Edited version of private advice

Authorisation Number: 1012640208808

Ruling

Subject: Income tax - research and development - connected or affiliated entities

Question 1

For the purpose of calculating the aggregated turnover in accordance with Item 1 in subsection 355-100(1) of the Income Tax Assessment Act 1997 (ITAA 1997) are XX Pty Ltd (XX) and YY Holdings Pty Ltd (YYH) connected entities?

Answer

No

Question 2

For the purpose of calculating the aggregated turnover in accordance with Item 1 in subsection 355-100(1) of the Income Tax Assessment Act 1997 (ITAA 1997) are XX Pty Ltd (XX) and YY Holdings Pty Ltd (YYH) affiliates?

Answer

No

This ruling applies for the following period

1 July 20AA to 30 June 20AB

The scheme commenced on

1 July 20AA

Relevant facts

YYH applied for the research and development (R&D) tax incentive. It is the head company of a consolidated group which manufactures and sells (wholesale and some online sales) personalised products. There are retail and manufacturing subsidiaries.

Another entity, XX has also applied for the R&D tax incentive. The 20AA-AB income year was XX's first year of operation, and it made a loss. As an interim measure (until the outcome of this private ruling is known) XX has lodged its R&D return on the basis of a 40% tax offset. XX is a retailer which has direct sales to shopping centres customers.

It has vehicles that tour throughout the country. They retail their own produce as well as to a very small extent contract with YYH for larger productions items for which fees are paid.

Directors and shareholders

The directors of YYH are AA and BA.

The directors of XX are:

• AA

• MM an employee/shareholder of YYH (owns 10% of YYH),

• WW - an employee/shareholder of XX with many years specific experience in this business, and

• JJ - an employee/shareholder of XX with many years specific experience in this business.

WW and JJ both worked previously in a similar business.

There are no common shareholders:

• YYH is owned to the extent of 80% by EE Family Holdings Pty Ltd (EE) and the remaining 20% is owned equally by two family trusts owned by EE employees. EE is owned by family trusts controlled by members of the EA extended family

• XX is owned to the extent of 50% by EEI Pty Ltd which is owned by the EA family members' family trusts and two EE employees' family trusts and the remaining 50% is owned by employees and associated entities of employees of XX. YYH does not own any shareholding in XX.

Business decisions

XX chooses its own business modus operandi in all material aspects. It chooses:

• how and where it will make its sales,

• what its sales projections will be,

• what staff It will employ, how it incurs expenses,

• what level of wages it pays its staff,

• what its marketing plan is,

• what products It develops and sells,

• how it does the work,

• what equipment it buys, etc

YYH's operational objectives are:

• manufacture - least cost and best quality

• innovate new methods of production that increases productivity and reduces waste

• develop new products for wholesale clients

• expand email data base and market share

ITP's operational objectives are:

• provide products to retail customers at shopping centres throughout Australia using traditional methods of face to face contacting.

• build and maintain business relationships with shopping centre owners and managers to ensure repeat work

• grow the business

Degree of connection with or dependence on the other company

Nature and extent of commercial dealings between the two entities - these are not substantial. YYH receives approximately 0.5% of its revenue from XX.

Sharing common resources

• Business premises - None.

• YYH operates from offices and factories in NSW.

• XX's premises are primarily in Queensland and travel to other states

• Staff - there is possibly 5% of staff used on an infrequent basis that are employed by YYH, these being information technology staff of YYH that provide technical services, for which a commercial fee is paid.

• Management - One director (AA) of YYH is a director of XX, but receives no remuneration from XX. One other employee/shareholder (MM) of YYH is a director of XX, but does not provide any substantive role or advice, and receives no remuneration from XX. No other directors of XX are directors of YYH.

• Accounting - Some reporting functions and some information technology work is done by a subsidiary of YYH. A commercial fee is charged for this.

Share income producing assets - none.

• Both entities stand independently in terms of premises and Income producing assets.

Involvement in day to day management decisions - not at all. The directors talk as needed about XX business affairs, but neither company tries to influence the other company for the betterment of either YYH or XX.

Financial Interdependence - access to loans or guarantees - yes. YYH provides a guarantee for finance that has allowed XX to grow at the pace it is growing at. The original owners of XX approached AA to provide finance when they set up the business. AA agreed on the basis that they could be 50% shareholders in the business.

Because the personal guarantees of AA and AB were being used, XX was able to raise the finance it needed. The bank also secured assurances from YYH, but YYH has no formal connection with XX in any other commercial dealing or ownership Interest.

Common flow of profits - none.

Common ownership - none

Shared purchasing of goods - none, each entity purchases their own goods.

Common customers - none.

• YYH's clients are mainly retailers and to a smaller degree direct email contacts.

• XX sources its customers from shopping centres as the customers are walking through the shopping centres.

Similarities of business - none.

• YYH is mainly a wholesaler producer.

• XX Is a retail business sourced from shopping centre patrons.

