Edited version of private advice

Authorisation Number: 1051652823854

Date of advice: 2 June 2020

Ruling

Subject: Exercise of the discretion in subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997)

Question

Will the Commissioner exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Shareholder does not control the Company?

Answer

No

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Company carries on a business.

The Company is currently making a Research and Development (R&D) application and wants to establish the control factor within the group.

During the income year ended 30 June 20XX, the Shareholder owned 46% of the shares in the Company and some convertible notes.

An Individual indirectly controls various other shareholders in the Company.

The Individual is also primarily involved in the day to day operations of the business as well as its strategic direction.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 section 328-125

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

Income Tax Assessment Act 1997 Division 355

Reasons for decision

The Company is currently applying for an R&D tax offset under the R&D tax incentive in Division 355 of the ITAA 1997 for the year ended 30 June 20XX.

The rate of the tax offset and whether it is refundable depends primarily on the R&D entity's aggregated turnover (section 355-100 of the ITAA 1997). Only eligible entities with an aggregated turnover of less than $XXX (and one or more exempt entities do not control more than 50 per cent of the entity), are entitled to a refundable tax offset equal to 43.5 per cent of its notional R&D deductions (per section 67-30 of the ITAA 1997).

Section 995-1 of the ITAA 1997 provides that the phrase 'aggregated turnover' has the meaning given section 328-115 of the ITAA 1997.

Aggregated turnover is calculated on a 'group' basis (section 328-115 of the ITAA 1997). In broad terms, it is the sum of the annual turnovers of all of the following:

·         the R&D entity

·         any entity connected with the R&D entity at any time during the income year;

·         any entity that is an affiliate of the R&D entity at any time during the income year;

excluding any dealings between those entities.

In the current circumstances, to determine whether the aggregate turnover test is met, it is initially necessary to determine which entities may be 'connected with' the Company.

The Shareholder is connected with the Company

Subsection 328-125(1) of the ITAA 1997 provides that 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.

The direct 'control' tests which are contained in section 328-125 of the ITAA 1997 differ according to whether the entity is a discretionary trust or not.

The Company is not a discretionary trust and therefore the 'direct' control test in subsection 328-125(2) of the ITAA 1997 will apply. This test states:

An entity (the first entity) controls another entity if the first entity, it's *affiliates or the first entity together with its affiliates:

(a)  except if the other entity is a discretionary trust beneficially own, or have the right to acquire the beneficial ownership of, interests in the other entity that carry between them the right to receive a percentage (the control percentage) that is at least 40% of:

(i)    any distribution of income by the other entity; or

(ii)   if the other entity is a partnership the net income of the partnership; or

(iii)  any distribution of capital by the other entity; or

(b)  if the other entity is a company - beneficially own, or have the right to acquire the beneficial ownership of, *equity interest 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.

During the 20XX income year, the Shareholder owned 46% of the shares in the Company and therefore the Shareholder controls and is connected with the Company.

Commissioner may determine that an entity does not control another entity

If your control percentage in a company is at least 40% but less than 50%, the Commissioner may determine under subsection 328-125(6) of the ITAA 1997, that you do not control the other entity if the Commissioner thinks that the entity is controlled by a third entity (other than your affiliate).

As detailed above, if it were based on its shareholding alone, the Shareholder had a control percentage in the Company of 46% during the 20XX income year and accordingly falls within the control percentage range within which this discretion may be exercised if the Commissioner thinks that the Company was controlled by a third entity.

It is noted however that, during the 20XX income year, the Shareholder also held convertible notes which were issued by the Company. The terms of the convertible notes have not been provided.

As highlighted above in paragraph 328-125(2)(a) of the ITAA 1997, an entity's control percentage also takes into account where you 'own, or have the right to acquire the ownership of', 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 capital or equity interests 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.

Accordingly, depending on the terms, it is possible that the rights attached to the convertible notes may be included in the control percentage of the Shareholder such that its control percentage is 50% of more, meaning that the Commissioner would be unable to exercise the discretion in subsection 328-125(6) of the ITAA 1997. This gap in information creates an over-arching doubt as to whether the Commissioner has the ability to exercise the power contained in subsection 328-125(6) of the ITAA 1997.

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. For example, a third entity may control a discretionary trust because the trustee acts, or could reasonably be expected to act, in accordance with the directions or wishes of the third entity even if the third entity's control percentage is zero. 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.

Factors such as who was responsible for the day to day and strategic running of an entity will be relevant when determining whether an entity is controlled by a third entity.

The Commissioner's determination can be based on fact or on a reasonable assumption or inference.

In the current circumstances, despite various factors pointing for and against this decision, it is considered that, the Commissioner should not exercise the discretion under subsection 328-125(6) of the ITAA 1997 to determine that the Shareholder does not control the Company.

This conclusion is considered reasonable given that, based on the information provided and available, it is uncertain whether the Shareholder's control percentage is less than 50% and, even if this were the case, insufficient evidence has been provided to show that, in practice, another entity (in this case, the Individual) solely controls the Company taking into consideration the Shareholder's involvement and ability to influence the affairs of the Company.