Edited version of your written advice

Authorisation Number: 1012976183350

Date of advice: 20 April 2016

Ruling

Subject: Income tax ~ research and development ~ entitlement to tax offset

Question 1

Will the Commissioner exercise his discretion under subsection 328-125(6) to determine that the Other Entity does not control the Holding Company?

Answer

Yes

Question 2

Is the Other Entity an affiliate of the R&D Claimant pursuant to section 328-130?

Answer

No

This ruling applies for the following periods:

Period ended 30 June 20YY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The scheme that is the subject of this Ruling is described below. The description is based on, and includes references to, the provided documents.

Structure of the R&D claimant and the Holding Company

The R&D claimant is an Australian company with 100% of its total ordinary shares held by the Holding Company. The Holding Company and its subsidiaries are collectively referred to as the Group.

Holding Company is an Australian company with its total ordinary shares held in the following proportions:

• More than 50% by Australian residents (ARS), and

• Less than 50% by the Other Entity.

These are the proportions in which rights to voting and receiving income and capital distributions are held.

A quorum for a meeting of shareholders requires at least one representative of the Other Entity and the ARS. Each shareholder has one vote for each fully paid share they hold.

The management of the Company vests in the Board. The Board is comprised of the ARS as directors, an individual appointed by the Other Entity (Other Appointed Director [OAD]) and another entity appointed by the Board as Chairman.

Board Voting of the Holding Company

The Board of the Holding Company does not report, and is not subject, to the board of the Other Entity and the boards are separately functioning with no directors common to both.

Each director has one vote for voting on Board resolutions. The Chairman is entitled to a second or casting vote in matters where equal votes are cast. The Chairman has a longstanding association with the ARS and was a former shareholder in the Group. The Chairman votes with the ARS on any matter considered by the Board. There have been no instances where the Chairman has voted against the ARS.

All Board meetings have been held in Australia. The ARS set the agenda and run the Board meetings. The Other Entity appointed director's involvement has been limited to asking questions about the financial information.

The strategic direction, decision making and actions of the Holding Company and subsidiary entities, including the R&D claimant, are determined by the ARS prior to the Board meetings without the involvement of the Other Entity appointed director or the non-executive director.

Day to day operations of the R&D claimant

The decision making and management of the day to day operations, including administration, legal and finance functions of the Holding Company and the R&D claimant rests with the ARS who constitute the executive management team. The Other Entity has a passive involvement in the operations of the R&D claimant through the Holding Company with the position taken that any decision made by the Holding Company's Board should be in the best interests of the Holding Company Group.

The ARS are not required to act in accordance with the directions of the Other Entity. There are times when the ARS request support and assistance form the Other Entity's staff on various matters but the ultimate decision making responsibility rests with the ARS in relation to any advice received from the Other Entity.

As part of the day to day operations the executive management team (consisting of the ARS) ensures that the Holding Company is operated in accordance with business plan, developed by the executive management team, is followed.

The ARS established their own Advisory Committee for the Group, which did not include the Other Entity or its representative.

The ARS and the Holding Company's finance manager are the only signatories on the Group's bank accounts. There is no one from the Other Entity eligible to transact on the accounts.

Relationship of the ARS/ARS

The ARS are the sole directors in the R&D claimant. They jointly make the strategic decisions regarding the direction of the Group and have always acted in concert with each other. The Other Entity has no involvement in this regard. The Group's direction ultimately rests with the ARS.

The ARS have always voted together in relation to all decisions of the Group, in their capacities as directors and shareholders. The ARS are financially interdependent and manage their personal affairs jointly.

Relationship between the Other Entity and the ARS

There are no personal relationships, financial dependencies, common links or shared strategic decision making that exist between the parties that would indicate that the ARS could be expected to act in accordance with the directions or wishes of, or in concert with, the Other Entity; or that the Other Entity could be expected to act in accordance with the directions or wishes of, or in concert with, the ARS.

Relationship between the Holding Company/R&D claimant and the Other Entity

The Shareholders' Agreement is the only agreement which establishes the relationship between the Group and the Other Entity.

Neither the Group nor the ARS own any shares in, or any rights to vote or receive any distributions of income or capital from, the Other Entity.

