Edited version of private advice

Authorisation Number: 1052037970093

Date of advice: 28 September 2022

Ruling

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

All legislative references stated below are to the Income Tax Assessment Act 1997, unless otherwise indicated.

Question

Will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 to determine that Company X does not control the Trust?

Answer

No, the Commissioner will not make the determination under subsection 328-125(6) of the Income Tax Assessment Act 1997.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Unit Trust (the Trust) carries a business.

The Trust has 3 Unitholders, Company X, Company Y, and Company Z, with their proportional unitholding of 45%, 45%, and 10% respectively.

Company X, Company Y, and Company Z, each has one company director, A, B, and C respectively.

Company M is the Trustee company of the Trust with 3 shareholders, also being A, B and C. They hold the shares in the following percentages:

•         A: 45%

•         B: 45%

•         C: 10%

A, B and C are also directors of the Trustee company.

Company X, Company Y, and Company Z are not 'affiliates' under the definition of 'affiliate' in section 328-130.

Management of the trust business

Company Y is one of the Unitholders of the Trust. B is the sole director of Company Y and is the only one (out of the 3 directors of the 3 unitholding companies) who has a credit card for the business operations.

The business address is B's home address.

B is the first point of contact when emailing IASes and BASes.

B is the individual who has signed all previous IASes, BASes and tax returns on behalf of the Trustee.

B is a mentor to A and C.

B has negotiated sale terms with buyers and liaised with lawyers, landlords and brokers regarding the sale and sale agreements.

Proposed Transaction

The business of the Trust is in the process of being sold.

As a Unitholder of the Trust, Company X is looking to apply small business CGT concession to its share of any potential capital gains from the sale.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subsection 152-10(1)

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Subsection 328-115(2)

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)(a)

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

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

Income Tax Assessment Act 1997 Section 328-130

Reasons for decision

Background to the request

The Trust business is in the process of being sold, and Company X, as a Unitholder of the Trust, will be sharing a portion of the Trust's potential capital gains from the sale. As a result, Company X wants to apply any small business CGT concessions available to its share of the potential capital gains from the sale.

In order to access the small business relief under Division 152, Company X has to satisfy the basic conditions as set out in subsection 152-10(1). One of the conditions is to satisfy the maximum net asset value test under section 152-15.

The taxpayer satisfies the test if, just before the time of the CGT event that results in capital gain, the sum of the following amounts does not exceed 6 million:

•         the net value of the CGT assets of the taxpayer

•         the net value of the CGT assets of entities connected with the taxpayer; and

•         the net value of the CGT assets of any affiliates of the taxpayer or entities connected with the taxpayer's affiliates.

This is referred to as the aggregation rules which use the concepts of 'connected with an entity'[1] under section 328-125 and 'affiliates' under section 328-130.

The question about 'control' which is the focus of this ruling, is a concept used in the definition of 'connected with an entity' under section 328-125.

"Connected with" under section 328-125

Subsection 328-125(1) states:

"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."

Subsections 328-125(2) to 328-125(4) then set out how direct control of an entity is worked out for the purposes of the section. These provisions use the concept of an entity's 'control percentage' (the first entity) in another entity (the second entity) and, where that percentage is at least 40%, the first entity is considered to control the second entity for the purposes of the section.

Paragraph 328-125(2)(a) applies to entities other than discretionary trusts; paragraph 328-125(2)(b) applies to companies only and, subsections 328-125(3) and 328-125(4) apply to discretionary trusts.

Paragraph 328-125(2)(a) is the relevant provision to the current ruling and is set out below:

Section 328-125(2) states:

"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."

Company X holds 45% of the units in the Trust which gives its entitlement to 45% of the distribution of income and capital of the Trust. Thus, according to subsections 328-125(2) and 328-125(1), Company X controls and is connected to the Trust.

Commissioner's discretion under subsection 328-125(6)

However, the Commissioner may exercise his discretion under subsection 328-125(6) to determine that Company X does not control the Trust if:

•         "the control percentage referred to in subsection (2) or (4) is at least 40%, but less than 50%"; and

•         "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."

Company X has a control percentage of 45%, that is at least 40% but less than 50%. So, the question is whether the Trust is controlled by an entity or entities (the third entity/entities) that is not, or does not include, the first entity or any of its affiliates.

The taxpayer submitted that the Trust is actually controlled by the other Unitholders - either by Company Y alone or, by Company Y and Company Z acting together.

The arguments presented by the taxpayer are twofold. First, B being the sole director of Company Y, has the majority involvement in the day to day running of the business, thus it has the actual control of the Trust. Second, Company Y and Company Z together have the majority voting rights to vote against or make decisions regarding the Trust, thus together these two Unitholders have the actual control of the Trust.

