Edited version of private advice

Authorisation Number: 1052163638446

Date of advice: 31 August 2023

Ruling

Subject: Commissioner's discretion - control

Question

Will the Commissioner exercise his discretion under section 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) that the Taxpayer does not control Company A on the basis that Company B controls Company A?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

DD MM 20XX

Relevant facts and circumstances

The Taxpayer made a capital gain on the sale of a commercial property.

The Taxpayer meets all requirements for CGT small business concessions except for the requirement to satisfy the maximum net asset value test under section 152-115 of the ITAA 1997.

The Taxpayer together with its affiliates, held more than 40% but less than 50% of the equity in Company A at the time of the CGT event.

Company B has 50% shareholding and there are other minor shareholders.

The current Directors of Company A includes the Taxpayer as the Managing Director, Company B appointed Director and two other Directors.

The current Directors of Company A are as follows:

....

The Shareholders Deed is the primary document governing Company A providing the conditions as to how the company is controlled and managed.

The Shareholders Deed states:

....

Day to Day Management

The Taxpayer is the Managing Director who is responsible for implementing the Business Plan, Budget and Marketing Plan, and managing the business of Company A on a day to day basis.

The Taxpayer can only continue the role subject to the Shareholders Deed and a unanimous decision by the Board who can revoke authorisation at any time.

Board of Directors

Company B has appointed Director B.

Director B and the Taxpayer have the right to cast two votes whereas all other Directors only have the right to cast one vote respectively.

Director B can be outvoted with two votes against three votes for all other Directors.

However, under clause X of the Shareholders Deed the Board is allowed up to two non-Company B appointed directors. There are currently three non-Company B directors for legacy purposes.

The non-Company B director/s can be removed under clause X of the Shareholders Deed if Company B wanted control at the Board level.

The following table shows the voting rights at the Board level:

...

Historically, there has been no issues of dispute or contention occurred and none have ever been put to a vote.

If a matter was in dispute of contention, it would be dealt with prior to any Board meeting.

For practical purposes, if Company B did not approve a particular matter, the matter would not be brought to a vote (clause xx).

Shareholding

Any decision the Board makes regarding the overall management and operations of Company A is dependent upon the support and agreement of Company B as they have a 50% shareholding, and under clause X of the Shareholders Deed no resolution can be made without any 2 or more of the Shareholders who together hold at least 75% of the Shares in issue.

In this respect the other minor shareholders cannot pass any ordinary resolution or make any decision without Company B.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-15

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

Income Tax Assessment Act 1997 subsection 328-125(1)

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

Income Tax Assessment Act 1997 subsection 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

Summary

The Commissioner will exercise his discretion in accordance with subsection 328-125(6) of the ITAA 1997 and determine that the Taxpayer does not control Company A, on the basis that Company A is controlled by Company B.

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 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

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. These sections are not applicable in regard to control of the group.

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.

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 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.

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. 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 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

The Taxpayer, together with its affiliates, held less than 50% but more than 40% shareholding of Company A. Under subparagraph 328-125(2)(b) of the ITAA 1997, the Taxpayer was in control of Company A at the time of the CGT event.

For the Commissioner to exercise the discretion under subsection 328-125(6) of the ITAA 1997 to make a determination that the Taxpayer does not control Company A for the XXXX income year:

•                     the Taxpayer's 'control percentage' (as referred to in subparagraph 328-125(2)(b)) must be at least 40% and less than 50% for the year, and

•                     the Commissioner must think that Company A was actually controlled by an entity other than the Taxpayer and any of its affiliates, or by entities that do not include the Taxpayer or any of its affiliates.

The Taxpayer satisfies the first requirement for 'control percentage' as the Taxpayer, together with its affiliates, held less than 50% and more than 40% of the control percentage in Company A.

Under Paragraphs 11 and 12 of TR 2018/5, the key element in the control and direction of a company's operations is the making of high level decisions. The control and direction of a company is different from the day to day conduct and management of its activities and operations.

Paragraph 14 of the TR 2018/5 provides that merely because a person is a major 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.

In looking at control at the Board level, under clause X of the Shareholders Deed, the Board is comprised of four Directors, who have the following votes:

The following table shows the voting rights at the Board level:

...

At Board level Company B currently holds x votes, whereas every other Director currently holds x vote.

This means that at a Board level Company B is outnumbered by x votes.

However, per clause X of the Shareholders Deed Company B can remove anyone who should not be on the Board. That is, nothing can be passed at the Board level without Company B approval with Company B having x votes and the Taxpayer having x votes.

Additionally, clause X provides that a quorum for Board Meetings cannot be formed unless at least one Company B Director is present. As a result, no resolution can be made or put to a vote without the support of Company B (clause x).

Paragraph 16 of the TR 2018/5 provides that an entity can exercise central management and control of a company by setting the investment and operation policy, appointing company officers, overseeing and controlling the day to day management and determining financial matters.

In paragraph 24 of the TR 2018/5 a person can control and direct a company without active intervention in the company's affairs provided they appoint agents or managers who tacitly control the company's day to day business, regularly exercise oversight of the company, and do not intervene in the company's affairs as they are running smoothly in the manner desired.

In your circumstances the Shareholders Deed provides that Company B performs all acts in paragraphs 16 and 24 of the TR 2018/5 by:

•                     approving:

-        the annual Business Plan and Budget,

-        the incurring or agreeing to incur expenditure above the Board Threshold,

-        the borrowing or acceptance of financial accommodation,

-        issue of Shares,

-        the disposal, lease or acquisition of any asset,

-        the creation or disposal of new subsidiaries,

-        the grant, variation or termination of any Encumbrance over company assets,

-        the variation of any staff with a total renumeration, fees or benefits payable of $xx or more,

-        all salaries of staff,

-        the commencement of litigation,

•                     making all decisions for the overall direction and management of the company including the business operations and Marketing Plan, and the formulation of policies to be applied to the conduct of the Business,

•                     determining any decisions which are not part of the day to day management of the company at Board meetings,

•                     approving the implementation of the Business Plan and how the Managing Director runs the day to day management with the ability to revoke authorisation at any time,

•                     unanimous decision to determine the Managing Director,

•                     advising the standard form for employment agreements of executives and consultants,

•                     implementing the use of the Company B Group trademark and incorporating Company B manuals,

•                     following, adopting and enforcing all resolutions and decisions by Company B or any committee established by Company B,

•                     providing the practice management system that the Business uses for day to day operation, and

•                     specifying the accounting policies and statutory reporting requirements used by Company A.

In your case Company B has control and management at the Board level, the shareholder level and also ultimate control over day to day activities and management.

Accordingly, the Commissioner will exercise the discretion contained in subsection 328-125(6) of the ITAA 1997 to determine that the Taxpayer does not control Company A during the 20XX-20XX income year as the Commissioner accepts that Company A is controlled by Company B.