Private ruling: Income tax - small business entity
Date of advice: 25 January 2016
Published: March 2016
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: For the purpose of determining whether A Co is a 'small business entity' in the year ended 30 June 20XX will the Commissioner exercise his discretion under subsection 328-125(6) of the Income Tax Assessment Act 1997 to determine that A Co did not control B Co? | A1: Yes

Relevant facts and circumstances: The director of A Co (Individual A) was approached by another company (B Co) which was under the control of an individual (Individual B) and two 'long-time friends' of Individual B to incorporate the A Co business into its operations. A Co agreed to transfer business assets to a subsidiary of B Co in exchange for shares in B Co. This transaction was concluded with A Co receiving between XX% of the shares in B Co. Individual B also held XX%, their two 'long-time friends' held X% each and a number of small shareholders held the balance of the shares (that is, X%). B Co was run by a board of directors consisting of Individual B, their two 'long-time friends', Individual A and an independent Chairman. Individual B was, and remains, the group CEO. Each of the directors had an equal vote. B Co commenced operations with the intention of growing the business. Individual A was responsible for sales, administration and accounting functions of the manufacturing business with their primary involvement related to a subsidiary company of B Co. Control of the holding company, overall business operations, branding and strategic decisions were handled by Individual B and the other directors. There was a turn of events immediately prior to the relevant period where Individual A was dismissed without notice. A Co remained as a shareholder but this shareholding was significantly watered-down by the new allotment of shares to other investors - the company's original XX% shareholding was reduced to XX% within a short time. Individual A was no longer consulted in any decision-making after their dismissal and A Co remained only as a passive investor. Individual B remains as the CEO with effective control over the company. Individual A has now accepted that they no longer has any active role to play in B Co and is now focused on business affairs including the remaining business operations of A Co.

Relevant legislative provisions: ITAA 1997 section 328-110 | ITAA 1997 section 328-115 | ITAA 1997 section 328-120 | ITAA 1997 section 328-125 | ITAA 1997 section 328-130 | ITAA 1997 section 995-1