Does 'control' mean day-to-day management of the Trust?

For the purpose of the discretion under subsection 328-125(6), it is important to distinguish between control of an entity and responsibilities a person may have to carry out certain functions in relation to the conduct of an entity's business. In this instance, the list of things carried out by B, such as signing all previous IASes, BASes and Tax Returns on behalf of the Trustee, being a mentor to A and C, and negotiating sale terms etc, are all the things often being carried out by employees. However, this certainly does not mean that employees have 'control' of the natured as referred to in paragraph 328-125(2)(a).

Also, certain people may have responsibility for the day-to-day conduct of an entity's business and have considerable autonomy in making significant business decisions, however these are not relevant 'control' of the entity for the purpose of subsection 328-125(6).

Therefore, the taxpayer's argument that B is the main person for running the day-to-day management of the Trust, either in the capacity of a director of the trustee company, or shareholder of the trustee company, or director of the unitholding company, is not a relevant factor for consideration under subsection 328-125(6).

Meaning of 'control' for the purposes of subsection 328-125(6)

The word 'controlled' in subsection 328-125(6) takes its meaning principally from its context within Subdivision 328-C and more specifically, subsections 328-125(2) to 328-125(5). These provisions indicate that control of rights to economic benefits in the form of income and capital distributions as well as voting rights, together being the usual indicia of ownership of business entities, is the relevant type of control.

As paragraph 328-125(2)(a) is the relevant provision for unit trusts, the term 'control' for the Trust should take its meaning from that provision. That is, control rights to economic benefits - rights to distribution of income or capital of the Trust - are the relevant factors for consideration when determining whether or not the Trust is controlled by a third entity/entities. Note that paragraph 382-125(b), which concerns voting powers in a company, is irrelevant to this case as the provision only applies where the 'other entity' is a company.

In the ordinary case, a relevant determination may be made under subsection 328-125(6) in favour of an applicant entity where:

• it has more than a 40% control percentage interest in a unit trust, but
• a third entity has a more than 50% control percentage interest in the trust.

In such a case, it is clear that this third entity 'controls' the trust given its entitlement to more than 50% of the distribution of trust income and capital.

However, in this case both Company X and Company Y have 45% control rights to the distribution of income and capital of the Trust. Therefore, Company Y does not have more control (than Company X) or actual control of the Trust.

It is acknowledged that while control percentage held by the third entity of more than 50% is the most likely basis for making a determination under subsection 328-125(6), there may be circumstances in which a third entity with less than 50% control may nonetheless be considered to have the requisite 'control' under subsection 328-125(6) such that a determination may be made.

However, even in such circumstances, the focus remains on control of rights to economic benefits - ie. the rights to distribution of income or capital. It may be possible, for example, to control rights to economic benefits in relation to the trust by means other than formal ownership of interests carrying requisite control percentages. For example, there may be clear evidence of legally enforceable arrangements that might practically affect a third-party unitholder's rights to distribution of income or capital from the trust (beyond the interests formally afforded to it as a unitholder under the trust deed).

No such evidence has been presented of such other arrangements in this case. In this regard, there is no basis upon which the Commissioner can hold the view that Company Y has, through legally enforceable arrangements, more rights to the distribution of income or capital than Company X.

It should also be noted that:

•         Where, as in this case, both entities have a control percentage of over 40% each, it is not necessarily the case that one or the other must control the trust. Clearly, it can be that both entities control the trust by reason of satisfying one of the tests in subsection 328-125(2), as appears to be the case here.

•         The taxpayer makes the argument that theoretically Company Y and Company Z may, when taking into account their combined 55% interest, can make controlling decisions without Company X.

However, as mentioned, the control percentages of voting power is not a relevant factor for trusts, (and, even in the context of voting powers, the mere alignment of purpose or agreement to act co-operatively on certain issues would rarely, if ever, be a sufficient basis to determine there is control by otherwise unrelated entities).

In this case, Company Y and Company Z are not affiliates of one another under section 328-130 and in the context of 'control' as defined by reference to rights to economic interests (and, not to voting power in this case), it is not appropriate to combine the interests of Company Y and Company Z for consideration under subsection 328-125(6).

Conclusion

The Commissioner will not exercise the discretion under 328-125(6) to determine that Company X does not control of the Trust.

[1] The definition of 'connected with an entity' is also relevant to whether an entity is required to aggregate its annual turnover with that of other entities in order to determine whether the entity satisfies the small business entity test under subsection 328-115(2).