Edited version of private advice

Authorisation Number: 1052033756511

Date of advice: 14 September 2022

Ruling

Subject: Commissioner's discretion

Question 1

Will the Commissioner exercise his discretion in accordance with subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that individual C did not control A Company Pty Ltd (A) for the period from 1 July 20XA to 30 June 20XC?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XB

Year ending 30 June 20XC

The scheme commences on

1 July 20XA

Relevant facts and circumstances

A Company Pty Ltd (A) is an incorporated entity.

The shares on issue in A were purchased by individuals B and C in 19XX.

B and C are spouses.

A is a proprietary company limited by shares and owned by the following shareholding percentages:

•        B - 60% (3 ordinary shares); and

•        C - 40% (2 ordinary shares).

The directors of the Board of A are B and C.

Voting rights for A were in line with their shareholding.

A does not have any Shareholders Agreement in place.

B's Background in Fishing and Farming.

A had and still has 5 ordinary shares on issue. Prior to the enactment of the First Corporate Law Simplification Act 1995 (No 115 of 1995) companies had to have a minimum of Two (2) Directors and Two (2) Shareholders. Thus, when B decided on buying A with Gulf fishing licences, they had to have two directors and two shareholders.

This was the sole reasoning behind C acquiring two of the five ordinary shares (40% holding) in A in 19XX. B owns the other 3 ordinary shares in the company (60% holding).

Additional information was supplied in your email dated 22 February 20XC. It contents and attachment form part of these facts. A summary of your responses to our further information request are as follows:

•         The only General Meetings held by A were a formality in relation to drawing dividends. C has no role in determining the dividend policy for the year or the amount of the dividend paid. No minutes are taken, and there are no phone hook ups in relation to company policy or direction. B is the Chairman of Directors and, thus, even though they have a controlling share of equity shares (60%) he also would have a casting vote under the Constitution of A.

•         There is no formal written business plan for A. The company has never prepared a formal written business plan. Most ideas originate from B's head. While B will consider many issues, and make many decisions, all of those decisions are made by them without consultation with C. None of B's decisions have been recorded in any written documents.

•         B has overall control over all maintenance work as they are hands on, knowing and understanding, all aspects of the machinery and safety requirements. They hire appropriate contractors (i.e., refrigeration engineers, boilermakers etc.). B orders the supplies needed to carry out this work. They have built many trawlers in the past and are very hands on and knowledgeable.

•         B is the director, controller, and manager of HFC. They made major strategic decisions in the past to expand the business (by buying a fishing licence in a different fishery) and then in recent years. Recently, a situation arose when two larger boats came on the market and as their children were stepping up, B decided this was opportune time to enlarge A's operations. Other less important decisions are made on a regular basis by B without consultation with C.

•         C is not paid by A.

•         B has been in the industry for many years. They have been to sea, have built many boats. They know their way around the industry. They are highly regarded within the industry, and they have key contacts throughout the area they live. They have grown professionally, as the fishing industry has grown more professionally. B maintains industry contacts with whom they communicate and C is not a part of any of these communications.

•         B spends a few months with the boating business (depending on where the boats tie up in the off-season). They go alone. C has no input as to what work is undertaken or who will do it. B organises trades or does the work themself.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 325-125

Income Tax Assessment Act 1997 subsection 325-125(1)

Income Tax Assessment Act 1997 subsection 325-125(2)

Income Tax Assessment Act 1997 paragraph 328-125(2)(a)

Income Tax Assessment Act 1997 paragraph 328-125(2)(b)

Income Tax Assessment Act 1997 subsection 325-125(3)

Income Tax Assessment Act 1997 subsection 325-125(4)

Income Tax Assessment Act 1997 subsection 325-125(6)

Income Tax Assessment Act 1997 section 325-130

Income Tax Assessment Act 1997 subsection 325-130(1)

Reasons for decision

Issue 1

Question 1

Summary

Based on the facts and circumstances, the Commissioner will exercise his discretion in accordance with subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) and determine that despite the fact that individual C holds 40% of the ordinary shares in A Company Pty (A) they do not control A during the period from 1 July 20XA to 30 June 20XC.

Detailed reasoning

Section 328-125 of the ITAA 1997 provides several control tests which govern when an entity will be deemed to be 'connected with' another entity. Subsection 328-125(1) states that:

An entity is connected with another entity if:

(a)  either entity controls the other 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.

In relation to entities other than discretionary trusts, the relevant control test is stated in subsection 328-125(2) of the ITAA 1997:

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

(a)  except if the other entity is a discretionary trust - own, or have the right to acquire the 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 - 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.

There are two separate control tests for discretionary trusts - under subsections 328-125(3) & (4) of the ITAA 1997. Subsection 328-125(3) adopts an 'actual control' test by stating:

An entity (the first entity) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates or the first entity together with its affiliates.

The other control test is in subsection 328-125(4) of the ITAA 1997, which states that if an entity, its affiliates, or the entity with its affiliates, receives 40% or more of the trust's income or capital in any of the last 4 income years, then the entity is deemed to "control" that discretionary trust.

