Edited version of private advice

Authorisation Number: 1052260857050

Date of advice: 11 June 2024

Ruling

Subject: Commissioner's discretion - connected with an entity

Question

Will the Commissioner exercise the discretion in subsection 328-125(6) of the Income Tax Assessment Act 1997 (ITAA 1997) and determine that, Company A as trustee for Trust A (Trust A) did not control Company B because Company B was controlled by Company E?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2023

The scheme commenced on:

1 July 2022/p>

Relevant facts and circumstances

You are a unit trust.

Your corporate trustee is Company A

You sold your interest in Company B to Company C

You made a capital gain from the sale of your shares in Company B to Company C.

You are now considering whether you would be entitled to small business capital gain tax relief under Division 152 of ITAA 1997 for that capital gain and have formed a view that this may be affected by whether you are taken to control Company B for the purpose of those provisions.

History of Company B

Company B was incorporated.

Shares on issue in Company B comprise of ordinary shares, held by the following:

•      Company D held more than 50% of the issued shares

•      Company A held at least 40% but less than 50% of the issued shares.

In accordance with Company B's Constitution, each ordinary share has the following rights attached:

•      the right to vote at all meetings of the Company

•      the right to participate in any dividend declared on the class of shares held

•      the right to participate in any division or distribution of any surplus assets or profits of the Company.

The Shareholders' Agreement was executed by the shareholders detailing their obligations.

It is noted that the Shareholders' Agreement states where any inconsistency exists between the Constitution of Company B and the Shareholders' Agreement, the Shareholders' Agreement will prevail.

The Shareholders' Agreement makes provision for the shareholders on the total number of directors they can appoint according to the percentage of shares held. A director can only be removed by the appointing shareholder.

Consistent with the provisions in the Shareholders' Agreement the majority shareholder:

•      must approve in writing any chairperson and managing director before appointment

•      is to ensure that the formation of the company, appointment of officers and execution of documents occur.

The Shareholders' Agreement states there is a unanimous resolution of the board of directors that is required on the disposal of the Company if the directors are unable to declare a dividend to Company A of not less than a certain amount per share.

A new shareholder of the company must, before registration of the transfer of shares, enter into an adherence deed with the other parties to the Shareholders' Agreement, agreeing to be bound by the Shareholders' Agreement as if named as a party and a shareholder.

The original directors of Company B were Person A and Person B. Person A was also the secretary.

Person C was appointed as director of Company B when Person B ceased their directorship.

Company B was established as a Special Purpose Vehicle for a specific project.

Trust A

Company A beneficially holds the shares in Company B on your behalf.

The units in Trust A are owned by Trust B.

Company F is the sole shareholder of Company A.

Company F shareholding is owned by Trust B.

Person D is the sole director of Company A and Company F.

Company D

Company D was incorporated.

Shares on issue in Company D comprise of ordinary shares, held by the following:

•      Person E held X

•      Company G held XX

Person A and Person C are the directors of Company D.

Company D transferred its ordinary shares held in Company B to Company E.

Company E

Company E was incorporated.

Shares on issue in Company E comprise of ordinary shares, held by the following:

•      Person E held XX

•      Company H held XX

•      Person C held XX

•      Person B held X

Person A and Person C are the directors of Company E.

Company E executed a deed of adherence to the Company B Shareholders' Agreement.

Day to day management of Company E

Person A and Person C (the two directors of Company B and the board of directors) were responsible for:

•      the day-to-day management of Company B

•      all legal, commercial, financial, programming and contracting decisions, and

•      negotiating and arranging development funding for the project.

All decisions affecting Company B were made by and under the control and direction of Person A and Person C in their capacity as directors of the company sitting on the board of directors.

When necessary, Person A and Person C consulted with industry experts and the minority shareholder to be able to make fully informed decisions on matters affecting the project.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 152

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

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

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

Reasons for decision

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

Commissioner's discretion

If the control percentage in a company 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 a third entity, or by entities that do not include, the first entity or any of its affiliates.

