiary company would receive a commission fee being a percentage of distribution. Ownership of the developed intellectual property vests solely with Company Z.

Conduct of Company Z R&D activities
The primary research facility has been established in Australia to carry out the operations of the joint venture. It is located at the Company Y site. All R&D activities are conducted by the staff of Company Y using the expertise and processes developed by Company Y. The majority of Company Y staff are working on this project. In contrast to the background intellectual property provided by Company X the technology licensed to Company Z from the Company Y subsidiary is critical to Company Z being able to further develop and commercialise the technology.

A secondary research facility has been established overseas. This employs a small number of Company X staff and uses Company X machinery and raw materials. The contribution from Company X to the joint venture is mainly limited to some background intellectual property, material supplies and Company X machinery to be used in the R&D process.

The Chief Technical Officer (CTO) from Company Y who is responsible for directing and coordinating all research and development activities of Company Z, both in the Australian and overseas facilities.

All operational costs and expenses are jointly funded by Company Y and Company X in proportion to their equity ownership in Company Z. Regardless of fund raising pursuits Company Y and Company X will always maintain their respective 51% and 49% shareholdings.

Day to day operations
The day to day finance and administrative functions of Company Z are fulfilled entirely by Company Y personnel, in particular the CFO of both Company Z and Company Y. Under the Joint Venture Agreement Company Y agrees to provide a reasonable level of services to Company Z at no cost to Company Z. Any costs that are incurred are recharged to Company X.

The CFO prepares the yearly business plans and budgets of Company Z and consolidates the results into the financial accounts of Company Y. In addition the CFO is also in charge of administrating all the key financial functions of Company Z including funding needs and calling for further equity injections.

The Company Y company secretary was appointed as the company secretary of Company Z. He is responsible for maintaining the company's records and annual accounts and ensuring that Company Z complies with statutory and regulatory requirements.

Employees of Company Y are the sole signatories on all Company Z bank accounts. No Company X employees have been made signatories.

Relationship between Company X and Company Y
Other than some transactions, minority shareholdings and the fact that they reside in the same industry, you state that Company X and Company Y are two independent companies, with Company Y listed on the Australian Stock Exchange.

Relationship between Company X and Company Z
You state that there is no family or close personal relationship between the board of Company X and Company Z. However, three of the directors are common to both companies.

You state that Company Z is not restricted from purchasing equipment from Company X and therefore is not dependent on Company X in order to conduct its research and development activities.

51% of the financing of Company Z is received from Company Y and 49% from Company X. Company Z is not solely reliant on Company X to fund its R&D activities.

The three directors common to both Company Z and Company X do not have a controlling vote on the board of either entity.

Apart from the 49% interest that Company X holds in Company Z, Company Z has no other shareholders which also hold interests in Company X.

There are no other partners in the Company X joint venture.

You state that Company Z and Company X are operated independently and Company X does not consult with Company Z in undertaking its own commercial activities.

The Company X staff involved in the R&D activities of Company Z only to the extent provided for under the Joint Venture Agreement. There is no separate consulting arrangement between Company Z and Company X by which Company X provides consulting services to Company Z in order to progress Company Z's commercial objectives.

You state that Company Z is under no obligation to conduct their business with Company X, apart from that which Company X has agreed to contribute to Company Z in the Joint Venture Agreement.

You reference Company Y's 51% majority shareholding and voting power in Company Z and state that it is not possible for Company X to influence the operation of Company Z outright.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 328-115

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

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

Income Tax Assessment Act 1997, section 328-125

Income Tax Assessment Act 1997, paragraph 328-125(1)(a)

Income Tax Assessment Act 1997, paragraph 328-125(2)(a)

Income Tax Assessment Act 1997, paragraph 328-125(2)(b)

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)

Income Tax Assessment Act 1997, section 355-100

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Section 328-125 discusses the meaning of 'connected' and states at paragraph 328-125(1)(a) that 'An entity is connected with another entity if ... either entity controls the other entity in a way described in this section'. With regard to companies, you may establish control via either the right to distribution control rule under paragraph 328-125(2)(a) or the voting power control rule under paragraph 328-125(2)(b).

