Edited version of your written advice

Authorisation Number: 1051514215698

Date of advice: 07 May 2019

Ruling

Subject: Connected entities

Question 1

Is Company A connected with Company B under section 328-125 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the Commissioner make a determination under subsection 328-125(6) of the ITAA 1997 that Company A is not controlled by Company B?

Answer

No.

Question 3

Will Company A’s ‘aggregate turnover’ (as defined under 328-115 of the ITAA 1997) include the ‘annual turnover’ (as defined in 328-120 of the ITAA 1997) of Company B?

Answer

Yes.

This ruling applies for the following period:

Income tax year ended 30 June 2018

The scheme commences on:

February 20XX

Relevant facts and circumstances

Company A is an incorporated Australian proprietary company registered in 20XX.

The issued share capital of Company A consists of ordinary shares only. All shares have equivalent rights in respect of voting, income and capital distributions. There are five shareholders as at 30 June 20XX with Company B holding 42.01% of these shares. None of the five shareholders are controlled by the same entity nor are they affiliates of one another.

Historically, Company C held 38.5% of the shares in Company A and acquired additional newly issued shares in June 20XX increasing their holding to 42.01% of the share capital.

Company C was part of the X Group. You have advised that the X Group was acquired by the Y Group.

You have advised that the Y Group decided they wanted their shareholding in Company A to be held by a related body corporate, Company B, (an Affiliate as defined in Company A’s Shareholder’s Agreement). Therefore Company C transferred all shares they held in Company A in June 20XX. Company A received a fully executed Deed of Accession to the Transaction Documents from Company B.

The Deed of Accession provides that Company B agrees to ‘observe, perform and be bound by all the terms of the Transaction Documents (so far as those terms apply to Existing Shareholders)’.

During the year ended 30 June 20XX, there were six directors on the board of Company A. Each shareholder was represented by one director, except Company B who was represented by two directors. The Chairman of the board was also a director from Company B.

The directors representing Company B are non-executive directors and have no involvement in any operational or strategic capacity or the day to day management of Company A.

The remaining four directors are executive directors who work full time within Company A and are responsible for the day to day operational and strategic decision making. These directors all represent founding owners of the business (Founding Shareholders).

Management of Company A

The composition and operation of the Board of Company A is governed by various documents (the Transaction Documents).

The Transaction Documents outlines the order of precedence in which these documents are to be interpreted.

The Transaction Documents have not been updated to amend the definition of Company D from meaning Company C.

The Transaction Documents outlines the circumstances where written unanimous approval of the Board is required and circumstances where written approval of Company D is required.

The actions that require Company D’s approval include:

● adoption or varying of any Strategic Plan, business financial plan or any operating capital or cash budget

● circumstances surround provision of financial accommodation except in the normal course of business

● borrow or accept a financial accommodation of more than $20,000

● create any mortgage, charge, pledge or other encumbrance that is not included in the Strategic Plan over an asset or undertaking

● appoint and/or remove Senior Staff of the Company

● pay any remuneration, profit or bonus to a Director

● sell or buy assets having a value of more than $100,000

● declare, make or pay a dividend or other distribution, and

● appoint or remove the chairperson of the Company or materially change or negotiate the terms of engagement, role or responsibilities of the chairperson.

The Transaction Documents outline where an event of default occurs by an Existing Shareholder, Company D may amongst other things:

● take possession and control

● acquire any asset

● employ or discharge any person

● vary and terminate agreements

● execute documents, and

● operate bank accounts.

A Transaction Document states that in the case of an equality of votes, the chairman of the meeting, has a casting vote in addition to any vote he may have in his capacity as a Director.

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 subsection 328-115(3)

Income Tax Assessment Act 1997 section 328-120

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)(b)

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

Reasons for decision

Question 1

Summary

Company A is connected with Company B for the purposes of section 328-125 of the ITAA 1997¹.

Detailed reasoning

Section 328-125 sets out the meaning of ‘connected with an entity’. Specifically, subsection (1) states:

(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.

There are different control tests in section 328-125 that apply depending on what type of entity is being tested. Subsection 328-125(2) sets out the criteria to determine when an entity directly controls another entity, other than a discretionary trust. As Company A is a company, the relevant control test is in paragraph 328-125(2)(b), which states:

(2) An entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates:

…

(b) if the other entity is a company - 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, a percentage (the control percentage) that is at least 40% of the voting power in the company.

