Edited version of your private ruling

Authorisation Number: 1012481957022

Ruling

Subject: Commissioner's discretion to determine if entity is an affiliate of another entity

Question 1

Will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that Company B does not directly control Company A for the purposes of section 328-125 of the ITAA 1997 and for calculating the aggregated turnover of Company A under section 328-115 of the ITAA 1997 and accessing the Research and Development (X%) refundable tax offset provisions under section 355-100 of the ITAA 1997?

Answer

No, the Commissioner will not exercise his discretion.

Question 2

For the same purpose as Question 1, will the Commissioner exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Company C does not directly control Company A for the purposes of section 328-125 of the ITAA 1997?

Answer

No, the Commissioner will not exercise his discretion.

Question 3

For the same purpose of Question 1, will the Commissioner exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Company A is not an affiliate of Company B under section 328-130 of the ITAA 1997

Answer

Yes, the Commissioner will exercise his discretion.

Question 4

For the same purpose of Question 1, will the Commissioner exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Company A is not an affiliate of Company C under section 328-130 of the ITAA 1997

Answer

Yes, the Commissioner will exercise his discretion.

This ruling applies for the following periods

Year ending 30 June 20BB

Year ending 30 June 20CC

Year ending 30 June 20DD

The scheme commences on

1 July 20AA

Relevant facts and circumstances

Company A was established in 200X with the objective of operating general business entities using an innovative and scalable centralised operating model.

During the income year 20AA-BB, Company A undertook significant Research and Development (R&D) activities towards developing an innovative centralised model of operating these business entities.

Company A intends to apply for the R&D tax offset for R&D expenditure incurred during the income year 20AA-BB and future years.

Company A only has one class of shares and their shareholding structure for the income year 20AA-BB is as follows:

The main shareholders of Company A, Company B and Company C, both have more that 40% ownership but less than 50% ownership during the income year.

We are advised that none of the shareholders are related to each other, each of them are unrelated parties.

There is a personal and family relationship to note and that is that the director of Company D is the sibling of the director of Company B. We are advised that the siblings are estranged and do not influence each other in any way with respect to investment decisions.

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. To determine whether the annual turnover of Company B and Company C is included in the aggregated turnover of Company A, it must first be determined whether Company B and Company C controls and is therefore connected with Company A, or alternatively is an affiliate of Company A.

The voting power of Company A is as per the company's Constitution where the shareholders have a right to vote at the General Meeting by either show of hand or a poll on demand. On a show of hand, which is the standard default voting method, each member has one vote, which in the year ended 30 June 20BB would be 1 in 4 votes.

However, if a poll is demanded, voting is determined by reference to the number of shares held.

At General Meeting, to pass members resolution, it would require the support of the minority shareholders or it would require both Company B and Company C to agree.

The Board of Directors of Company A currently have two directors who are each appointed by Company B and Company C. The third director resigned early in 20BB

The director appointed by Company B is also the main director of Company B.

The director appointed by Company C is also one of the directors of Company C.

The Board has not appointed any Chair or Managing Director, but according to the constitution has appointed a Company Secretary, who is also the Chief Executive Officer (CEO) of the Company A.

The Board has delegated the Company Secretary and CEO the day-to-day management of the company, which means that if the Board cannot agree on a particular action, the ultimate decision will fall on the CEO.

The CEO's responsibilities are:

· coordinates and directs all R&D activities;

· conducts all strategic planning for the business;

· prepares the yearly plans and budgets and administers all the key financial functions including funding needs and calling for further debt and equity injections for the taxpayer

· maintain company records and accounts; and

· ensure that the company complies with statutory and regulatory requirements.

Company B is in the business of investing in property and has investments in property developments as well as operating a private company in development.

Company C is in the business of investing in retail businesses.

Both Company B and Company C has no experience investing in or managing Company A businesses.

Neither Company B nor Company C has the skills or experience necessary to manage the operations of Company A's business.

The shareholders rely on the CEO to undertake the business planning and managing operations of the company's business including providing recommendations as to investment decisions and capital allocation for the business.

Upon request Company A provided copies of it's bank statements in their name, payroll records and an extract from the authorised body's secure online portal for such organisations, and a relevant body showing the company's Identifier Organisation number for its business.

