Edited version of private advice

Authorisation Number: 1051778711011

Date of advice: 11 November 2020

Ruling

Subject: Connected with - an R and D entity

Question

Will A Co be 'connected with' the proposed Sub Co of B Co, as that term is defined in subsection 328-125(1) of the Income Tax Assessment Act 1997[1]?

Answer

Yes. A Co will be 'connected with Sub Co for the purpose of subsection 328-125(1) because A Co would be deemed to have control of Sub Co via its interests in B Co, as set out in subsection 328-125(7), and thus A Co will satisfy the requirement in paragraph 328-125(1)(a) that it controls Sub Co.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

The scheme commenced on 1 July 20XX

Relevant facts and circumstances

B Co is a privately held start-up company that is conducting Research & Development (R&D) and is considering conducting the R&D in Australia through an Australian subsidiary.

A Co is a venture capital investor.

Prior to the investment made by A Co, B Co two classes of shares on issue, namely ordinary and preference shares.

A Co entered into an agreement with B Co, whereby A Co purchased preference shares that in B Co and also acquire the right to acquire the beneficial ownership of additional preference shares in B Co.

B Co has not issued any ordinary or preference to existing or new investors since A Co made its investment in B Co.

Generally the ordinary and preference shareholders will vote as a single class. The ordinary shareholders are entitled to cast one vote for each ordinary share held and the preference shareholders are entitled to cast votes equivalent to the number of ordinary shares that each preference share converts into on the record date of the meeting.

The preference shares purchased by A Co carry voting power equivalent to 33% of all votes that can be cast at shareholder meeting.

If A Co exercised its right to acquire additional shares in B Co then its voting power would be increased from 33% to over 60% of all the votes that could be cast as shareholder meetings.

Assumption(s)

The following assumptions have been made in making this ruling:

1.1      B Co will directly hold all the issued share capital in Sub Co.

1.2      Voting rights will attach to the Sub Co shares held by B Co.

1.3      A Co's shares in B Co and B Co's proposed shares in Sub Co are/will be equity interests for the purpose of Division 974.

1.4      There will be no changes in the ownership of the A Co's shares or rights granted to acquire ownership of shares in A Co before the end income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 328-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(1)(b)

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

Income Tax Assessment Act 1997 paragraph328-125(2)(a)

Income Tax Assessment Act 1997 paragraph328-125(2)(b)

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)

Reasons for decision

The rate of the Research & Development (R&D) tax offset available under section 355-100 and whether it is refundable or not depends primarily on the R&D entity's aggregate turnover (Item 1 of the table in subsection 355-100(1)).

The rules for determining the aggregated turnover of an R&D entity are set-out in Subdivision 328-C and the provisions of the R&D Tax Incentive (Division 355) do not make any modifications to these rules.

The aggregated turnover of an R&D entity, per section 328-115, is the sum of the annual turnovers of the R&D entity, any entity connected with the R&D entity and any entity affiliated with the R&D entity, excluding any dealings between those entities.

Meaning of connected entity

The term 'connected entity' is defined under section 328-125 which states:

An entity is connected with another entity if:

(a)       either entity controls the other entity in the 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 a company

Paragraph 328-125(2)(a) provides that an entity controls a company if the entity, its affiliates, or the entity together with its affiliates beneficially 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:

(i)         any distribution of income of the company; or

(ii)        any distribution of capital by the company.

Paragraph 328-125(2)(b) provides that an entity controls a company if the entity, its affiliates, or the entity together with its affiliates beneficially 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 that is at least 40% of the voting power in the company.

Indirect control of a company

Subsection 328-125(7) provides that where an entity (the first entity) directly controls another entity (second entity) and the second entity controls a third entity (directly or indirectly) as described in section 328-125, then the first entity is taken to control the third entity.

However, the indirect control test does not apply where the second entity is an entity of any of the following kinds listed in subsection 328-125(8), namely:

(a)       a company whose shares are listed for quotation in the official list of an approved stock exchange, except where the shares carry a right to a fixed rate of dividend.

(b)       A publicly traded unit trust;

(c)       A mutual insurance company;

(d)       A mutual affiliate company;

(e)       A company (other than one covered by paragraph (a)) all the shares in which are owned by one or more of the following:

(i)        A company covered by paragraph (a);

(ii)       A publicly traded unit trust;

(iii)      A mutual insurance company;

(iv)      A mutual affiliate company.

Application to A Co

Thus, in the case of A Co, it will be connected with Sub Co for the purpose of subsection 328-125(1) if:

(a)       A Co has control of B Co in accordance with paragraph 328-125(2)(b);

(b)       B Co has control of Sub Co in accordance with paragraph 328-125(2)(b); and

(c)       A Co is deemed to control Sub Co by the application of subsection 328-125(7).

Control of B Co

A Co acquired the beneficial ownership of preference shares and the rights to acquire the ownership of additional preference shares.

As the ordinary and preference shareholders generally vote together as a single class

In determining A Co's control percentage in B Co, the voting power attaching to the equity interests in B Co that A Co beneficially owns or has the right to acquire is relevant. If A Co were to excise its right to acquire additional preference shares in B Co, B Co would hold equity interests in B Co that carry voting rights equivalent to 60% of the overall voting power in B Co.

Therefore, A Co has direct control of B Co pursuant to paragraph 328-125(2)(b), with a control percentage of 60%.

However, section 328-125(6) provides the Commissioner with a discretion to determine that an entity does not control another entity:

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.

As A Co's control percentage of B Co exceeds 50%, subsection 328-125(6) does not provide the Commissioner with the discretion to determine that A Co does not control B Co.

Direct control of Sub Co

B Co itself will directly control Sub Co pursuant to subsection 328-125(2), because it will beneficially own all the shares in Sub Co, and therefore will have equity interests in Sub Co that carry the right to exercise, or control the exercise of, 100% of the voting power in Sub Co. Again, subsection 328-125(6) does not provide the Commissioner with the discretion to determine that B Co does not control Sub Co.

Deemed control of Sub Co

Under subsection 328-125(7), A Co is deemed to control any entity that B Co directly controls, because A Co directly controls B Co, unless the application of subsection 328-125(7) is excluded by the operation of subsection 328-125(8) in relation to B Co.

As B Co is not an entity of the kinds listed in subsection 328-125(8), subsection 328-125(8) does not exclude the application of subsection 328-125(7).

As above, A Co controls B Co, and B Co in turn will directly control Sub Co. A Co is thus deemed to control Sub Co for the purpose of subsection 328-125(7). As A Co will control Sub Co, A Co will therefore be 'connected with' Sub Co for the purpose of paragraph 328-125(1)(a).

[1] All legislative references will be to the Income Tax Assessment Act 1997 unless otherwise indicated.