Edited version of private advice

Authorisation Number: 1052064169695

Date of advice: 29 November 2022

Ruling

Subject: Commissioner's discretion - connected with an entity

Question 1

Will the Commissioner 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 A Pty Ltd (Entity A) holds 40% of the ordinary shares in C Pty Ltd (Entity C), Entity A does not control Entity C?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XB

The scheme commences on

1 July 20XA

Relevant facts and circumstances

1.    C Pty Ltd (Entity C) is an incorporated entity.

2.    The shares on issue in Entity C comprise ordinary shares currently held by:

(a)          B Pty Ltd (Entity B) as trustee for the D Family Trust (Taxpayer) has (60%); and

(b)          Entity A (40%).

3.    The Taxpayer and Entity A (Vendors), wish to sell all of the shares in Entity C to a third party (Purchaser) who is unrelated to any of the Vendors (Transaction).

4.    Individual F (F), being the sole director of Entity C, is in the process of negotiating a contract of sale with a purchaser on behalf of the Vendors. It is currently anticipated that such a contract will be entered into during the income year ending 30 June 20XB.

5.    It is anticipated that the Taxpayer will make a capital gain from the sale of its shares in Entity C to the Purchaser.

6.    The Taxpayer is now considering whether it would be entitled to small business capital gains tax (CGT) relief under Division 152 of ITAA 1997 for that capital gain and has formed the view that this may be affected by whether Entity A is taken to control Entity C for the purposes of those provisions.

History of Entity C

7.    F has been the sole director and company secretary at all times since Entity C was incorporated.

8.    Entity C carries on the business of designing and manufacturing products.

9.    F and his wife (G) are the directors and equal shareholders of Entity B.

10.  G does not take part in the management or decision making of Entity C.

11.  F is the Chief Executive Officer of Entity C. F is employed on a full-time basis and he is a PAYG employee. F is also provided a company car and telephone.

12.  The Taxpayer and Entity A are not 'connected with' each other as that expression is defined by Division 328 of the ITAA 1997.

13.  During 20XX the Taxpayer entered the following agreements:

(a)          A sale of shares agreement (Share Sale Agreement) for the transfer of 40% of shares in Entity C from the Taxpayer to Entity A; and

(b)          A shareholders agreement (Shareholder Agreement) with F as the Taxpayer's representative and Individual H (H) as Entity A's representative.

14.  It is noted that the Shareholder Agreement states where any inconsistency exists between the original Constitution of Entity C and the Shareholder Agreement, the Shareholder Agreement will prevail to the extent of any inconsistency.

15.  Prior to 20XZ the shares in Entity C were held by the Taxpayer (being F's family trust) as to 50% and F's former business partner as to 50%. In around 20XZ, F negotiated for the former business partner to sell his 50% shareholding to the Taxpayer.

16.  The taxpayer needed to raise funds in order to pay the purchase price for the former business partner's 50% shareholding. H became aware of the former business partner's exit and made an offer to purchase (via Entity A) a 40% shareholding from the taxpayer.

17.  From F's perspective, this was beneficial in that it provided the taxpayer with a source of funds to assist with payment of the price for the purchase of the former business partner's 50% shareholding.

18.  The Purchase Price and Issue Price under the Share Sale Agreement were both determined by negotiation between F and H.

19.  On or around 20XZ, an interest-only loan agreement (Loan Agreement) was entered between Entity A, as lender and Entity C, as borrower.

20.  The Loan Agreement was entered into to enable Entity C to repay a pre-existing loan between Entity C and the former business partner. In substance this was a refinancing of the pre-existing shareholder loan. This loan is still outstanding.

Individual H

21.  H has had an ongoing relationship with the Taxpayer for over many years. F first became acquainted with H about x years ago when F visited an Asian country with a view to establishing component supplier relationships for Entity C - H was their tour coordinator and translator for F. H has a company in the Asian country. This company subsequently became a supplier to Entity C.

22.  H is employed by Entity C. H is employed on a full-time basis and he is a PAYG employee.

23.  H is the sole director and shareholder of Entity A and owns all the shares in Entity A.

24.  At the time of the acquisition of shares by Entity A, H did not wish to take on the responsibility of being a director of Entity C and Entity C was being successfully managed by F, and H did not wish to change that position.

25.  H acquired his shares in Entity C whilst still a resident of the Asian country. H resided in the Asian country until 20XZ, at which time he commenced to reside in Australia.

26.  Uponarriving in Australia, H commenced employment with Entity C. You advised there was no connection between the sale of shares and his subsequent employment in the next year.