The statutory condition for exercising the Commissioner's discretion requires that the Commissioner positively conclude that there is actual control by a third entity or entities. It is not sufficient to merely show that the first entity is not a controller.

Taxation Determination TD 2023/5 Income tax: aggregated turnover and connected entities - Commissioner's discretion that an entity does not 'control' another entity (TD 2023/5) provides guidance on particular issues that have emerged from the administration of the discretion in subsection 328-125(6) of the ITAA 1997 to determine that an entity does not 'control' another entity.

Sole or primary responsibility for the day-to-day management of the affairs of the entity, while not irrelevant to the question of who controls that entity, does not of itself constitute control for the purpose of the Commissioner's discretion in subsection 328-125(6) of the ITAA 1997.

Having regard to the statutory context, the nature of control relevant for the Commissioner's discretion is control over those matters typically associated with ownership of a business entity, namely, entitlements to the income and capital of the entity as well as participation in decision-making on key matters affecting constitution, funding, structure, and management. The latter would ordinarily include matters such as:

•      decision making on the composition and oversight of the management team

•      amending the entity's constituent documents

•      deciding on capital and entity restructuring proposals, the issue of new ownership interests or winding up, and

•      authorising significant changes in the direction of the entity's business operations.

Other ways in which an entity may be said to be 'controlled', such as the control exercised by managers with responsibility for the day-to-day conduct of the business, does not, of itself, constitute control of the entity in the sense contemplated by the aggregation rules. It is necessary to distinguish control of an entity from powers relating to the conduct of business.

Managers or directors with responsibility for the day-to-day conduct of a company's business may have considerable autonomy in making significant business decisions, but this of itself is not considered 'control' of the entity for the purpose of subsection 328-125(6) of the ITAA 1997.

Example 2.10 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (EM) illustrates when the discretion might be exercised to disregard a control percentage interest of between 40% and 50% on the basis of a conclusion that a third entity controls the text entity. The example refers to a manager of the test entity with a 58% shareholding in that entity, and another person with a 42% shareholding who has no dealings at all with the manager.

We consider that, in these circumstances, the significance of who manages the business of the test entity stems from the relative ownership interests which dictate who has the power to determine who performs the managerial functions. The identity of who actually performs the managerial function is generally of limited relevance to the question of control of the test entity. The manager in Example 2.10 of the EM, with the 58% shareholding, would not cease to control the test entity merely because they decided to appoint a new manager with full responsibility for the day-to-day conduct of the business of the entity.

We also consider that Example 2.10 of the EM illustrates circumstances in which we would be likely to conclude that the test entity is controlled by a third entity (the 58% shareholder) and exercise the discretion to disregard the 42% shareholding accordingly. The holding of interests carrying rights to more than 50% of the income, capital and voting power in a company is consistent with control of the company for the purposes of subsection 328-125(6) of the ITAA 1997. Assuming that the majority ordinary shareholding is sufficient to carry the vote on most or all of the fundamental matters relating to the test entity, we would think there is control by the third entity unless the third entity's control through its majority shareholding is in some way qualified or compromised by other circumstances or arrangements.

Application to your circumstances

In this case, Trust A held at least a 40% but less than 50% shareholding in Company B just prior to the sale of the shares. At this time, Trust A, and its controller Person D, were not involved in the day-to-day operations of Company B.

According to the Company B Constitution Company E via Person C and Person A controlled this responsibility for managing the affairs of Company B. Company E controls the board of directors of Company B and Trust A plays no role in managing the affairs of Company B nor does it have any representation on the board of Company B.

It is acknowledged that Trust A as the minority shareholder was consulted from time to time to make fully informed decisions on matter affecting the project. Company E's control of Company B is not in any way compromised by the consultation with Trust A.

Based on the information provided, the Commissioner will exercise the discretion in subsection 328-125(6) of the ITAA 1997 to determine that Trust A does not control Company B because Company B is controlled by Company E.