Also provided are letters signed by the directors of Company B and Company C confirming that they are not participating in any of the activities of the company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 subsection 328-115(2)

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)(b)

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

Income Tax Assessment Act 1997 section 328-130

Corporations Act 1989 paragraph 15(1)(a)

Reasons for decision

Summary

For the purposes of the R&D tax offset provisions in section 355-100, both Company B and Company C are connected entities to Company A and their annual turnover will be added into the aggregated turnover of Company A in terms of paragraph 328-115(2)(b) of the ITAA 1997.

Company B and Company C are not an affiliate of Company A under section 328-130 of the ITAA 1997 for the purposes of determining the aggregated turnover of Company A in terms of paragraph 328-115(2)(c) of the ITAA 1997

Detailed Reasoning

To be eligible for the Research and Development tax offset under section 355-100 of the ITAA 1997, Company A must have an 'aggregate turnover' of less than $20 million for a full 45% refundable tax offset.

The meaning of 'aggregate turnover' is included in section 328-115 of the ITAA 1997 and it consists of the sum of the relevant 'annual turnovers'.

For the purposes of this calculation, subsection 328-115(2) of the ITAA 1997 indicates that a taxpayer will include their own annual turnover together with the annual turnovers of any 'connected entities' or 'affiliates'.

Connected Entity

The meaning of 'connected with' an entity is discussed at section 328-125 of the ITAA 1997. It introduces the concept of 'control'. Under subsection 328-125(1) of the ITAA 1997 an entity is connected with another entity if either entity controls the other entity in the way described in section 328-125 of the ITAA 1997 or both entities are controlled in that way by the same third entity.

An entity controls another entity if it, its affiliates, or it together with its affiliates beneficially owns, or has the right to acquire the beneficial ownership of, interests in the other entity that carry between them the right to receive at least 40% of any distribution of income or capital by the other entity as prescribed under subsection 328-125(2) of the ITAA 1997.

Where the control percentage is at least 40% but less than 50%, subsection 328-125(6) of the ITAA 1997 provides that the Commissioner may determine that the first entity does not control the second entity if the Commissioner thinks that the second entity is controlled by another entity or entities that do not include the first entity or any of its affiliates.

The 'Advanced guide to capital gains tax concessions for small business 2011-12' (Concessions Guide) states at page 25 that in regards to control between 40% and 50%, 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, 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) of the ITAA 1997 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.

In your case, you argue that in reality neither Company B nor Company C could pass a members resolution on their own to control Company A. To pass members resolution, it would always require the support of the minority shareholders or it would require both Company B and Company C to agree.

You state that the CEO is responsible for the strategic decision-making and capital allocation as well as the day-to-day running of the company. Whilst the CEO reports these activities to the Board, the directors only have one vote each and there is no deadlock provision in the constitution. This means that recommendations by the CEO will always be passed unless the directors agree to pass an alternative resolution.

In determining who has control of the company, the provision under section 328-125 of the ITAA 1997 requires the controlling entity to have beneficial ownership of or interests in the entity, giving them the right to receive a percentage of any distribution of income by the entity. Although the CEO is responsible for the day-to-day running and strategic decision-making on behalf of the company, the CEO has no beneficial ownership or interests in Company A. The CEO cannot be considered as having control of Company A.

Therefore, the discretion afforded the Commissioner under subsection 328-125(6) of the ITAA 1997 will not be exercised.

We find that both Company B and Company C have the control percentages of between 40% and 50% and are both, in this instance, regarded as the controllers of the company and are both the connected entities to Company A under section 328-125 of the ITAA 1997.

Affiliates

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 B and Company C are reasonably expected to act in accordance with Company A's directions or wishes, or in concert with Company A in relation to the business affairs of Company B and Company C.

The meaning of affiliate is under section 328-130 of the ITAA 1997, reads as follows:

(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

(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.

Whether a person or company acts or could reasonably be expected to act, in accordance with the taxpayer's directions or wishes, or in concert with the taxpayer is a question of fact dependent on all the circumstances of the particular case. No one factor will necessarily be determinative.

Section 328-130 of the ITAA 1997 provides an example which indicates that a director of a company would not be an affiliate of another director or the company, merely because he/she acts, or could reasonably be expected to act, in accordance with the directions or wishes of the other director/company, or in concert with them in relation to the affairs of the company.

The term 'act in concert' is not defined in the in the ITAA 1997. The term must therefore be interpreted both according to its ordinary meaning and in keeping with the purpose and scope of Subdivision 328-C of the ITAA 1997.

The Macquarie Dictionary (Second Edition) defines the term 'in concert' to mean:

in a coordinated or organised way; together.