Paragraph 328-125(2)(a) provides that you control a company if you, your affiliates, or you together with your affiliates beneficially own, or have the right to acquire the beneficial ownership of, interests in the company that carry between them the right to receive a percentage (the control percentage) that is at least 40% of any distribution of income or capital by the company.

Paragraph 328-125(2)(b) provides that you control a company if you, your affiliates, or you together with your affiliates 'beneficially own, or have the right to acquire the beneficial 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'.

Under section 328-125 the Commissioner may also determine that you do not control the company, and subsection 328-125(6) provides that if the control percentage referred to in subsection 328-125(2)(a) or subsection 328-125(2)(b) is at least 40%, but less than 50%, he may determine that you do not control the company if he thinks that the company is controlled by an entity other than, or by entities that do not include, you or any of your affiliates.

With regards to subsection 328-125(6) the 'Advanced guide to capital gains tax concessions for small business' (Concessions Guide) states that 'it is possible that both of the entities with a control percentage of at least 40% may control the company if such responsibilities are shared.' This confirms the Commissioner's view that control of a particular entity may in fact rest with more than one connected entity.

The Concessions Guide, however, goes on to state that in a case where there is more than one entity with a control percentage of at least 40% 'it would be necessary to consider additional factors to determine if the third entity controls it. Such additional factors could include who is responsible for the day to day and strategic running of the company.

Where both entities have an identical control percentage in the range allowed for under subsection 328-125(6) but one is not involved in the running of the business at all, the Commissioner would determine that the non-active 40% interest holder does not control the relevant entity.

Application to your circumstances

You concede that Company Y (51%) and Company X (49%), having control percentages of greater than 40% are both, in the first instance, connected to Company Z under section 328-125. However, you argue that in reality Company Z is in fact controlled solely by Company Y. Consequently, you request under subsection 328-125(6) that the Commissioner find that STPS does not control Company Z and is therefore not connected to it for the purposes of section 328-125.

In determining the controlling entity/entities in relation to Company Z we must consider who is responsible for and controls both the strategic decision making on behalf of the company and also the day to day running of the company.

Strategic decision making in relation to Company Z
Both Company Y and Company X contribute three representatives each to the board of directors of Company Z. However, given that the voting power of the directors rests in equal proportion to their overall shareholdings it remains that the Company Y directors enjoy a 51% majority.

It follows that Company Y will always retain ultimate control over the strategic operations and decision making aspects of the company at board level.

Day to day management and running of Company Z
You advise that the operations of Company Z are conducted in both Australia and overseas out of premises from which Company Y and Company X conduct their existing business activities.

The primary research facility is located at the Company Y site in Australia.

A secondary research facility has been established overseas. It employs a small number of Company X staff and uses Company X machinery and raw materials. You state that the contribution from Company X to the joint venture is mainly limited to some background intellectual property, material supplies and Company X machinery to be used in the R&D process.

In contrast, the day to day financial and administrative functions of Company Z are fulfilled entirely by Company Y personnel, in particular the CFO of both Company Z and Company Y. The CFO prepares the yearly business plans and budgets of Company Z and consolidates the results into the financial accounts of Company Y. In addition the CFO is also in charge of the administration of all key financial functions of Company Z including funding needs and calling for further equity injections.

The Company Y company secretary was appointed as the company secretary of Company Z. He is responsible for maintaining the company's records and annual accounts and ensuring that Company Z complies with statutory and regulatory requirements.

Employees of Company Y are the sole signatories on all Company Z bank accounts. No Company X employees have been made signatories.

All R&D activities are conducted using the expertise and processes developed by Company Y. The majority of Company Y staff work on this project.

In relation to the day to day running of Company Z it is evident that Company Y management and staff are appointed to all relevant administrative positions and fulfil these roles outright. Company X management have no involvement in this aspect of the business.

