Private ruling: R&D tax offset - control test - aggregated turnover - Commissioner's discretion
Date of advice: 11 August 2020
Published: September 2020
Ruling period: The year ended 30 June XXXX
Date scheme commenced: 1 July XXXX

Ruling: Q1: Will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 to determine that Company B does not control Company A? | A1: Yes

Relevant facts and circumstances: Company A currently has X ordinary shares on issue that are held as follows: · 60% are held by Company C; · 40% are held by Company B. Prior to a time occurring during the income year, Company C had held all of the ordinary shares (100% of the share capital) in Company A. All of the issued shares in Company C are held by Individual A. Individual A is the sole director and secretary of Company C. During the income year, Company A entered into a Shareholders Agreement (Shareholders Agreement) with Company C and Company B to further the business of Company A. Immediately after entering into the Shareholders Agreement, ordinary shares were issued to Company B giving Company B a 40% holding in Company A. Individual A has been the sole director and secretary of Company A since incorporation and is still the sole director and secretary of Company A. Individual A is, and has been since incorporation, the Chairman of Company A. Individual A is the CEO of Company A. The strategic and day to day decisions of Company A are made by Individual A. Company B plays no part in the strategic or day to day decision making of the business of Company A. The Shareholders Agreement The Shareholders Agreement provides for the Shareholders and Company A's (the Company's) agreement on the ownership, control and management of Company A and its business. The terms of the Shareholders Agreement are summarised below. The Shareholders (as defined in clause 1.1) are Company C and Company B. The Shareholders Agreement commences upon the Subscription (the subscription for Shares by Company B and the issue of those Shares as contemplated in clause 3(b)) and continues until it terminates in accordance with its terms or as otherwise agreed by the parties to the Shareholders Agreement (Clause 2). Clause 19 provides that the Shareholders Agreement will be terminated on a date mutually agreed by the Shareholders or when Company A is wound up or when one entity acquires all the Shares. Share is defined as a fully paid ordinary share in Company A (clause 1.1). Clause 3(b) provides that on the date of execution of the Shareholders Agreement, Company B will subscribe for X ordinary shares (as set out in Part 3 of Schedule 1) for the sum of $1 and Company A will issue those Shares to Company B, following which Company C will hold 60% of the ordinary shares and Company B will hold 40% of the ordinary shares. Further issues of shares are subject to the procedure set out in the Constitution and the Shareholders Agreement (Clause 3(c)). Nothing in the Shareholders Agreement is to constitute a relationship of partner, agent, legal representative or create any agency or trust (except as where expressly provided) (Clause 4.2). Clause 4.3 sets out the general obligations of the Shareholders to act in good faith. Clause 4.4. provides that each Shareholder will exercise, or refrain from exercising, as necessary, any voting rights or other powers of control and all means reasonably available to it to ensure the passing of every resolution or the provision of every approval necessary or desirable to procure that the Business (as described in clause 5) and the affairs of the Company are conducted in accordance with the Shareholders Agreement and to give full effect to the provisions of the Shareholders Agreement. Nothing in the Shareholders Agreement gives rise to or is intended to give rise to any fiduciary duties between the Shareholders. The business of Company A Clause 5 summarises the business of Company A. The objectives of the business are to carry on, develop and expand the business and maximise the profit and value of the business and Company A. Directors and Management and Decisions Clause 6.1 provides that on commencement Individual A will be the Director of Company A and that the Board (of directors) may from time to time appoint any person to be a director in accordance with the Constitution. Clause 6.2 provides that Company A may remove any Director from office in accordance with the Constitution and where applicable the Corporations Act 2001 (Corporations Act). Clause 6.3 provides for the procedures for Board Meetings. Decisions of the Directors can be made by each Director entitled to vote on the resolution signing a written resolution approving the matters the subject of the resolutions (Clause 6.3(g)). Clause 6.4 provides that Individual A is the initial Chairman of the Board. The Chairman does not have a casting vote. The Chairman may only be removed by a resolution of the Board. Clause 6.5 provides that the Board will be responsible for the overall direction and control of the management of Company A. Following commencement, the Board will create a delegated authority matrix, setting out day to day management of the business. Clause 7 provides that all decisions at a meeting of the Directors or Shareholders will be decided by simple majority of all Directors or Shareholders (as applicable).The Applicant states that in the case of decisions by directors, this is by simple majority in number of votes cast by each director at a meeting of directors. In the case of decisions by shareholders, this is by simple majority of votes cast per share at a meeting of shareholders. The Applicant states that clause 7 does not, and was never meant to, override the normal way that decisions requiring a vote of the shareholders would take place under the Constitution i.e. that effectively a poll takes place so that there is one vote for each fully paid share. Clause 8 sets out the dividend policy and provides that a decision to pay dividends is a decision of the Board. Shares