All operational and R&D business matters of the Group are handled without any input from the Other Entity.

The Group and the Other Entity do not undertake business dealings with each other.

The Group and the Other Entity do not share common resources and do not operate together. In particular:

• They use different business systems.

• The Group is not dependent on the Other Entity for access to loans or guarantees.

• They do not share common banking facilities and are not signatories on each other's accounts.

• There are no common flows of revenues.

• They purchased goods and services independently of each other.

• They maintain separate client bases.

• They have different employees.

• They operate from different locations.

• They do not seek to pursue business opportunities through each other.

• The Other Entity does not communicate or negotiate with suppliers, clients or other key external stakeholders on behalf of the Group.

• There are no financial dependencies between the two groups.

• There are no close personal relationships between any key employees, including Board members and directors, between the Other Entity and the Group. There are no common directors.

• The Group has no ownership interest in the Other Entity.

The Group does not have any affiliates with, relationships or interest in, any entities that have an interest in the Other Entity. The Group does not have any other relationship with, or interests in entities, that have a connection with the Other Entity that would be covered by section 328-130 of the ITAA 1997.

Relationship between the Other Appointed Director and the ARS

There are no family or close personal relationships between these parties. No directors are common to both the Other Entity and the Holding Company.

Relationship between Holding Company and the Other Entity

Holding Company does not control, directly or indirectly, the Other Entity.

Relationship between the Other Appointed Director and the ARS

There are no circumstances that would indicate that either entity could be expected to act in accordance with the directions or wishes of, or in concert with, the other in relation to each other's business. There are no other relationships between these parties other than the requirements outlined in the Shareholder's Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 328-115

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, paragraph 328-125(2)(a)

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

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

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

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

Question 1

Summary

The Commissioner has exercised his discretion under subsection 328-125(6) to determine that the Other Entity does not control the Holding Company.

Detailed reasoning

The relevant provisions

Subsection 328-125(1) provides that:

328-125(1)

An entity is connected with another entity if:

(a) either entity controls the other entity in a 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 an entity other than a discretionary trust is defined in subsection 328-125(2). Under paragraph 328-125(2)(b), an entity controls a company where an entity 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 (the control percentage).

Under subsection 328-125(7), 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.

The Commissioner's discretion

Subsection 328-125(6) provides that:

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 other entity is controlled by an entity other than, or by entities that do not include, the first entity or any of its affiliates. (emphasis added)

While this subsection refers to 'control by entities', it does not indicate that those entities must necessarily be affiliates.

Subsection 328-125(1) refers to control 'in a way described in this section', which limits control by more than one entity to the entities that are affiliates. However, subsection 328-125(6) refers to 'control' by an entity or entities without stipulating that the control must be 'in a way described in this section'. This distinction indicates that in exercising his discretion, the Commissioner may consider which entity actually has 'control' as understood in the ordinary sense.

Referring to the Commissioner's discretion in subsection 328-125(6), paragraph 2.60 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Act 2007 states,

The Commissioner may think that another entity controls the entity either based on fact or on a reasonable assumption or inference. Whether or not the third entity or entities has a control percentage of at least 40% may assist in determining whether the third entity or entities control the other entity, but it is not decisive.

A relationship of control may be inferred from the interaction between the entities concerning the operation of the entity's business. For example, who has the power to decide what has to be done, how it will be done, when will it be done and where?¹

Application to your circumstances

The Other Entity has a control percentage of more than 40% and so, in the first instance, has direct control of the Holding Company pursuant to paragraph 328-125(2)(b) and indirect control of the R&D claimant pursuant to section 328-125(7). The Other Entity is therefore connected with the Holding Company and the R&D Claimant for the purposes of section 328-125.

However, as the Other Entity holds a control percentage of at least 40% but less than 50%, the Commissioner may exercise his discretion under subsection 328-125(6) to determine that the Other Entity does not control the Holding Company if he is satisfied that Holding Company is controlled by an entity other than, or by entities that do not include, the Other Entity or any of its affiliates.

Control of the Holding Company

The Commissioner may exercise his discretion to determine that the Other Entity does not control Holding Company if the Commissioner thinks that Holding Company is controlled by the ARS.