As Company B controls 42.01% of the issued share capital of Company A, Company B satisfies the requirement in paragraph 328-125(2)(b).

Company B directly controls Company A for the purposes of section 328-125.

Question 2

Summary

The Commissioner will not exercise his discretion under subsection 328-125(6) and determine that Company B does not control Company A.

Detailed reasoning

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.

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

Discussion of the Commissioner’s discretion under this subsection is found in paragraph 2.60 of the Explanatory Memorandum to the Tax law Amendment (Small Business) Act 2007, which 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.

In determining the controlling entity/entities of Company A, the Commissioner will give consideration to who is responsible for the strategic decision making on behalf of the company as well as the day-to-day management of the company.

You have advised that the directors of the Founding Shareholders all work full-time within the business on a day-to-day basis and hold positions which are responsible for all day to day operational and strategic decision making for Company A. These roles include the Chief Operations Officers, Managing Director, Senior Adviser and Head of Client Services.

Taxation Ruling TR 2018/5 Income tax: central management and control test of residency (TR 2018/5) provides some guidance on what to consider when determining control of an entity. Paragraphs 11-12 state that:

11. The key element in the control and direction of a company's operations is the making of high-level decisions that set the company's general policies, and determine the direction of its operations and the type of transactions it will enter.

12. The control and direction of a company is different from the day-to-day conduct and management of its activities and operations. The day-to-day conduct and management of a company's activities and operations is not ordinarily an act of central management and control. Nor is the management of day-to-day activities under the authority and supervision of higher-level managers or controllers.

Paragraph 14 of TR 2018/5 states:

14. Merely because a person is a majority shareholder, or has the power to appoint those who control and direct a company's operations does not, by itself, mean the person controls and directs a company's operations and activities.

Paragraph 16 of TR 2018/5 outlines acts that would indicate the exercising of central management and control of a company. These include setting investment and operational policy including deciding to buy and sell significant assets of the company, appointing company officers and agents (and revoking such appointments), overseeing and controlling those appointed and matters of finance including how profits are used and the declaration of dividends.

Paragraph 24 of TR 2018/5 states:

A person may control and direct a company without actively intervening in the company's affairs on an ongoing basis provided they:

● have appointed agents or managers whom they tacitly control to conduct the company's day-to-day business

● tacitly control and regularly exercise oversight of the affairs of the company, including monitoring the company's performance, and

● do not need to actively intervene because the company's affairs are running smoothly and in the manner they desire.

Application to your situation

The following factors have been considered in deciding who has control of Company A:

● The board of directors of Company A is constituted by six directors. Company B has two directors (non-executive) on the board and the remaining shareholders have one director (executive) each.

● Each director is entitled to one vote; Company B therefore has 33% of the voting rights at a board level.

● The chairman is appointed by Company D and is a non-executive director.

● A Transaction Document outline that in the case of an equality of votes, the chairman of the meeting, has a casting vote in addition to any vote he may have in his capacity as a Director.

● A Transaction Document outlines multiple actions that cannot occur without prior written approval of Company D.

● That Company D and Company B are part of the Y Group.

You have advised that the Managing Director is solely responsible for the strategic direction of the company. However in accordance with the Transaction Documents it is clear that Company D has significant powers over the management and decision making of Company A.

Additionally the chairperson (a director appointed by Company B) holds the casting vote in the case of an equality of votes.

Company D and Company B are part of the Y Group and combined hold significant control over Company A. Their role in Company A is not passive, but rather an active strategic role in the direction of Company A.

Further it cannot be established that Company A is controlled by another entity/entities and accordingly, based on the facts and circumstances, the Commissioner will not exercise the discretion under subsection 328-125(6).

Question 3

Summary

The annual turnover of Company B will be included in the aggregate turnover of Company A under section 328-115.

Detailed reasoning

The meaning of “aggregated turnover” is defined by section 328-115. Aggregated turnover for an income year is the sum of your relevant annual turnovers for the year and certain related entities of yours (excluding certain amounts as provided for in subsection 328-115(3)).

The relevant annual turnovers as per subsection 328-115(2) are:

(a) your annual turnover for the income year;

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

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

As outlined in the above questions, Company B is considered to be connected with Company A and therefore Company B’s annual turnover will be included in the aggregate turnover of Company A under section 328-115.