Edited version of private advice

Authorisation Number: 1051924290992

Date of advice: 22 November 2021

Ruling

Subject: Commissioner's discretion pursuant to subsection 328-125(6) of the Income Tax Assessment Act 1997

Question

Will the Commissioner exercise his discretion pursuant to subsection 328-125(6) of the Income Tax Assessment Act 1997 ('ITAA 1997') to determine that Company B does not control Company X for the period from 1 July 20XX to 30 June 20XX?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Background

Company X is a company incorporated in Australia in 20XX.

On incorporation, Company X issued 51% of its shares to Company A and 49% of the shares Company B.

The shares have been held by the shareholders since incorporation and have not been transferred from incorporation up to 30 June 20XX (being the end of the period of this ruling).

All shares in Company X are ordinary shares, carrying the same rights.

On incorporation, Company X's board of directors consisted of 1 director appointed by Company B and 1 director appointed by Company A.

In January 20XX, Company B and Company A each appointed 1 additional director, bringing total board members up to 4.

There have been no other changes to board members or shareholdings up to 30 June 20XX (being the end of the period of this ruling).

Shareholders' Agreement

There is a Shareholders' Agreement between Company X, Company B and Company A.

The Shareholders' Agreement sets out various clauses outlining rights and responsibilities including the following:

3.1 Joint Venture Certification Criteria

It is the intention of the Shareholders that the operation of the board of Directors at all time complies with the Joint Venture Certification Criteria published from time to time by Certifying Entity. In the event of any uncertainty in the interpretation of this clause 3, that uncertainty will be resolved in favour of an interpretation which complies with the Joint Venture Certification Criteria.

3.2 Composition of the board

(a) Subject to the other provisions of this clause, each shareholder may appoint directors of the Company and remove any director appointed by it.

(b) At all times the Board must consist of an equal number of Company B directors and Company A directors.

(c) Whilst there must be at all times be a minimum of 1 Company B director and 1 Company A director, the Shareholders may agree to the appointment of a greater number of directors so long as at all times there is an equal number of Company B directors and Company A directors.

...

3.4 Chair of directors

(a) The directors must appoint one of their number as chair of directors, who must be a Company A director.

(b) If the chair is not present at a meeting of directors which is otherwise validly constituted, their place will be taken by another Company A director who shall be chairman for that particular meeting.

(c) In the event of deadlock, the chair has a casting vote.

...

3.5 Quorum and voting rights

(a) Subject to the chair's casting vote and to the provisions of this subclause, each director present at a meeting has 1 vote.

(b) The directors may transact business at a meeting only if a Quorum of directors is present. A Quorum is at least 1 Company B and 1 Company A director.

(c) If the number of Company A directors and Company B Directors at a meeting is not equal, the director representing the under-represented Shareholder shall have increased voting rights such that the voting rights of the Company B directors on the one hand and of the Company A directors on the other hand, are equal.

Example

The board consists of 2 Company B directors and 2 Company A directors, but one of the Company B directors is unable to attend a meeting of directors. At that meeting the Company B director is entitled to two votes, whilst the Company A directors are entitled to one vote each

...

3.7 Shareholder interest

Any director, including the chair, may make a decision in the interests of the Shareholder appointing him or her, without being required to have regard to:

(a) the interests of another Shareholder; or

(b) the interests of the Company or its members as a whole.

...

4.1 Administrative services to be provided by Company B

(a) The Board will appoint Company B, and Company B will accept such appointment, to provide to the Company the administrative services described in Schedule 3 together with such other tasks as required or delegated by the Board from time to time ("Administration Services").

(b) The Company will pay to Company B in consideration for the provision of the Administration Services (excluding the Bid Preparation Services) a fee to be agreed between the Board and Company B for each Contract (both the Company and Company B acting reasonably and in good faith) ("Administration Fee").

(c) Company B will invoice the Company for the Administration Fee monthly in arrears.

(d) The Company will pay to Company B in consideration for the provision of the Bid Preparation Services, a fee to be agreed between the Board and Company B for each project or contract bid for by the Company (both the Company and Company B acting reasonably and in good faith). Company B will only be entitled to fee where the Company is awarded a Contract, upon which Company B will invoice the Company for that fee.

...