The term 'in concert' has not been considered judicially in an income tax context. However, in IPT Systems v. MTIC Corporate Pty Ltd (2000) 158 FLR 349; (2000) 36 ACSR 454; (2001) 19 ACLC 386, Owen J considered the meaning of the term 'acting in concert' for the purposes of paragraph 15(1)(a) of the Corporations Act 1989.

Owen J referred to his earlier consideration of the term in Bank of Western Australia v. Ocean Trawlers Pty Ltd (1995) 13 WAR 407; (1995) 16 ACSR 501 and the decision in Adsteam Building Industries Pty Ltd v. Queensland Cement & Lime Co Ltd (No 4) [1985] 1 QdR 127; (1984) 14 ACLR 456; (1984) 2 ACLC 829. His Honour identified the following three principles from those cases:

(a) the words 'in concert' take their meaning from the context and the scope and the purpose of the legislative framework they appear in;

(b) the term 'acting in concert' involves at least an understanding between the parties as to a common purpose or object; and

(c) the common purpose or object can be established by inference as much as by direct evidence.

In the Adsteam Building Industries Case (at ACLC 832), McPherson J said:

I cannot see that it is possible for persons to act in concert towards an end or object, or even simply to act in concert, unless there is at least an understanding between them as to their common purpose or object. The expression in question evokes the notion of joint actors, or perhaps even joint tortfeasors, as to which it is settled that there must be "concerted action to a common end": see The Koursk (1924) p. 140 at 156.  A mere coincidence of separate acts is insufficient: see Fleming: The Law of Torts, 6^th ed., at pp. 227-228.

In Australasian Meat Industry Employees Union v. Allied Trades Federation of Australia (1991) 32 FCR 318 at 329; (1991) 104 ALR 199 at 209; Gray J said:

The difficulties in the concept of in concert are acute when the acts of one person are confined to advising, requesting, encouraging or inciting the other, who responds by performing the desired act.

At FCR 334, ALR 215 French J said:

The phrase in concert has been construed as involving knowing conduct, the result of communication between the parties and not simultaneous actions occurring spontaneously. It has been said to involve contemporaneity and a community of purpose which requires a consensual element:

And, in J-Corp Pty Ltd v. Australian Builders Labourers Federated Union of Workers (WA) (1992) 111 ALR 502 at 536; French J said:

Conduct involving direction and response may, according to the circumstances of the case, be conduct in concert on the part of the person directing and the person acting upon that direction.

Consistent with the views drawn from the above cases and the ordinary meaning of the term, a person will be viewed as acting in concert with a taxpayer for the purposes of the 'affiliate' definition where they both act together in pursuit of a common goal or purpose and the taxpayer is able to direct the other person in relation to, and not merely where the taxpayer is involved, connected to or participated in, the carrying on of the business.

The provision is not directed at situations where parties act in a certain way in relation to each other based on such things as formal agreements or relationships, legal requirements, fiduciary obligations and the like. The affiliate concept requires something more than the mere relationship.

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, partnerships, etc, 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.

Relevant factors that may support a finding that a person acts, or could reasonably be expected to act, in accordance with the taxpayer's directions or wishes, or in concert with the taxpayer include:

· the existence of a close family relationship between the parties,

· the lack of any formal agreement between the parties prescribing how the parties are to act in relation to each other,

· the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements; and

· the actions of the parties.

In applying the above points to your situation:

· although Company B and Company C appointed directors to Company A, neither of their appointed directors can exercise a casting vote on Company A;

· all the companies have autonomous administrative structures and sets of employees,

· they have no dealings with each other,

· all the day-to-day administrative functions of Company A are undertaken by the CEO and employees;

· there are no family or close personal relationships between the board of Company B and the board of Company C.

· Company A board does not influence or work in concert with Company B in relation to the business affairs of Company C;

· Company A board does not influence or work in concert with Company C in relation to the business affairs of Company B.

We find that Company B and Company C are not an affiliate of Company A under section 328-130 of the ITAA 1997 for the purposes of determining the aggregated turnover of Company A in terms of paragraph 328-115(2)(c) of the ITAA 1997.

Conclusion

On the facts of this ruling, for the purposes of the R&D tax offset provisions in section 355-100, both Company B and Company C are connected entities to Company A and their annual turnover will be added into the aggregated turnover of Company A in terms of paragraph 328-115(2)(b) of the ITAA 1997.

Company B and Company C are not an affiliate of Company A under section 328-130 of the ITAA 1997 for the purposes of determining the aggregated turnover of Company A in terms of paragraph 328-115(2)(c) of the ITAA 1997