Day to Day Management of Entity C

27.  As F has been sole director of Entity C since incorporation, F has been responsible for and has undertaken the day-to-day management of Entity C at all relevant times.

28.  Until 20XX, the taxpayer was the sole shareholder of Entity C. Notwithstanding the acquisition of 40% of the shares in Entity C by Entity A in 20XX, since Entity A became a shareholder:

(a)          F has retained his pre-existing 'hands-on' role in relation to Entity C and the running of its business; and

(b)          Entity A has been a completely passive investor in Entity C.

29.  This arrangement is consistent with the terms of the Shareholder Agreement which states:

The Director of the Company is responsible for the day to day management of the Company...

30.  The Shareholder Agreement makes provision for the shareholders to agree on the total number of directors to be appointed and provides for F to continue as the sole director of Entity C.

31.  Consistent with these provisions in the Shareholders Agreement you state:

(a)          F has continued to be the sole director of Entity C, and has worked on a full-time basis managing Entity C's business; and

(b)          H has never been appointed a director of Entity C and has never been involved in the day-to-day management of Entity C's business.

32.  The Shareholders Agreements states there are certain resolutions that require unanimous approval. Unanimous approval is defined as 'a vote or resolution passed by - in the case of a vote or resolution of Shareholders, all Shareholders'. You have advised that there have been no matters in the relevant clause of the Shareholders Agreement which failed to achieve a resolution that required unanimous approval.

33.  F engages in all of the day-to-day management of Entity C and will continue to do so until the Relevant Date. This includes taking unilateral decisions in relation to matters such as:

(a)          Obtaining finance facilities from financiers, namely the Bank for Entity C and providing guarantees on such facilities;

(b)          Negotiating renewals of leases in relation to properties leased by Entity C and providing guarantees on the leases;

(c)           Negotiating car hire-purchase agreements for Entity C including providing guarantees on hire purchase agreements;

(d)          Interacting with customers and suppliers;

(e)          Attending trade shows, export prospecting trips and business development activities;

(f)            Marketing, and staffing levels, staff roles and responsibilities, staff remuneration, hiring and termination.

34.  As there is only one director, no directors' meetings are held and accordingly there are no minutes of directors' meetings. However, you have provided the following information to support that all decisions are made by John:

•                     Minutes from a management meeting; and

•                     An email with the agenda and minutes for the Sale and Operations meeting held in 20XA.

35.  You state that these documents indicate that H was not invited to, copied in or otherwise involved in these meetings in any way. These documents also evidence that F leads the discussion on the majority of agenda items, conveys key messages and sets the agenda items for the next meeting.

36.  You also supplied a copy of Entity C's current Lease Agreement for lease of their business premises indicating that F was solely involved in negotiating the lease. There is a handwritten note which states 'F would like to extend 12 months longer'.

37.  In contrast, H has not provided any guarantees or been involved in decision-making or participated in other matters listed above as performed by F. In relation to any financing, leasing and other matters listed above, decisions have been made unilaterally by F.

38.  H has not been involved or included in the day-to-day communications or processes or otherwise participated in the above matters. In particular:

•                     Where F has made day-to-day management decisions of the type mentioned above, H has not been informed of the decision, and H's consent has not been sought prior to the making of the decision by F;

•                     H has never been invited to Entity C's monthly management meetings (convened between F and senior management of the company);

•                     H has had no interactions with suppliers or customers (other than in the context that one of Entity C's suppliers is a company in the Asian country owned by H);

•                     H's only involvement with Entity C's financial statements has been in the context of the statements being presented to him annually in accordance with the terms of the Shareholder Agreement. H has had no involvement with Entity C's external accountant (who has never met or spoken with H);

•                     H has never had contact with or dealt with anyone from Entity C's bank;

•                     H has never had any involvement with any staff recruiting, has never attended a recruitment interview, and has never had any input on the hiring or firing of staff; and

•                     Notwithstanding that H is fluent in Asian language, he has never participated in any export prospecting trip (including those to Asia). H has similarly never attended the annual medical trade show held overseas attended by an Entity C delegation.

Strategic decisions

39.  F has been responsible for all strategic decisions of Entity C at all times since its incorporation.

40.  Since Entity A became a shareholder of the company, there have arguably been three major strategic decisions affecting Entity C. These key decisions have been:

(a)          Product development and accessing Research and Development (R & D) incentives.

(b)          Commencing exporting products to Asia approximately 4 years ago; and

(c)           The negotiation by Entity C, on behalf of its shareholders of the potential sale of all of the shares in Entity C to an arm's length purchaser.