Reasons for decision: Summary: In the arrangement that is the subject of this Ruling, A Co owned XX% of the shares in B Co in the relevant period The table at subsection 328-110(1) of the Income Tax Assessment Act 1997 (ITAA 1997) sets out a number of concessions available to an entity that is a 'small business entity' for an income year. The term 'small business entity' is defined in section 995-1 of the ITAA 1997 as having the meaning given by section 328-110. Subsection 328-110(1) of the ITAA 1997 provides that in general an entity is a 'small business entity' for an income year if it carries on a business in the current year and one or both of the following conditions apply: • it carried on a business in the previous income year before the current year and its 'aggregated turnover' for the previous year was less than $2 million; • its 'aggregated turnover' for the current year is likely to be less than $2 million. The meaning of the term 'aggregated turnover' is provided in section 328-115 of the ITAA 1997. Subsection 328-115(1) of the ITAA 1997 provides that an entity's 'aggregate turnover' for an income year is the sum of the 'relevant annual turnovers' for the year of the entity and certain related entities (excluding certain amounts). In accordance with subsection 328-115(2) of the ITAA 1997 the 'relevant annual turnovers' are: • the entity's annual turnover for the income year; • the annual turnover for the income year of any entity that is 'connected with' the entity at any time during the income year; and • the annual turnover for the income year of any entity that is an 'affiliate' of the entity at any time during the income year. The meaning of the term 'connected with an entity' is provided in section 328-125 of the ITAA 1997. Subsection 328-125(1) of the ITAA 1997 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. The meaning of 'affiliate' is provided in section 328-130 of the ITAA 1997 as follows: 328-130(1) An individual or a company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of the individual or company. 328-130(2) However, an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share. | Detailed Reasoning - Example:: A partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could reasonably be expected to act, in accordance with the directions or wishes of the second partner, or in concert with the second partner, in relation to the affairs of the partnership. Directors of the same company, or the company and a director of that company would be in a similar position. 'Control' may be direct or indirect. Indirect control of an entity is relevant to business structures with interposed entities and is considered in subsection 328-125(7) of the ITAA 1997. Relevant to the arrangement that is the subject of this Ruling is subsection 328-125(2) of the ITAA 1997 which relates to direct control of an entity other than a discretionary trust by another entity. Subsection 328-125(2) of the ITAA 1997 states: An entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates: (a) 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. [emphasis added] In the arrangement that is the subject of this Ruling, A Co owned XX% of the shares in B Co in the relevant period. Therefore, in accordance with subparagraph 328-125(2)(b) of the ITAA 1997, A Co controlled B Co with a control percentage of XX% in the relevant period. However, subsection 328-125(6) of the ITAA 1997 provides that where the 'control percentage' referred to in subsection 328-125(2) of the ITAA 1997 is at least 40%, but less than 50%, the Commissioner may determine in certain circumstances that the first entity does not control the other entity. Subsection 328-125(6) of the ITAA 1997 under the heading ' Commissioner may determine that an entity does not control another entity' states: If the control percentage referred to in subsection (2) … 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. As A Co's 'control percentage' in the relevant period was XX%, the Commissioner may determine that it did not control B Co if the Commissioner thinks that B Co was controlled by an entity other than, or by entities that did not include, A Co or any of its affiliates. There is no evidence that A Co had any affiliates as defined in section 328-130 of the ITAA 1997 in the relevant period. | Detailed Reasoning - Does the Commissioner think that B Co was controlled by an entity other than, or by entities that do not include, A Co in the relevant period?: Explanatory Memorandum to Tax Laws Amendment (Small Business) Bill 2007 (the Explanatory Memorandum) provides guidance in relation to the Commissioner's discretion in subsection 328-125(6) of the ITAA 1997: 2.59 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. … 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. ... [emphasis added] Further guidance in relation to the Commissioner's discretion in subsection 328-125(6) of the ITAA 1997 can be found on page 22 of the Advanced guide to capital gains tax concessions for small business 2013-14 (NAT 3359-06.2014) (the Advanced Guide): If an entity's control percentage in another entity is at least 40% but less than 50%, the Commissioner may determine that the first entity does not control the other entity if he is satisfied that a third entity (not including any affiliates of the first entity) controls the other entity. Whether or not the third entity has a control percentage of at least 40% may assist in determining whether the third entity controls the other entity, but it is not decisive. … In working out the third entity's control percentage, the interests of any affiliates of the third entity are taken into account. Alternatively, it is possible that both of the entities with a control percentage of at least 40% … may control the other entity if responsibilities are shared. | Detailed Reasoning - Example:: Lachlan owns 48% of the shares in Ayoubi Art Supplies. He plays no part in the day-to-day or strategic decision making of the business . Daniel owns 42% of the shares in the company. The remaining 10% of shares are beneficially owned by a third shareholder who does not take part in the management of the business. All shares carry the same voting rights and Daniel makes all day-to-day and strategic decisions for the company . Even though Lachlan owns 48% of the shares in Ayoubi Art Supplies, he would not be taken to control the company if the Commissioner was satisfied that the company is controlled by Daniel. [emphasis added] Therefore, in accordance with the Explanatory Memorandum and the Advanced Guide, the following factors are considered when determining whether the Commissioner will apply the discretion in subsection 328-125(6) of the ITAA 1997: a. whether the third entity has a 40% interest in the other entity; and b. who makes all of the day-to-day and strategic decisions for the other entity. Further, the determination will be based on fact or on a reasonable assumption or inference. | Detailed Reasoning - Application to your circumstances: The factors the Commissioner will take into account in determining whether the discretion in subsection 328-125(6) of the ITAA 1997 will apply in relation to A Co's interest in B Co in the relevant period include the following: • A Co owned XX% of the shares in B Co • Individual B owned XX% of the shares in B Co • two other individuals, described by the applicant as 'long-time friends' of Individual B, each owned X% of the shares in B Co • B Co was run by a board of directors consisting of Individual B, their two 'long-time friends', Individual A and an independent chairman • all directors had an equal vote • prior to the relevant period Individual A's primary responsibility was with a subsidiary company of B Co • Individual A was dismissed by Individual B and the Finance Director • the overall business operations, branding and strategic decisions of B Co were handled by Individual B and the other directors apart from Individual A • Individual A was not consulted in any decision-making and A Co was a passive investor only • a short time after the relevant period A Co's shareholding in B Co was reduced to XX% • Individual A has now accepted that they no longer have any active role to play in B Co and is now focused on business affairs including the remaining business operations of A Co. Consistent with the Explanatory Memorandum and the Advanced Guide and with reference to the factors listed above, the Commissioner will consider the following when determining whether the Commissioner will apply the discretion in subsection 328-125(6) of the ITAA 1997 in the relevant period: a. whether Individual B had a 40% interest in B Co; and b. who makes all of the day-to-day and strategic decisions for B Co. Whether Individual B had a 40% interest in B Co Individual B owned XX% of the shares in B Co in the relevant period. Who makes all of the day-to-day and strategic decisions for B Co The applicant advises that overall business operations, branding and strategic decisions of B Co were handled by Individual B and the other directors (except Individual A) in the relevant period. The applicant also advises that Individual A, as director of A Co, was not consulted in any decision making and that A Co is merely a passive investor. Further, the applicant advises that Individual A has now accepted that they no longer have any active role to play in B Co and is now focused on business affairs including the remaining business operations of A Co. The information provided indicates that Individual B (along with their fellow directors other than Individual A) and not A Co made the day-to-day and strategic decisions for B Co in the relevant period. | Detailed Reasoning - Example in Advanced Guide: Also relevant is the example given on page 22 of the Advanced Guide where: • Lachlan owned 48% but played no part in the day-to-day or strategic decision making of the other entity; • Daniel owned 42% but made all of the day-to-day and strategic decisions for the of the other entity; and • the remaining 10% of shares were beneficially owned by a third shareholder who did not take part in the management of the business. In this example the Commissioner was satisfied that that the other entity was controlled by Daniel. Relevant factors to be taken into account in the arrangement that is the subject of this Ruling include the following: • A Co owned XX% of B Co but appeared to take no part in the day-to-day or strategic decision making of B Co; • a further XX% of the shares in B Co were owned by 'long time friends' of Individual B who were also directors of B Co and who the Commissioner is advised voted along with Individual B on all occasions in the relevant period; and • Individual B was a XX% shareholder and a director and CEO of B Co and appears to have made all of the day-to-day and strategic decisions for B Co along with their two 'long time friends'. Taking account of the above factors, it is consistent with the example provided on page 22 of the Advanced Guide for the Commissioner to be satisfied that B Co was controlled by Individual B and not A Co in the relevant period. | Detailed Reasoning - Conclusion: The Explanatory Memorandum states that the determination of whether the Commissioner will apply the discretion in subsection 328-125(6) of the ITAA 1997 will be either based on fact or on a reasonable assumption or inference. Based on the facts provided and on reasonable assumption and inference, the Commissioner determines that Individual B 'actually controlled' B Co in the relevant period. Therefore, for the purpose of determining whether A Co is a 'small business entity' in the year ended 30 June 20XX, the Commissioner will exercise his discretion under subsection 328-125(6) of the ITAA 1997 to determine that A Co did not control B Co.