None of the entities involved are exempt entities.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 328-115

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

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, subsection 328-125(1)

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

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(7)

Income Tax Assessment Act 1997, subsection 328-125(8)

Income Tax Assessment Act 1997, section 328-130

Income Tax Assessment Act 1997, subsection 328-130(1)

Income Tax Assessment Act 1997, Division 355

Income Tax Assessment Act 1997, section 355-100

Income Tax Assessment Act 1997, Item 1 subsection 355-100(1)

Income Tax Assessment Act 1997, section 995-1

Reasons for decision

Division 355 of the ITAA 1997 applies to tax periods commencing on or after 1 July 2011 to encourage companies to conduct research and development (R&D) activities in Australia. It does this by providing a revised tax incentive in the form of a tax offset referred to as the 'R&D Tax Incentive' for eligible R&D expenditure.

Item 1 in subsection 355-100(1) allows a rebate to the extent of 45% for R&D expenditure provided the aggregated turnover for the income year is less than $20million provided the R&D entity is not controlled by exempt entities.

'Aggregated turnover' is a defined term and section 995-1 of the ITAA 1997 states that 'aggregated turnover' has the meaning given in section 328-115 of the ITAA 1997.

Section 328-115 of the ITAA 1997 states that the aggregated turnover for an income year is the sum of the relevant annual turnovers as outlined in subsection (2).

Subsection 328-115(2) of the ITAA 1997 states:

The relevant annual turnovers are:

(a) your annual turnover for the year, and

(b) the annual turnover for the income year of any entity (a relevant entity) that is connected with you at any time during the income year, and

(c) the annual turnover for the income year of any entity (a relevant entity) that is an affiliate of yours at any time during the income year.

Question 1

Summary

Based upon the information provided it has been determined that XX is not connected with YYH.

Detailed reasoning

In order to apply entitlement to an R&D tax offset at the rate of 45% as recorded in item 1 of the table under subsection 355-100(1) of the ITAA 1997, XX's aggregated turnover must be less than $20 million. For the purposes of calculating the aggregated turnover of XX under section 328-115 of the ITAA 1997 it is necessary to determine whether YYH is connected with XX.

The concept of control is fundamental to the meaning of 'connected with' for the purposes of section 328-125 of the ITAA 1997. The control test depends on the type of entity in question.

In accordance with subsection 328-125(1), an entity is connected with another entity if one of the entities controls the other entity, or if the two entities are controlled by the same third entity.

For entities other than discretionary trusts - in accordance with paragraph 328-125(2)(a) of the ITAA 1997, an entity controls another entity where that entity alone and/or its affiliates own, or have the right to acquire the ownership of, interests in the other entity that between them give the right to receive at least 40% of any distribution of either income or capital by the other entity.

For companies, an alternative test applies - in accordance with paragraph 328-125(2)(b) of the ITAA 1997, an entity controls another entity where an entity alone 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.

There is no direct control of either entity in the other. For that to occur one entity would be required to have shares that give it at least 40% of the voting interests in the other entity. In this case there are no ownership interests that either entity has in the other. YYH does not own any shareholding in XX or vice versa therefore there is no question of either entity having direct control of the other as a result of shareholding.

An indirect control test also applies to all entities. In accordance with subsection 328-125(7) of the ITAA 1997, if an entity (the first entity) directly controls another entity (the second entity) and that second entity controls (directly or indirectly) another entity (the third entity), the first entity is deemed to control the third entity.

Subsection 328-125(8) provides exceptions for certain entities to limit the operation of subsection 328-125(7) however, none of the exceptions apply in this situation.

There is no indirect control as outlined in subsection 328-125(7) of the ITAA 1997.

XX and YYH are not connected entities

Question 2

Summary

Based upon the information provided it has been determined that XX is not an affiliate of YYH.

Detailed reasoning

In order to be eligible for a R&D tax offset at the rate under item 1 of the table under subsection 355-100(1) of the ITAA 1997, XX's aggregated turnover must be less than $20 million. For the purposes of calculating the aggregated turnover as described in section 328-115 of the ITAA 1997 it is necessary to determine whether YYH is an affiliate of XX.

In accordance with section 328-130 of the ITAA 1997 an individual or company is an affiliate of an entity where that individual or company acts, or could reasonably be expected to act in accordance with the entity's directions or wishes in relation to the affairs of that individual or company's business, or in concert with the entity in relation to the affairs of the individual or company's business. However, an individual or a company is not an affiliate of an entity merely because of the nature of the business relationship the entity and the individual or company shares.

Taxation Ruling 2002/6 Income tax: Simplified Tax System: eligibility - grouping rules (*STS affiliate, control of non fixed trusts) (TR 2002/6) sets out the Commissioner's views on the meaning of an 'STS affiliate' for the purposes of determining whether an entity satisfied the eligibility rules in Subdivision 328-F of the ITAA 1997 (the provision has been repealed).

Although the STS no longer operates for the 2007-08 and later income years, the definition of 'STS affiliate' under the former Subdivision 328-F of the ITAA 1997 is closely aligned with the requirements set out in section 328-125 of the ITAA 1997. As such, the Commissioner's guidelines in TR 2002/6 are relevant to the meaning of affiliates for the purposes of section 328-130 of the ITAA 1997.

