Edited version of your written advice

Authorisation Number: 1012978417342

Date of advice: 4 March 2016

Ruling

Subject: Determination under subsection 328-125(6) of the Income Tax Assessment Act 1997

Question

Will the Commissioner exercise the power given to him by subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that Company A was not controlled by Company X, in the relevant income year?

Answer

Yes

Relevant facts and circumstances

1. Company A is an Australian incorporated proprietary company subject to its constitution (Constitution) and a shareholders' deed (Deed).

2. Two categories of shares have been issued by Company A. The voting rights are the same for both categories of shares.

3. Company A's capital structure throughout the relevant income year was as follows:

a. Company X held 49% of the shares.

b. A group of other entities held the remaining 51% of the shares (the Group), in their own right or through their nominees (individuals, trusts and companies).

4. The Group is recognised as the founders of Company A in the Deed.

5. The shareholders of Company A operate at arm's length according to the terms of the Deed and have no other relationship or affiliation.

6. The Constitution and Deed sets out the obligations and rights of the shareholders of Company A, and provides for the governance of Company A, including:

a. the composition, meetings and resolutions of the board of directors

b. the management of Company A; and

c. requirements for shareholders resolutions.

7. The Board Meetings were attended by Company X and Group appointed directors during the income year.

8. On a day-to-day basis, the members of the Group work in concert in relation to all matters pertaining to the day-to-day management of Company A.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-125

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

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

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

Reasons for decision

The control provisions in section 328-125 of the ITAA 1997 prescribe that an entity controls another entity if it has an at least 40% control percentage in that other entity (on an affiliate inclusive basis). In particular, control of a company is relevantly defined in subsection 328-125(2) of the ITAA 1997 as an entity, its affiliates, or the entity together with its affiliates:

• owning interests in the company that carry between them the right to receive a percentage that is at least 40% of any distribution of income, or any distribution of capital by the company; or

• owning equity interests in the company that carry between them the right to exercise, or control the exercise of, a percentage that is at least 40% of the voting power in the company.

Further, an affiliate is defined by subsection 328-130(1) of the ITAA 1997, as an individual or a company which acts, or could reasonably be expected to act in accordance with another entity's directions or wishes, or in concert with another entity, in relation to the affairs of the business of the individual or company.

Subsection 328-125(6) of the ITAA 1997 provides that if an entity's control percentage in another entity 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.

However, there is no definition of the term 'control' as used in subsection 328-125(6) of the ITAA 1997. Some guidance is provided in the Guide To Capital Gains Tax Concessions For Small Business 2014-15 (the Guide). The Guide sets out the following with respect to subsection 328-125(6) of the ITAA 1997:

Between 40% and 50% control

Whether or not a third entity has a control percentage of at least 40% may assist in determining whether the third entity controls the other entity, but it is not decisive...In working out the third entity's control percentage, the interests of any affiliates of the third entity are taken into account.

Alternatively, it is possible that both of the entities with a control percentage of at least 40%, or both an entity with a control percentage of at least 40% and an entity that controls the other entity in another way, may control the other entity if responsibilities are shared.

Example

Lachlan owns 48% of the shares in Ayoubi Art Supplies. He plays no part in the day-to-day or strategic decision making of the business. Daniel owns 42% of the shares in the company. The remaining 10% of shares are beneficially owned by a third shareholder who does not take part in the management of the business. All shares carry the same voting rights and Daniel makes all day-to-day and strategic decisions for the company. Even though Lachlan owns 48% of the shares in Ayoubi Art Supplies, he would not be taken to control the company if the Commissioner was satisfied that the company is controlled by Daniel.

Further, the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (the EM), relevantly sets out the following in relation to subsection 328-125(6) of the ITAA 1997:

2.59 Where an entity's interest in another entity is at least 40 per cent but less than 50 per cent the Commissioner may choose to ignore the interest of that entity in the other entity if the Commissioner determines that a third entity actually controls the other entity. [Schedule 1, item 1, subsection 328-125(6) of the ITAA 1997]

2.60 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 has a 40 per cent interest may assist in determining whether the third entity controls the other entity, but it is not decisive.

Example 2.10

Chandra owns a restaurant with a turnover of less than $2 million and has inherited his father's 42 per cent interest in a software company. The other 58 per cent of the software company is owned by the manager of the company, and Chandra has had no dealings with the manager whatsoever.

The turnover of Chandra's restaurant will not be aggregated with the turnover of the software company if the Commissioner thinks that the software company is actually controlled by the other person with the 58 per cent interest.

The plural reference in subsection 328-125(6) of the ITAA 1997 to "entities" admits the possibility of a group of entities controlling a company but does not expressly require such entities to be affiliates. As such, the text of the provision shows that the notion of shared control of an entity (including companies) exists within the meaning of control in subsection 328-125(6) of the ITAA 1997. However, there must be a valid and meaningful sense in which such a group of shareholders can be said to control a company (and to the exclusion of other shareholders).

The examples and associated commentary in the EM and the Guide lend support to this and also show that the Commissioner will not automatically determine that an entity with a control percentage of 40-49% does not control another entity because there is a majority shareholder (or group of shareholders). Rather, the Commissioner will also have regard to voting rights at the board level, day-to-day management and strategic decision making of the company. Furthermore, if control is shared between the 40-49% shareholder and a 51-60% shareholder (or group of shareholders), then the Commissioner will not determine the 40-49% shareholder does not control the company.

Accordingly, it is considered the meaning of control of a company in subsection 328-125(6) of the ITAA 1997 departs from its general law meaning (being control of a majority of votes at a general meeting by a single shareholder), as stated by Windeyer J in Mendes v. Commissioner of Probate Duties (1967) 122 CLR 152 (at 170):

For the purposes of the revenue laws a member of a company who holds enough shares to give a majority of votes at a general meeting has 'control' on the company. That is the general rule. Control in that sense means the capacity to carry an ordinary resolution at a general meeting.

The share ownership in Company A is as follows:

a. Company X held 49% of the shares.

b. A group of other entities (or through their nominees) held the remaining 51% of the shares (the Group).

Based on the above share ownership, Company X controls Company A under subsection 328-125(2) of the ITAA 1997 as it has an at least 40% control percentage. Further, no other shareholder or group of shareholders control Company A under subsection 328-125(2) of the ITAA 1997. The members of the Group are not affiliates of Company X. The members of the Group are also not affiliates of each other as they do not carry on business themselves - the requisite behaviour must be in relation to the affairs of the supposed affiliate's business. In addition a number of the Group shareholders are trusts which cannot be affiliates, as that status is restricted to individuals and companies.

However, subsection 328-125(6) of the ITAA 1997 does not require the contended group of controllers (in this case, the Group) to be affiliates. In this case, the Group founded Company A together, collectively own the majority of it, and in practice, actively run it together. The Deed and the Constitution point to the Group collectively having a majority of the voting power on most matters at shareholder meetings and at board meetings. In practice, they also have control of all the day-to-day management of the company and have general control of the company's strategic direction.

Having regard to the substance and the commercial reality of the matter, the Group can on balance be said to control Company A, even though they are not "affiliates" of each other within the meaning of subsection 328-130(1) of the ITAA 1997.

In the circumstances, as the Commissioner thinks that Company A is controlled by the Group, the Commissioner will exercise the power given to him by subsection 328-125(6) of the ITAA 1997 to determine that Company A was not controlled by Company X, in the relevant income year.