Edited version of private advice

Authorisation Number: 1052128346652

Date of advice: 13 June 2023

Ruling

Subject: Commissioner's discretion - control

Question

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

Answer

No.

This ruling applies for the following period:

Income year ended 30 June 2021

Relevant facts and circumstances

The Company is an Australian private company and is governed by its Constitution (the Constitution). The "replaceable rules" referred to in sections 135 and 141 of the Corporations Act 2001 do not apply to the Company (rule 4).

In relation to directors and meetings of directors, the Constitution relevantly provides:

• the company may have one or up to but no more than 8 directors (rule 96);

• the business of the company is to be managed by or under the direction of the directors (rule 108);
• the directors may exercise all the powers of the company, except for those that require the company to exercise in general meeting (rule 109);
• the directors of the company may appoint one or more of themselves to the office of managing director (rule 114);[1]
• a resolution may be passed without a directors' meeting being held if all the directors entitled to vote on the resolution sign a document containing a statement that they are in favour of that resolution (rule 124);
• the directors may elect a director to chair their meetings (rule 129);
• the quorum for a director's meeting is 2 directors (where the company has 2 or more directors) (rule 131);
• a resolution of the directors must be passed by a majority of the votes cast by directors (rule 132); and
• the chairman has a casting vote in addition to any vote they may have in their capacity as a director (rule 133).

Matters requiring resolution at a meeting of directors include:

• the appointment of office holders/directors;
• a declaration of solvency;
• the approval of financial statements;
• the approval of share transfers; and
• the declaration of dividends.

The Company initially had two directors, Director A and Director B. Director B ceased his directorship for several years before being reappointed as director in the 2021 income year. Director A remains one of 2 directors of the Company (with Director B) and was the sole director of the Company for the period Director B ceased his directorship.

The Company does not have employees. Director A was solely responsible for the design and building of the Company's product, managed all of operational aspects of the Company and managed the strategic direction of the Company.

Director A was the sole director when a third party initiated discussions regarding the licencing of the Company's product and the decision to proceed with negotiations was Director A's alone at the time. The reappointment of Director B as director was made to assist with the negotiation and execution of the licence agreement.

In relation to meetings of members, the Constitution relevantly provides:

• a director may call a meeting of the company's members either at their own discretion (rule 68) or at the request of a member in accordance with sections 249D to 249F of the Corporations Act 2001 (rule 69);
• a quorum for a meeting of the company's members is 2 (where the Company has 2 or more members) (rule 72);
• the directors may elect an individual to chair meetings of the company's members (rule 76);
• at a meeting of the members of the company, each member has one vote on a show of hands or, on a poll, one vote for each share held (rule 87); and
• the chairman of a meeting of the company's members has, subject to any conflict of interest, a casting vote in addition to any vote they may have in their capacity as a member (rule 88).

Matters requiring resolution at a meeting of members include:

• the issue of new capital;
• a share buy-back;
• the disposal of the company/business; and
• acquisitions of a competitor.

The issued capital in the Company is XXXXX ordinary shares. All ordinary shares on issue carry equal rights to vote, dividend income and capital distributions.

As at 1 July 2020, the shares in the Company were held as follows:

Table 1: As at 1 July 2020, shares in the Company were held as follows:

None of these shareholders are an 'affiliate' of the other pursuant to section 328-130 of the ITAA 1997.

Shareholder C became a shareholder to provide additional future capital as required for the continued development of the business. Director B is a 50% shareholder and one of two directors of Shareholder C.

Shareholder D is wholly owned by a company. Director A was a former employee of Shareholder D.

As at 30 June 2021, and as a consequence of the transfer of the XXXX ordinary shares in the Company held by Shareholder C to Shareholder B, the shares in the Company were held as follows:

Table 2: After the transfer of ordinary shares, shares in the Company were held as follows:

None of these shareholders are an 'affiliate' of the other pursuant to section 328-130 of the ITAA 1997.

As at the date of this ruling, the Company is wholly owned by Shareholder B following the transfer of the ordinary shares by the other shareholders to Shareholder B.

Shareholder B, of which Director B is chief executive officer and a director, acquired its interest in the Company as part of the negotiation for Shareholder B to be a distributor of the Company's product. Shareholder B' role was to market the product only.

Director B (through his interest in Shareholder C, together with his spouse) owns approximately 41% of the issued capital in Shareholder B while Director A (through his interest in his company) owns approximately 20% of the issued capital in Shareholder B.