Conclusion

In relation to the discretion afforded the Commissioner under subsection 328-125(6) we find that the strategic decision making and day to day running of Company Z are controlled by Company Y personnel.

Provided Company Y is not an affiliate of Company X, Company X will not be considered connected to Company Z under section 328-125 for the purposes of paragraph 328-115(2)(b) and determining Company Z's aggregated turnover.

Question 2

Application to your Circumstances

For the purposes of subsection 328-125(6), we have established (in Q1) that Company X is not directly connected to Company Z. However, this subsection requires that we also establish that Company Z is not controlled by any of Company X's affiliates. The relevant entity for this test is Company Y.

To this end the affiliate provisions in section 328-130 require that we determine whether Company Y is reasonably expected to act in accordance with Company X's directions or wishes, or in concert with Company X in relation to the business affairs of Company Y.

With reference to the above mentioned affiliate factors we find that although there is the existence of a common purpose and a requirement that the two entities cooperate and work closely together in pursuit of this purpose, most activities in which Company X and Company Y liaise are strictly governed by the formal Joint Venture agreement which outlines the obligations, expectations and responsibilities of both parties with regard to the Company Z project.

Outside of their common pursuits under this agreement, some minor transactions, minority shareholdings and the fact that they reside in the same industry Company X has no influence or involvement in the business affairs of Company Y. They are two independent companies located in different countries with autonomous administrative structures and sets of employees.

In view of this we find that Company Y is not an affiliate of Company X.

Conclusion

Therefore, given that Company Y (and not Company X) directly controls Company Z and that Company Y is not an affiliate of Company X, we have decided to exercise the discretion under subsection 328-125(6) and confirm that Company X is not connected with Company Z under section 328-125 for the purposes of paragraph 328-115(2)(b). That is, Company X's annual turnover will not be included in Company Z's aggregated turnover by way of it being connected to Company Z.

The direct affiliate relationship test under paragraph 328-115(2)(c) between Company X and Company Z is addressed at Q3.

Question 3

The general affiliate provisions have already been explained at Q2.

Application to your circumstance

For the purpose of the aggregated turnover test under paragraph 328-115(2)(c) the affiliate provisions in section 328-130 require that we determine whether Company X is reasonably expected to act in accordance with Company Z's directions or wishes, or in concert with Company Z in relation to the business affairs of Company X (note that your application incorrectly sought to establish that the reverse relationship didn't exist i.e. in relation to Company Z's business).

With reference to the affiliate factors and the facts provided in your application we find that although Company X is working in conjunction with Company Y under the Company Z company structure towards a common purpose described under the Joint Venture agreement as being the development and commercialisation of certain technologies and intellectual properties, the very nature of the relationship that exists between Company X and Company Z is that all activities undertaken in relation to this project whereby any form of consultation takes place are directed only towards the business affairs of Company Z.

Despite the three common directors there are no family or close personal relationships between the board of Company X and the board of Company Z. The Company Z board does not influence or work in concert with Company X in relation to the business affairs of Company X.

All Company X day to day administrative functions are undertaken by Company X employees. The administrative aspects of Company Z are undertaken by Company Y management and staff and these individuals have no involvement in the day to day operation of Company X.

Both entities have autonomous administrative structures and sets of employees. You state the Company X does not consult with Company Z in undertaking its own commercial activities. There is also no obligation on the part of Company Z to acquire machinery, goods or services from Company X.

The example in section 328-130 makes it clear that there must be more than a business relationship. With this in mind we find that there is minimal involvement of Company Z in the business affairs of Company X. Any involvement between the two parties is generally limited to the Joint Venture agreement and to the affairs of Company Z.

Conclusion

We find that Company X is not an affiliate of Company Z under section 328-130 for the purposes of determining the aggregated turnover of Company Z in terms of paragraph 328-115(2)(c).

Overall Conclusion

Based on the facts of this ruling, for the purposes of the R&D tax offset provisions in section 355-100, the annual turnover of Company X will not be added into the aggregated turnover of Company Z by way of either the connected entity provisions or the affiliate provisions.