participate equally in dividends. Unless otherwise agreed, Company A will repay any loans to Shareholders in priority to making any distributions. Clause 9 provides that the Board determines the working capital requirements of Company A and may borrow from Shareholders or third parties or undertake an issue of Shares (in accordance with the Agreement). There are no obligations to provide additional funding under the Shareholders Agreement. Access to records Clause 10 provides for access by a Director or Shareholder or their representative to the documents relating to the business of Company A (including books of account) such that they can undertake an audit of the books. It also provides for Company B to be assisted to obtain all information necessary to undertake an independent valuation of its shareholding as required for the purposes of clause 12 and 13. Company A must provide Shareholders with annual financial statements within 3 months of the end of a financial year with an operations report and outlook for the next financial year. Issue and transfer of Shares Clause 11 provides that the Board may issue Shares in accordance with the Constitution but may only issue shares to a person who is not a Shareholder if they sign a Deed of Accession. Clause 12 provides that Company B may not transfer its shares without first offering them to each other Shareholder (Offeree) on a proportionate basis (i.e. all shares would need to be offered to Company C - right of pre-emption). Clause 12 sets out the process to be followed. If the Offerees do not agree to buy all the Shares for sale those unsold shares can be sold to the third party identified in the relevant notices provided consent is given by the Board or the Board may nominate an alternate third party buyer. Clause 12 (except clause 12.2 and 12.11) does not apply to transfers of Shares by a Shareholder to an Affiliate or if the transfer has been approved by all Shareholders in writing (Clause 12.12). If a Shareholder fails to comply with the transfer provisions in clause 12, Company A may refuse to register the transfer of Shares and the transfer will be of no effect (clause 12.13). Buy-out or buy-back rights Clause 13 provides for the buy-out or buy-back of Shares on termination of the Licence Agreement. The Licence Agreement is defined as the licence agreement entered into by Company B and Company A on or about the date of the Shareholders Agreement. Clause 13 provides that on a date no later than one month after the termination of the Licence Agreement, Company B shall commission a written independent valuation of its Shares and the valuation shall set out a specified price for the Shares. That written valuation shall be provided to the Board within two months of the termination of the Licence Agreement and the Board shall have one month to consider the report after which the Company shall either: · buy-back Company B's Shares for the sum set out in the Valuation Report and the Parties must do all necessary things to effect that buy-buck of Shares; or · declare that Company B shall be deemed to have given the Board and each other Shareholder a Transfer Notice for all of its Shares at a sale price set out in the Valuation Report, and the provisions of clauses 12.4 to 12.11 (with the exception of clauses 12.8 and 12.9) shall then apply with respect to the sale of Company B's shares. Other matters The Shareholders Agreement also provides for the event of default by the Shareholders (clause 14), confidentiality (Clause 15), a dispute resolution process (clause 16) and warranties (clause 17). Clause 18.1 provides that the Shareholders agree that the instruments which govern the relationship between themselves and with Company A are the Shareholders Agreement and the Constitution and it is intended that this Agreement and the Constitution be read together. Clause 8.2 provides that in the event of inconsistency between the Shareholders Agreement and the Constitution, the provisions of the Shareholders Agreement prevail, subject to the Corporations Act. Clause 19 includes other miscellaneous matters. The Constitution The share capital of the company may consist of different classes of shares (clause 24) but the only shares on issue at the relevant times are ordinary shares. The rights of ordinary shares are set out in Schedule 2 as follows: A member being the holder of an ordinary share holds that share subject to the following rights and conditions: (a) the right to attend and vote at all meetings of the Company and on a show of hands or poll to vote for every share held; (b) the right to participate in the dividends (if any) determined by the directors to be paid on that share; (c) in a winding up of the Company - the right to repayment of the paid issue price of such share and to participate in the division of surplus assets or profits of the Company and in this regard to rank equally with all other shareholders so entitled; And (d) any other rights in the [ Corporations Act 2001 ]. Company A may, by ordinary resolution, alter its share capital by consolidation or dividing or cancelling shares (clause 30). Pursuant to the Constitution: For meetings of members (clause 2 to 6): · no annual general meetings are required and the directors may call a meeting of members at any time (clause 2.1 and 2.2); · no business may be transacted unless a quorum (two members present in person or by proxy or representative who are entitled to vote (clause 4); · subject to the Constitution and any terms of issue, each natural person who is present may vote if they are a member, a proxy or a representative (clause 5); · subject to any rights or restrictions attaching to any class of shares, a matter requiring member's approval is by ordinary resolution of the members unless a special resolution is required by the Constitution, any Shareholders Agreement or the Corporations Act (clause 5); · a natural person present at a meeting has on a show of hands, one vote per person; on a poll, one