Edited version of private advice

Authorisation Number: 1052201757475

Date of advice: 8 December 2023

Ruling

Subject: Commissioner's discretion - control test

Question

Will the Commissioner exercise the discretion allowed under subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) to determine that the Trust did not control the Company prior to the sale of its 45% shareholding in the Company?

Answer

No.

This private ruling applies for the following period:

Year ending 30 June 2023

The scheme commenced on:

1 July 2022

Prior to the sale of its shareholding, the Trust owned 45% of the issued shares in the Company.

The Trust is a discretionary trust controlled by individual A and their spouse as trustees of the trust.

The other shareholders of the Company were as follows:

•         Company B 45%

•         Company C 10%

Company B and C are not affiliates of the Trust and are not related.

Prior to the sale of shares, the directors of the Company were as follows:

•         Individual B (Company B's representative)

•         Individual C (Company C's representative)

•         Individual A (the Trust's representative)

•         Individual D (Group CEO)

Individual A commenced medical stress leave in XX Month 20XX.

An agreement was approved from to place Individual A on paid leave from their employment (gardening leave) while the parties seek to document and execute an agreement for:

•         The sale by the trustees of the Trust of its shares in the Company; and

•         The termination of Individual A's employment

The terms of the leave did not require Individual A to have any role in the management of the Company.

Individual A remained on medical stress leave until the gardening leave commenced in the 20XX financial year.

Although Individual A was still technically a director of the Group after this time, he did not attend any Board meetings from this date and had no knowledge of or involvement or input in any Board or management decisions after this date.

Minutes were not kept at board meetings.

Individual A's access to several Company IT systems was terminated and all staff were instructed to liaise with only Individual B and D in performing their duties.

The Company's constitution

To summarise the effect of some of the provisions in the constitution governing voting, meetings and decision making:

•         A quorum is constituted by two persons who, between them hold or represent by proxy one-third of the issued shares

•         A member is required to give written notice of an intention to transfer shares

•         Appointed directors hold office until they are removed by an ordinary resolution passed at a general meeting

•         Dividends can only issue if directors have recommended and authorised

•         Winding up requires the sanction of a special resolutions

The company's constitution states at X.X:

Where there is a change in control of a shareholder, then that shareholder will, at the time of the change in control, be deemed to have offered all of its shares to the other shareholders in the manner provided for, mutatis mustandis, in clause X at a price determined in accordance with clause X.X to be fair market value of the shares of that shareholder.

The company's constitution states at Y.YY:

A Director may appoint a person (whether a member of the Company or not) to be an alternate Director in his place during such period as he thinks fit and an ASIC Form 484 must be prepared and lodged with ASIC within 28 days of the effective date of the appointment of the alternate Director.

An alternate Director may exercise any powers that the appointor may exercise and the exercise of any such power by the alternate Director shall be deemed to be the exercise of the power by the appointor.

Y.YY The appointment of an alternate Director may be terminated at any time by the appointor notwithstanding that any period of the appointment of the alternate Director has not yet expired, and terminates in any event if the appointor vacates office as a Director.

Y.YY An appointment, or the termination of an appointment, of an alternate Director shall be effected by a notice in writing signed by the Director who makes or made the appointment and served on the Company.

Y.YY If the appointing Director requests the Company to give the alternate Director notice of Directors meetings, the Company must do so.

Sale of shares

In the 20XX financial year, a contract was signed whereby the Trust sold its 45% shareholding in the Company.

Evidence

Individual A provided the following:

•         series of communications between himself and various staff, between the period XX Month 2021 to XX Month 2022 inclusive, on various general business operational matters.

•         a PowerPoint leadership update report dated XX Month 2022. This report contains a business update including financials, brand and people update, sales update, tech update and a CEO update.

•         reports for Company D from specified dates in 2022. These reports detail various financial information.

Relevant legislative provisions

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

Reasons for decision

Subsection 328-125(1) of the ITAA 1997 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.

With regard to companies, you may establish control via either the right to distribution control rule (paragraph 328-125(2)(a) of the ITAA 1997) or the voting power control rule (paragraph 328-125(2)(b) of the ITAA 1997).

Paragraph 328-125(2)(a) of the ITAA 1997 provides that you control a company if you, your affiliates, or you together with your affiliates beneficially own, or have the right to acquire the beneficial ownership of, interests in the company that carry between them the right to receive a percentage (the control percentage) that is at least 40% of any distribution of income or capital by the company.

Paragraph 328-125(2)(b) of the ITAA 1997 provides that you control a company if you, your affiliates, or you together with your affiliates 'beneficially own, or have the right to acquire the beneficial 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'.

Commissioner's discretion

Broadly, if your control percentage in a company is at least 40% but less than 50% the Commissioner may determine under subsection 328-125(6) of the ITAA 1997, that you do not control the other entity if the Commissioner thinks that the entity is controlled by a third entity (other than your affiliates).

Paragraphs 2.59 and 2.60 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (EM) state that:

Where an entity's interest in another entity is at least 40 per cent but less than 50 per cent the 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. [Schedule 1, item 1, subsection 328-125(6) of the ITAA 1997]

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.

We consider that the discretion in subsection 328-125(6) is a strict test of legal control. Control over day-to-day management,, may be a factor that points towards control, but on its own is not enough to establish control. Merely pointing towards another entity that has a control percentage of greater than 40% under subsection 328-125(2)does not establish that that entity has control for the purposes of s 328-125(6). The basis for a determination that the first entity does not control the company requires a positive conclusion that the company is actually controlled by a third entity or entities. We do not consider that two or more unrelated entities habitually acting together, or conducting the business on a 'consensus basis' necessarily would have control of an entity, for the purposes of determining whether the discretion in subsection 328-125(6) is available.

For the purposes of subsection 328-125(), it is relevant to consider the legal powers which entities can exercise under the relevant law, including applicable governing documents. For the Company, this means the Company's Constitution, the Shareholders Deed, as affected by Australian company law.

Application to your circumstances

In this case, the Trust held a 45% shareholding in the Company just prior to the sale of the shares. At this time the Trust and its controller, Individual A, were no longer involved in the day to day operations of the Company. Individual A was placed on medical stress leave and while he retained his director title, he did not attend any board meetings from this time.

It is the Commissioner's view, based on the above terms of the gardening leave agreement, that there was no legal impediment to Individual A partaking in decision making or asserting control by way of his 45% interest in the Company.

The application for private ruling suggests that Individuals C and D acted in concert with Individual B during board meetings and voted in accordance with Individual B's directions and wishes. The application contends this gave Company B control of all strategic and operational decisions made in respect of the Company. However, no minutes were kept at board meetings and based on the information provided there was no written agreement between the relevant parties to influence their actions.

The Trust had the power to appoint an alternative director, as per the company constitution, to exercise any powers that the appointor (the Trust) may exercise. The terms of the gardening leave did not prevent the trust from invoking this clause.

Based on the information provided we cannot accept that the Company was controlled by Individual B and by extension, Company B. Therefore, the Commissioner will not exercise the discretion under subsection 328-125(6) of the ITAA 1997.