4.3 Role of Company A

Company A shall be responsible for performing the following tasks:

(a)             Assisting with the recruitment, interviewing and appointment of key staff of the JV;

(b)             Assisting with business development;

(c)             Assisting with estimating and tendering for Contracts;

(d)             Assisting with the supply of indigenous labour and equipment for projects; and

(e)             Assisting with Project Management.

Company A involvement in Company X

Since the incorporation of Company X, Company A and Company B have had an equal number of board votes.

However, in the event of a voting deadlock, the chair being a director appointed by Company A, who through-out the period was also the sole director of Company A, would have the casting vote.

To date, there has been no voting deadlock such that a casting vote has needed to be made.

In accordance with Clause 4.3 Shareholders Agreement, Company A is to assist with recruitment, interviewing and appointment of key staff, assist with business development, assist with estimating and tendering for contacts, assist with the supply of indigenous labour and equipment for projects and assist with project management.

Company B involvement in Company X

Company B provides administrative services to Company X, as listed in Schedule 3 of the Shareholders Agreement, which includes assistance with preparation of bids for contracts.

Relevant legislative provisions

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 subsection 328-125(4)

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

Reasons for decision

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; or

(b)             both entities are 'controlled' by the same third entity.

Paragraph 328-125(2)(a) of the ITAA 1997 contains a connected entity direct control test which applies to all entities except discretionary trusts and is based on a 'control percentage' of at least 40%. This test is based on an entity's entitlements to income distributions and capital distributions.

In addition to the general direct control test in paragraph 328-325(2)(a) of the ITAA 1997, a specific rule applies in relation to the control of companies. This additional rule is based on voting power. Paragraph 328-125(2)(b) of the ITAA 1997 provides that an entity controls a company if the entity and/or its affiliates own, or have the right to acquire ownership of, equity interests in the company with at least 40% of the voting power of the company.

However, the Commissioner has the power under subsection 328-125(6) of the ITAA 1997 to determine that Company B does not control Company X.

Subsection 328-125(6) states:

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.

In the Commissioner's view, the discretion in subsection 328-125(6) adopts the ordinary meaning of 'controlled'. The term 'controlled', for the purposes of subsection 328-125(6), is undefined.

The Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (the EM) states:

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.

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

Thus, it is actual control that is taken into account.

Further, the use of the words 'a reasonable assumption or inference' indicates the intention of the legislation was to give the broadest powers possible to the Commissioner. Example 2.10 in the EM states:

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

Example 2.10 suggests that in considering whether 'the software company is actually controlled by the other person with the 58 per cent interest' the Commissioner turns his mind to who controls the software company in the ordinary sense, regardless of the percentage interest held.

To determine whether the third entity controls the other entity in the ordinary sense of that term, all relevant facts and evidence will be considered to determine actual control. The Commissioner is not restricted by an entity's legal ownership interest.

The Commissioner may think that an entity has actual control based either on fact or on a reasonable assumption or inference. The exercise of the discretion will turn on the facts and circumstances of any case.

Application to Company X

An entity is 'connected with another entity' as provided in subsection 328-125(1) of the ITAA 1997 if at any time during the year the entity controls the other entity in a way described in section 328-125.

Company B has owned 49% of the ordinary shares in Company X since 20XX. Therefore, Company B's direct control percentage in Company X is 49%. As such, Company X is connected with Company B under section 328-125 of the ITAA as it controls that entity under subsection 328-125(2).

Company A has owned 51% of the ordinary shares in Company X since 20XX. Therefore, Company A's direct control percentage in Company X is 51%. As such, Company A is also connected with Company X under section 328-125 of the ITAA as it controls that entity under subsection 328-125(2).

To determine whether Company A, controls Company X in the ordinary sense of that term and whether the Commissioner will exercise discretion pursuant to subsection 328-125(6), all relevant facts and evidence will be considered, including the following:

•                 Strategic decision making is done by the board of directors

•                 The ultimate board voting power, lies with the chair having the casting vote

•                 The chair of the board of directors of Company X is appointed by Company A and is also the sole director of Company A

•                 Company B through the provision of administration services controls the day-to-day operations of Company X

Based on the evidence you have provided, the Commissioner will exercise the power given to him by subsection 328-125(6) of the ITAA 1997 to determine that Company X was not, in the income years ended 30 June 20XX and 30 June 20XX, controlled by Company B, but instead was controlled by Company A.