The ARS together carry between them the right to exercise, or control the exercise of, more than 50%, of the voting power in the company.

In determining the controlling entity/entities of the Holding Company, a primary consideration is who is responsible for the strategic decision making on behalf of the company and the day to day running of the company.

Strategic decision making in relation to the Holding Company

The strategic direction, decision making and actions of the Holding Company and subsidiary entities is determined by the ARS, without involvement by the Other Entity or any entity controlled by the Other Entity. The ARS form the executive management team along with independent advisors who have no relationships with the Other Entity. Given this and the fact that the ARS hold more than 50% of the shareholder voting rotes, ultimate control of the strategic operations and decision making aspects of the Holding Company is held by the ARS.

Day to Day Management

The decision making and management of the day to day operations, including administration, legal and finance functions of the Holding Company and the R&D claimant rests with the ARS, who constitute the executive management. The executive team does not act in accordance with the instructions of the Other Entity or their appointed director and does not report to them. Further, the ARS and the Holding Company's finance manager are the only signatories on the Group's bank accounts, and there is no one from the Other Entity eligible to transact on the accounts.

The ARS fulfil the relevant administrative positions in relation to the day to day running of the Holding Company. The Other Entity has no part in this taking a passive stance and providing assistance infrequently only as required. Even in this case, the ultimate decision making responsibility rests with the ARS.

Relationship between the Other Entity and the ARS

If the Other Entity and the ARS are affiliates or one controls the other then the aggregated turnover of the Other Entity will still be included in the turnover of the R&D Claimant.

There are no circumstances that would indicate that either entity could be expected to act in accordance with the directions or wishes of, or in concert with, the other in relation to each other's business. Neither has control of the other in the sense explained by subsection 328-125(2) or in the ordinary sense as exemplified in subsection 328-125(6).

Conclusion

It is reasonable to conclude that the strategic decision making and day to day running of the Holding Company are controlled by the ARS.

The Commissioner is satisfied that the ARS directly control the Holding Company and are neither controlled by nor affiliates of the Other Entity. Thus, the Commissioner will exercise his discretion under subsection 328-125(6) and determine that the Other Entity does not control the Holding Company and thus does not indirectly control the R&D claimant. Thus, the Other Entity's annual turnover should not be included in the R&D Claimant's aggregated turnover under subsection 328-115(2).

Question 2

Summary

The Commissioner has determined that the Holding Company and the Other Entity are not affiliates pursuant to section 328-130.

Detailed reasoning

The relevant provisions

Meaning of affiliates

Section 328-130 states the meaning of affiliate 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.

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 ' STS affiliate' for the purposes of determining whether an entity satisfies the eligibility rules in Subdivision 328-F (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 is closely aligned with the requirements set out in section 328-125. As such, the Commissioner's guidelines in TR 2002/6 are relevant to the meaning of affiliates for the purposes of section 328-130.

The scope of the affiliate definition is described in TR2002/6 as follows:

31. The *STS affiliate definition in subsection 328-380(8) 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.

Meaning of 'could reasonably be expected'

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

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.

Meaning of in 'concert'

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.

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

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

n common resources, facilities or services;

n involvement in managerial decisions and day to day management;

n financial interdependencies;

n common flow of profits;

n common ownership/capital;

n shared purchasing of goods or services;

n common customers; and

n similar kind of business

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

Application to your circumstances

There is nothing to suggest that either entity will act in accordance with the other's wishes or act in concert with each other. The only relationship the entities have is that the Other Entity holds a substantial shareholding in the Holding Company. There are no other routes of control by one entity over the other and no routes of common control of both companies by any third parties.

Thus, the Holding Company and the Other Entity are not affiliates pursuant to section 328-130.

¹ The concept of control is discussed in Taxation Ruling No. IT 2602 Income tax: privately owned power stations : control by state electricity authorities and Taxation Ruling TR 96/22 Income tax: section 51AD - deductions not allowable if an asset financed by non-recourse debt is used by a tax exempt or other entity and Taxation Ruling TR 2002/6 Income Tax: Simplified Tax System: eligibility - grouping rules (*STS affiliate, control of non fixed trusts).