vote for each fully paid share (clause 5.3); · a resolution is determined by a show of hands unless a poll is demanded (which may be, for example, demanded by any person or persons present having the right to vote at least 5% of the votes that may be cast on the resolution on a poll). The chair has a casting vote (clause 5.10 - 5.13). For appointing Directors (clause 9): · The directors holding office at the date of adoption of the Constitution continue in office subject to this Constitution. The members may at any time elect any director by special resolution. The members may at any time remove a director by special resolution and where the director was appointed by a particular member, by that member alone by written notice to the Company and that member may then appoint another director in their stead; · The directors may at any time appoint any person as a director, either to fill a casual vacancy or as an addition to the directors, by special resolution of the directors; · The directors may remove a director from office by an ordinary resolution of directors; · The directors may appoint a managing director and revoke the appointment of a managing director. For director meetings (clause 12): · for a single director company, the quorum is one, otherwise the quorum is two; · a meeting of directors at which a quorum is present is capable of exercising any or all of the authorities, powers and discretions exercisable by the directors; · the directors may meet and transact business as they think fit; · a resolution must be passed by a majority of votes cast by the directors eligible to vote on the resolution; · resolutions may be made by document setting out the resolution and signed by all eligible directors. Powers of directors: · subject to the Corporations Act and the Constitution, the management and control of the Company and of the business and affairs of the Company is vested in the directors. The directors may exercise all such powers of the Company and do all acts or things not expressly required by this Constitution, any shareholders agreement or the Act to be exercised or done by a meeting of members (clause 14); · the Directors have the power to declare dividends and accumulate reserves (clause 20); · subject to the Corporations Act and the other provisions of the Constitution the Directors have the power to allot, grant options over, or otherwise dispose of the shares in the Company on such terms as they think fit (clause 23); · the Directors have the power to borrow for the purposes of the Company (clause 41). While the Company is a single director company, directors means that director (clause 50). The Company may amend or repeal the Constitution or any of the rules of the Constitution by special resolution (clause 47). There is not any ability under the Constitution or the Shareholders Agreement (or otherwise) for Company B to veto or restrain the decision making of the directors (currently Individual A). Company A provided the following documents in support of its application: a. A copy of the Constitution of Company A; b. A copy of the Shareholders Agreement. We have considered the entirety of these documents in making our decision.


Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated The Commissioner exercises his discretion under subsection 328-125(6) of the ITAA 1997 to determine that Company B does not control Company A. | Detailed Reasoning - The legislative context: 1. Generally, where a R&D entity has engaged in R&D activities, subsection 355-100(1) allows the entity to claim a R&D tax offset on certain specified amounts at one of two specified rates. The applicable rate depends on certain circumstances as detailed in the table in subsection 355-100(1) as follows: | Detailed Reasoning - The percentage is:: 1 the *R & D entity's *aggregated turnover for the income year is less than $20 million (and item 2 of this table does not apply) 43.5% 2 at any time during the income year an *exempt entity, or combination of exempt entities, would control the *R & D entity in a way described in section 328-125 (connected entities) if: (a) references in section 328-125 to 40% were references to 50%; and (b) subsection 328-125(6) were ignored 38.5% 3 any other case 38.5% 2. Further, the tax offset will be a refundable tax offset entities for R&D entities with an aggregated turnover for the income year of less than $20 million that are entitled to a tax offset at the rate of 43.5% i.e. under Item 1 of the table (section 67-30). 3. 'Aggregated turnover' is defined in section 328-115. Subsection 328-115(1) states, your aggregated turnover for an income year is the sum of the 'relevant annual turnovers' (see subsection (2)) excluding any amounts covered by subsection (3). 4. Subsection 328-115(2) states the 'relevant annual turnovers' are: · your annual turnover (as defined in section 328-120) for the income year, and · the annual turnover for the income year of any entity (a relevant entity) that is connected and/or affiliated with you at any time during the income year. 5. Therefore, in order for a R&D entity to calculate its aggregated turnover for the purposes of Item 1 of the table in subsection 355-100(1), it is necessary to determine whether the R&D entity is connected with or affiliated with any other entity. 6. 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) provides: 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. 7. Subsection 328-125(2) sets out how an entity (other than a discretionary trust) directly controls another entity. Broadly, a company will be directly controlled by another entity, if that other entity, its affiliates, or that other entity together with its affiliates, own or have the right to acquire ownership interests that carry with them the right to at least 40% of the company's income distribution or capital distribution or to exercise or control the exercise of 40% of the voting power. 