There were 2 meetings of directors of the Company held during the 2021 income year. The first, attended by Director A only as the sole director and chairperson was to appoint Director B as a director of the Company, and the second, attended by both Directors (with Director A as chairperson), was to approve the transfer of the shares in the Company from Shareholder C to Shareholder B.

No meeting of the members of the Company were held during the 2021 income year.

The members of the Company have not entered into a shareholder agreement.

The Company was a small business entity for the 2021 income year pursuant to section 328-110 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 paragraph 328-115(2)(b)

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)(b)

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

Income Tax Assessment Act 1997 section 328-130

Corporations Act 2001 section 135

Corporations Act 2001 section 141

Corporations Act 2001 section 249D

Corporations Act 2001 section 249E

Corporations Act 2001 section 249F

All subsequent legislative references are to the ITAA 1997.

Reasons for decision

Taxpayers need to determine their aggregated turnover for many reasons under taxation laws, including to determine if they are a small business entity and to access certain concessions. An entity's aggregated turnover includes the annual turnover of entities connected with it (paragraph 328-115(2)(b)).

Section 328-125 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). Pursuant to paragraph 328-125(2)(b), an entity (the first entity) controls a company if the first entity, its affiliates or the first entity together with its affiliates 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.

The Commissioner's discretion, as set out in subsection 328-125(6), states the following:

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' as the term is undefined.

Meaning of 'control'

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 a third entity controls the other entity for the purpose of subsection 328-125(6), consider the third entity's ability to, for example, command the other entity to undertake/not undertake actions.

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, 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.

In the context of subsection 328-125(6), 'control' relates to the control typically associated with share ownership, rather than the management of a business' day-to-day, operational activities. Therefore, when testing the third entity's control of the other entity for the purpose of subsection 328-125(6), the Constitution and other relevant documents are critical, noting entitlements to income and capital and the ability to participate in decision making about matters such as:

• the composition and oversight of the management team;
• the amendment of constituent documents;
• proposals for the restructure of capital or the restructure of the company;
• the issue of new shares;
• the winding up of the company; and
• the authorisation of significant changes in the company's business operations.

The exercise of the discretion will turn on the facts and circumstances of any case.

Application to the circumstances

Under subsection 328-125(2), Shareholder B is deemed to have controlled the Company for the 2021 income year as a result of having owned shares in the Company that carry between them the right to exercise or control the exercise of at least 40% of the voting power in the Company.

For the Commissioner to exercise the discretion under subsection 328-125(6) to make a determination that Shareholder B does not control the Company for the 2021 income year:

• Shareholder B's 'control percentage' (as referred to in paragraph 328-125(2)(b)) must have been less than 50% for the year, and
• the Commissioner must think that the Company was actually controlled by an entity other than Shareholder B or any of its affiliates, or by entities that do not include Shareholder B or any of its affiliates.

As a result of its holding of 45% of the shares issued in the Company, Shareholder B controlled the exercise of 45% of the voting power in the Company (i.e. a control percentage of at least 40% but less than 50%), and satisfies the first requirement.

It is therefore necessary to determine if the Company was controlled by a third entity other than Shareholder B or any of its affiliates, or by entities that did not include Shareholder B or any of its affiliates.

The Commissioner is not satisfied that any entity (including Director A, either individually or through Shareholder A) controlled the Company for the purpose of subsection 328-125(6) in respect of the 2021 income year. The reasons for this conclusion include:

• During the 2021 income year no single shareholder held a majority shareholding and was able to exercise control alone.
• In order for any shareholder to exercise control over the Company, they would require another shareholder to vote in accordance with them when resolving significant decisions. Even though Director A could appoint himself as the chair and have a casting vote at member meetings at the time he was sole director, that would only be of relevance where Shareholder D abstained. It is possible that Shareholder D and Director B (i.e. through Shareholder B and Shareholder C before that) could vote together to defeat Director A.
• None of the shareholders were affiliated with Director A or Shareholder A pursuant to section 328-130.
• Whilst Director A was sole director for part of the year and set the strategic direction of the Company, his powers as director were limited to the extent that the shareholders (i.e. Director B (through Shareholder B) and Shareholder D) could exercise control by voting together to remove and replace Director A as director and/or amend the Constitution to allow them to set the strategic direction of the Company.

Accordingly, the Commissioner will not exercise the discretion in subsection 328-125(6) to determine that Shareholder B does not control the Company for the purposes of section 328-125.

[1] No managing director of the Company has been appointed.