Apart from the 'actual control' test in subsection 328-125(3) of the ITAA 1997 - all other control tests in section 328-125 deems an entity to control another entity - regardless of whether they in fact control the entity or not.

The Commissioner's discretion in subsection 328-125(6) of the ITAA 1997 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) of the ITAA 1997 adopts the ordinary meaning of 'controlled', i.e., it is not equivalent to 'control' for the purpose of subsection 328-125(1) or 'controls' for the purpose of the statutory tests set out in subsections 328-125(2) and (4).

The Commissioner may think that another entity controls the entity either based on fact or on a reasonable assumption or inference.

Ordinary meaning of 'Control'

'Control' is undefined and takes its ordinary meaning. The term 'control' is defined in the Macquarie Dictionary Online Edition to include:

                    (i)        To exercise restraint or direction over, dominate; command.

                   (ii)        To hold in check; curb.

Thus, it is considered that the Commissioner may, in determining whether another entity (or entities) control the other entity for the purposes of subsection 328-125(6), consider the other entity's (or entities') ability to, for example, command the other entity to undertake/not undertake actions, and other relevant facts and evidence. This would include where the other entity (or entities) have less than a majority shareholding, or even no shareholding, in the other entity.

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

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 15 of TR 2018/5 defines decision making as:

15. A person, or group of people, make a decision if they actively consider and decide to do, or not do something based on it being in the best interests of the company.¹⁷ It does not include the mere implementation, or rubberstamping, of decisions made by others (see paragraphs 26 to 29 of this Ruling).

Paragraph 16 of TR 2018/5 outlines acts that would indicate the exercise 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.

Paragraphs 20-23 of TR 2018/5 outline what is the starting point in considering control. It states:

A starting point

20. Normally, where a company is run by its directors in accordance with its constitution and the company law rules applicable to that company, which give its directors the power to manage the company, the company's directors will control and direct its operations. It follows that ordinarily it is a company's directors who exercise its central management and control.

21. However, the actions of a company's directors, or others with the legal power and authority to control and manage the company, are not the end of the enquiry as to who exercises central management and control. There is no presumption that the directors of a company will always exercise its central management and control.

22. When determining who exercises a company's central management and control, all the relevant facts and circumstances must be considered. Facts and circumstances to be considered in determining who exercises a company's central management and control include the role of anyone who assumes the role of the directors' role in managing and controlling the company's affairs or has a role in the decision-making processes or governance of the company.

Mere legal power or authority to manage a company is not sufficient to establish exercise of central management and control

23. A person who has legal power or authority to control and direct a company, but does not use it, does not exercise central management and control. For example, in Bywater, the court disregarded the role of those directors who were formally appointed but did not play any real role in the affairs of the company.

Paragraph 24 of TR 2018/5 states:

Tacit Control and delegated authority

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 circumstances

Pursuant to the statutory control test under subsection 328-125(2) of the ITAA 1997, both B and C control A because they had ownership interests in A that carried the right to exercise, or control the exercise of, a percentage (the control percentage) that was at least 40% of the voting power of A.

You have requested that the Commissioner exercise the discretion in subsection 328-125(6) of the ITAA 1997 for the period from 1 July 20XA to 30 June 20XC. Therefore, this is the relevant 'test time' during which the Commissioner is required to consider if C did not control A because another entity, or entities, that do not include C, actually controlled A.

Your Contentions

You contend that B controls A and not C because B:

•         Makes the high level decisions that set the company's general policies and determines the strategic direction of its operations and the type of transactions it will enter.

•         B has always made all of the decisions in relation to the operations of A.

•         The only reason that C is a shareholder in the company is to satisfy a historical regulatory requirement set down by Corporations Law.

•         B not only makes the strategic decisions of the company but also makes the day to day decisions as to the operations of the company.

•         B has control over the voting power of the company given that he holds 60% of the shares in the company.

•         B effectively makes all of the strategic and day to day management decisions of A without any input from C.

Consideration of the exercise of the discretion in subsection 328-125(6) of the ITAA 1997

C has statutory control of the Company as C has a direct shareholding in the company of 40% ('control percentage') (paragraphs 328-125(2)(a) & (b) of the ITAA 1997).

C is 'connected with' the Company because C controls it in a way described in section

328-125 of the ITAA 1997 (see subsection 328-125(1)).

C's 'control percentage' in subsection 328-125(2) is at least 40%, but less than 50% so the Commissioner may consider the exercise of his discretion under 328-125(6).

B is not an 'affiliate' of C under section 328-130 as he could not be taken to '... act, or could reasonably be expected to act, in accordance with...' C's ' ... directions or wishes, or in concert with...' her, '... in relation to the affairs of the business ...' of B or the Company (subsection 328-130(1)).

In this case, the Commissioner accepts that B makes all decisions in relation to the fishing business and is responsible for the day to day operations of A. While C held 40% of the shares in A, they never had any direct involvement in the day to day running of the business or any strategic decision making of the business.

Accordingly, the Commissioner will exercise the discretion contained in subsection 328-125(6) of the ITAA 1997 to determine that C does not control A during the period from 1 July 20XA to 30 June 20XC as the Commissioner accepts that A is controlled by their spouse, B.