8. In addition, subsection 328-125(7) contains an indirect control test. It applies to an entity (the first entity) that directly controls another entity (the second entity) as if the first entity also controlled any other entity that is directly or indirectly controlled by the second entity. 9. The Commissioner is however provided with a discretion in subsection 328-125(6) to determine that an entity does not control another entity. Subsection 328-125(6) 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. 10. Referring to the Commissioner's discretion in subsection 328-125(6), paragraph 2.60 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 (EM) states: 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 or entities has a control percentage of at least 40% may assist in determining whether the third entity or entities control the other entity, but it is not decisive. 11. Example 2.10 in the EM states: Chandra owns a restaurant with a turnover of less than $2 million and has inherited his father's 42 per cent interest in a software company. The other 58 per cent of the software company is owned by the manager of the company, and Chandra has had no dealings with the manager whatsoever. The turnover of Chandra's restaurant will not be aggregated with the turnover of the software company if the Commissioner thinks that the software company is actually controlled by the other person with the 58 per cent interest 12. Taxation Ruling TR 2018/5 Income tax: central management and control test of residency (TR 2018/5) albeit in the context of the residency test for a company, provides some guidance as to what matters the Commissioner will consider when determining control of an entity. TR 2018/5 relevantly states: ... 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. 13. The day-to-day conduct and management of a company's operations might be an exercise of central management and control in circumstances where they are effectively the same. For example, for a small passive investment company with a very small number of investments, the decisions to make, hold and dispose of those investments, would be both the day-to-day management and the central management and control of the company. 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. | Detailed Reasoning - What is 'decision making'?: 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). | Detailed Reasoning - Acts of central management and control: 16. Exercising central management and control of a company can involve: § setting investment and operational policy including: o setting the policy on disposal of trading stock, and/or the use and development of capital assets o deciding to buy and sell significant assets of the company · appointing company officers and agents and granting them power to carry on the company's business (and the revocation of such appointments and powers) · overseeing and controlling those appointed to carry out the day-to-day business of the company, and · matters of finance, including determining how profits are used and the declaration of dividends. ... | Detailed Reasoning - Who exercises central management and control of a company?: 19. Identifying who exercises central management and control is a question of fact. It cannot be determined solely by identifying who has the legal power or authority to control and direct a company. The crucial question is who controls and directs a company's operations in reality. | Detailed Reasoning - 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.(footnotes omitted) | Detailed Reasoning - Your request: You have requested that the Commissioner determine that Company B does not control Company A under subsection 328-125(6). Therefore, it is necessary to consider whether Company A is controlled by an entity, other than, or by entities that do not include, Company B or any of its affiliates. Company C owns 60% of the ordinary shares in Company A that carry the right to 60% of the income, capital and voting rights in Company A. Company C is wholly owned by Individual A who is the sole director and shareholder. Therefore, Individual A controls Company C and controls 60% of the voting rights of the members of Company A. However, while the fact that the third entity has a control percentage of at least 40% may assist in determining whether the third entity controls the relevant company, it is not decisive. In determining the control of a company, the Commissioner will consider who has actual control of the company by examining the totality of facts and circumstances that may be relevant to determining control (as discussed in TR 2018/5). Individual A is the sole director of Company A, and as the sole director under the Constitution and Shareholders Agreement, Individual A is responsible for making all the strategic decisions of Company A including setting the overall direction and control of the management of Company A and overseeing day to day management of the business (clause 6.5 of the Shareholders Agreement). Individual A, as sole director, is also responsible for determining working capital requirements and financing needs (clause 9 of the Shareholders Agreement), making decisions to issue Shares (clause 10) and to declare dividends (clause 8). The Applicant advises that Individual A makes all the strategic and day to day decisions of Company A and Company B takes no part in the strategic decision making. There is nothing in the Constitution or the Shareholders Agreement (or otherwise) that gives Company B a power of veto or a power to restrain the decision making of Individual A as the sole director of Company A. There is nothing in the Shareholders Agreement or Constitution that would allow Company B to control the board of directors of Company A (i.e. it cannot unilaterally appoint directors). There is also no evidence that would suggest that Company A is controlled by anyone other than its director, Individual A. Therefore, the Commissioner will exercise his discretion under subsection 328-125(6) and determine that Company B does not control Company A.