41.  The decisions and initiatives for Entity C to develop products, access R & D incentives, expand exports to Asia and to negotiate a sale of shares in Entity C, and the implementation of those decisions, have been initiated and implemented solely by F. To the extent that H (as the representative of Entity A) has been involved in those decisions, this has been merely by way of 'rubber stamping' decisions and steps taken by F. For example, in relation to the Transaction, to date H has had no interaction with the Purchaser or their representatives.

42.  In respect of H 'rubber stamping' you offered the following explanation in your letter dated in 20XA:

•                     F has lunch with H from time to time, and in that context, F keeps H informed of business-related matters.

•                     To the extent "rubber stamping" suggests the taking of positive action by H, this may not have been the best choice of words. This was intended to convey that "as a matter of course" H provides tacit approval (by way of not raising any objection), with the intended emphasis being on such tacit approval being a foregone conclusion (rather than on the taking of any positive action by H).

•                     In relation to the three examples in your submission, when H was informed by F of those matters, no objection was raised by H.

•                     In relation to the potential sale of shares in Entity C, all negotiations were carried out by F. H did not participate in the negotiations. A copy of an email directed to F enclosing a non-binding offer from a potential purchaser was attached.

•                     The potential purchaser did not copy H on the email. We are unable to provide a copy of the attachment to the email due to the terms of a confidentiality agreement in place between Entity C and the potential purchaser.

43.  You believe from the above facts, H has played no meaningful role in the strategic decisions of Entity C.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 152

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 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(3)

Income Tax Assessment Act 1997 subsection 328-125(4)

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

Income Tax Assessment Act 1997 section 328-130

Income Tax Assessment Act 1997 subsection 328-130(1)

Reasons for decision

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 Entity A holds 40% of the ordinary shares in Entity C, that Entity A does not control Entity C during the relevant test period.

Detailed reasoning

1.    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 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].

2.    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.

3.    There are two separate control tests for discretionary trusts - under subsections 328-125(3) & (4) of the ITAA 1997. These sections are not applicable in regard to control of DPL.

4.    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.

5.    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.

6.    In the Commissioner's view, the discretion in subsection 328-125(6) of the ITAA 1997 adopts the ordinary meaning of the term '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).

7.    The Commissioner may think that another entity 'controls' an 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 is not determinative.

Ordinary meaning of 'Control'

8.    '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.

9.    To hold in check; curb.

10.  Thus, it is considered that the Commissioner may, in determining whether a third entity (or entities) control the other entity for the purposes of subsection 328-125(6) of the ITAA 1997, consider the third 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 third entity (or entities) have less than a majority shareholding, or even no shareholding, in the other entity. The term 'controlled' is to take its ordinary meaning.

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

12.  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.

13.  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.

14.  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.

15.  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).

16.  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.

17.  Paragraphs 20-23 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 company³³, which give its directors the power to manage the company, the company's directors will control and direct its operations.³⁴ 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.³⁵

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 role³⁶ in the decision-making processes or governance of the company.³⁷

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.³⁸ 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.

18.  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

19.  Pursuant to the statutory control test under subsection 328-125(2) of the ITAA 1997, both the Taxpayer and Entity A may control Entity C where they had ownership interests in Entity C 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 Entity C during the period 1 July 20XA until 30 June 20XB.

20.  Therefore, the period from 1 July 20XA to 30 June 20XB is the relevant 'test time' during which the Commissioner can consider if Entity A does not control Entity C because another entity or entities that do not include Entity A, actually controlled Entity C under subsection 328-125(6) of the ITAA 1997.

Your Contentions

21.  You contend that F, as the 50% shareholder of Entity B as trustee for the D Family Trust (Taxpayer), that holds 60% ownership of Entity C shares, controls Entity C and not H, who own all the shares in Entity A which owns 40% ownership in Entity C. You believe the Taxpayer and not Entity A control Entity C because:

•                     F has been sole director of Entity C since incorporation. F has been responsible for and undertaken the day-to-day management of Entity C at all relevant times;

•                     This arrangement is consistent with the terms of the Shareholder Agreement. In particular, it states:

The Director of the Company is responsible for the day to day management of the Company;

•                     F has continued to be the sole director of Entity C, and has worked on a full-time basis managing Entity C's business;

•                     H has never been appointed as a director of Entity C and has never been involved in the day-to-day management of Entity C's business;

•                     F engages in all of the day-to-day management of Entity C and will continue to do so until the Relevant Date. This includes taking unilateral decisions in relation to matters such as:

o        Obtaining finance facilities from financiers, namely the Bank, for Entity C and providing guarantees on such facilities;

o        Negotiating renewals of leases in relation to properties leased by Entity C and providing guarantees on the leases;

o        Negotiating car hire-purchase agreements for Entity C including providing guarantees on hire purchase agreements;

o        Interacting with customers and suppliers;

o        Attending trade shows, export prospecting trips and business development activities;

o        Marketing, and staffing levels, staff roles and responsibilities, staff remuneration, hiring and termination.