The scope of the affiliate definition is described in TR 2002/6 as follows:

31. The *STS affiliate definition in subsection 328-380(8) of the ITAA 1997 does not apply where the potential *STS affiliate acts or could reasonably be expected to act as another directs or wishes, or in concert with it, only in relation to isolated transactions or on an irregular, ad hoc basis. For the definition to apply, the potential *STS affiliate must act in accordance with the entity's directions or wishes or in concert with it, or could reasonably be expected to so act, in relation to all or a substantial part of the affairs of the potential *STS affiliate's business.

The Full High Court, in FC of T v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344 (Peabody's case), held that the phrase 'might reasonably be expected' requires more than a possibility.

As discussed in TR 2002/6 an entity, the first entity, 'could reasonably be expected' to act in accordance with another entity's, the second entity's, wishes where the second entity has a relationship of control or influence over the first entity. Such a relationship can be evidenced by the entities behaviours and the presence of any influential relationships, such as:

(a) family or other close personal relationships;

(b) financial relationships and dependencies; and

(c) relationships created through links such as common directors, partners or shareholders.

Conversely, the entities' behaviours, obligations to each other and external parties, and their own interests may evidence the lack of such a relationship.

For a company, this relationship depends on whether the majority shareholders and/or directors of the company can reasonably be expected to act in accordance with another entity's directions or wishes or 'in concert' with the other entity.

TR 2002/6 explains, at paragraph 59, that entities will only be regarded as acting 'in concert' with each other where:

(a) it is acting together with the other entity in pursuit of a common goal or objective; and

(b) that common goal or objective is the carrying on of a business by the potential *STS affiliate with a substantial degree of connection with or dependence on the business carried on by the other entity.

The table at paragraph 65 in TR 2002/6 suggests a number of factors to take into account when determining whether two entities are acting in concert with each other. These include:

• the nature and extent of commercial dealings between the two entities;

• common resources, facilities or services;

• involvement in managerial decisions and day to day management;

• financial interdependencies;

• common flow of profits;

• common ownership/capital;

• shared purchasing of goods or services;

• common customers; and

• similar kind of business

Whether an entity is an affiliate is a question of fact and degree in relation to which an exercise in judgment is necessary, which involves a process of evaluating and weighing a range of factors for the particular circumstances.

As discussed in TR 2002/6 we must consider the factors which could influence the actions of entities which may be affiliated by first examining the 'influential relationships' between the entities. These exist in the nature of the ownership of shares by family trusts, family members and employees of the companies. They are also present in the nature of a common director of the two companies as well as a director of XX being a staff member and shareholder of YYH.

There are also substantial financial links in the nature of loans and guaranteed loans.

Paragraph 54 of TR 2002/6 must be considered with reference to the nature of the relationship between XX and YYH:

However even where such a relationship is present, it must be of sufficient strength to enable the entity to direct or influence the… actions in relation to all or a substantial part of the affairs of the latter's business.

Despite the potential which 'could reasonably be expected' to influence the behaviour of the company we must examine whether or not that has actually occurred and the companies can be said to be acting 'in concert' with each other.

In accordance with the 'facts' provided it has been asserted that there are few parallels between the companies and the businesses which they conduct. There are limited commercial dealings between the companies and these mainly comprise technical assistance and manufacturing tasks which the company could reasonably be expected to outsource. In the ordinary course of business those tasks could be performed by another business however in this case they are performed by a business with a common director.

The business decisions as well as operational objectives are independent. There are no shared purchases of goods and services, common customers or even a similar kind of business, there are no common resources, facilities or services. Most importantly the businesses do not pursue common goals or objectives. It seems therefore that neither entity has 'sufficient strength' to direct all or a substantial part of the other business' affairs.

Paragraph 328-130(1) of the ITAA 1997 states that a company is an affiliate of yours if they act or could reasonably be expected to act in accordance with your direction or wishes however they are not an affiliate merely because of the nature of the business relationship you share.

Hill J in Peabody's case also considered the reasonable expectation test. His Honour held that the word 'reasonable' must be understood as distinguishing what is required from an expectation that is 'unreasonable, irrational or absurd'. He further held that the word 'expectation' requires the hypothesis to be one that proceeds beyond the level of a mere possibility to become one which is the expected outcome.

XX does not act, nor can it be reasonably expected to act in accordance with the directions of, or in concert with YYH as stated in subsection 328-130(1) of the ITAA 1997. As provided for in subsection 328-130(2) a company is not an affiliate merely because of the nature of their business relationship.

Having regard to the full facts and circumstances presented in this case, it is evident that, despite the relationship between the companies, XX cannot reasonably be expected to act in a manner where it is directed or influenced in all or a substantial part of the affairs of their business by YYH thereby placing it within the meaning of an affiliate of YYH.

Further issues for you to consider

Where the facts presented in the ruling application change, this ruling may no longer apply.