22.  Alternately, you believe Entity A does not control Entity C as H has not been involved or included in the day-to-day communications or processes or otherwise participated in the above matters. In particular:

•                     Where F has made day-to-day management decisions of the type mentioned above, H has not been informed of the decision, and H's consent has not been sought prior to the making of the decision by F;

•                     H has never been invited to Entity C's monthly management meetings (convened between F and senior management of the company);

•                     H has had no interactions with suppliers or customers (other than in the context that one of Entity C's suppliers in a company in the Asian country owned by H);

•                     H's only involvement with Entity C's financial statements has been in the context of the statements being presented to him annually in accordance with the terms of the Shareholder Agreement. H has had no involvement with Entity C's external accountant (who has never met or spoken with H);

•                     H has never had contact with or dealt with anyone from Entity C's external financier;

•                     H has never had any involvement with any staff recruiting, has never attended a recruitment interview, and has never had any input on the hiring or firing of staff; and

•                     Notwithstanding that H is fluent in Asian language, he has never participated in any export prospecting trip (including those to Asia). H has similarly never attended the annual medical trade show held in Europe attended by an Entity C delegation.

23.  In regard to strategic decision-making of Entity C you have stated:

•                     F has been responsible for all strategic decisions of Entity C at all times since its incorporation.

•                     Since Entity A became a shareholder of the company, there have arguably been three major strategic decisions affecting Entity C. These key decisions have been:

o        product development and accessing Research and Development (R & D) incentives;

o        commencing exporting products to Asia approximately 4 years ago; and

o        The negotiation by Entity C, on behalf of its shareholders of the potential sale of all of the shares in Entity C to an arm's length purchaser.

•                     The decisions and initiatives for Entity C to develop products, access R & D incentives, expand exports to Asia and to negotiate a sale of shares in Entity C and the implementation of those decisions, have been initiated and implemented solely by F.

ATO position

24.  Entity A has control of the Company during the relevant time as Entity A has a direct shareholding in the company of 40% (their 'control percentage') (paragraphs 328-125(2)(a) & (b) of the ITAA 1997).

25.  Entity A is 'connected with' the Company because it controls it in a way described in subsection 328-125(1) of the ITAA 1997.

26.  As Entity A's 'control percentage' in subsection 328-125(2) of the ITAA 1997 is at least 40%, but less than 50%, the Commissioner may consider the exercise of his discretion under subsection 328-125(6).

27.  The Taxpayer is not an 'affiliate' of Entity A under section 328-130 of the ITAA 1997 as F could not be taken to 'act, or could reasonably be expected to act, in accordance with H's directions or wishes, or in concert with him in relation to the affairs of the business of F or the Company (Entity C) (subsection 328-130 (1)).

28.  F makes all the important high level decisions in regard to Entity C's operations. This is in accordance with the definition of decision-making in paragraph 14 of TR 2018/5. Conversely, H by being simply informed or agreeing with decisions made by others, is not a decision maker under the definition and is excluded from being such.

29.  F performs all the acts as presented in paragraph 16 of TR 2018/5 as representing acts of control of a company. F's acts in accordance with this paragraph include:

•                     Obtaining finance facilities from financiers, namely the Bank for Entity C and providing guarantees on such facilities;

•                     Negotiating renewals of leases in relation to properties leased by Entity C and providing guarantees on the leases;

•                     Negotiating car hire-purchase agreements for Entity C including providing guarantees on hire purchase agreements;

•                     Involvement with staff recruiting, attending recruitment interviews, and having any input on the hiring or firing of staff;

•                     Interacting with customers and suppliers;

•                     Attending trade shows, export prospecting trips and business development activities;

•                     Marketing, and staffing levels, staff roles and responsibilities, staff remuneration, hiring and termination;

•                     Product development and accessing Research and Development (R & D) incentives.

•                     Commencing exporting products to Asia approximately 4 years ago; and

•                     The negotiation by Entity C, on behalf of its shareholders of the potential sale of all of the shares in Entity C to an arm's length purchaser.

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

31.  Accordingly, the Commissioner will exercise the discretion contained in subsection

32.  328-125(6) of the ITAA 1997 to determine that Entity A does not control Entity C during the test time as the Commissioner accepts that Entity C is controlled by the Taxpayer through the actions of Entity C's sole director, F.