House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 7 - Control of entities

Outline of chapter

7.1 This chapter explains which entities are either Australian controllers of foreign entities, or foreign controlled Australian entities, and therefore subject to the thin capitalisation rules. These provisions are in Subdivision 820-H and part of Subdivision 820-I.

7.2 The concept of control is a fundamental building block in the new regime as for many entities it will determine whether they fall within the new regime.

7.3 The thin capitalisation rules will apply to:

•

Australian entities that control foreign entities and their associate entities;

•

foreign controlled Australian entities; and

•

foreign entities with operations and/or investments in Australia.

Context of reform

7.4 The existing thin capitalisation legislation generally only applies where there is a foreign controller of an Australian entity. Currently, the control rules identify foreign controllers as those having a control interest of at least 15%. Control interest is measured generally by reference to shareholding, voting power or entitlement to income flows. The holdings of associates of the foreign entity are included in testing whether there is sufficient foreign control to attract the thin capitalisation rules.

7.5 The new thin capitalisation regime will be expanded to include the Australian operations of both inbound and outbound investors. To maintain broad consistency between these cases, the control rules will be changed to a unified system based on the control rules in Part X of the ITAA 1936 that deals with CFCs.

7.6 To ensure that entities cannot avoid the thin capitalisation measures by disguising control through the use of chains of interposed or associated entities, the control rules focus not only on direct control but also on control held indirectly via other entities and associate entities. Associate entities are defined in Subdivision 820-I. Subdivision 820-I narrows the application of the associates concept and will remove many unintended applications of the regime that could otherwise result.

Summary of new law

Detailed explanation of new law

7.7 Subdivision 820-H is concerned with the threshold issue of whether an entity is subject to the proposed thin capitalisation measures contained in Division 820. Subdivision 820-I contains definitions of associate entity and associate interests relevant to this threshold issue. Among the entities subject to the thin capitalisation requirements are Australian controllers of controlled foreign entities, Australian entities that are foreign controlled and Australian associate entities.

7.8 In considering whether a foreign company or foreign trust meets the definitions of a CFC or CFT, a comprehensive set of rules is contained in Part X at Division 3, sections 349 to 356 of the ITAA 1936. Furthermore, certain other relevant definitions are located in sections 317 and 318 of the ITAA 1936.

7.9 In Division 820, similar comprehensive rules have been provided to measure control interests held by foreign entities in Australian entities and to determine whether an Australian entity is a controller of a controlled foreign entity. These and other control interests (e.g. in corporate limited partnerships) are referred to as TC control interests. These are discussed in paragraphs 7.55 to 7.85.

7.10 It is important to note that Subdivision 820-H adapts the control tests and concepts contained in Part X to determine whether an entity is an:

•

Australian controller of an Australian controlled foreign entity; or

•

Australian entity that is foreign controlled.

Australian controller of a foreign entity

What is an Australian controlled foreign entity?

7.11 Australian controllers of Australian controlled foreign entities will be subject to the thin capitalisation measures. Therefore, it is necessary to identify all foreign entities that are Australian controlled. The rules provide for 3 categories of Australian controlled foreign entities . These are:

•

controlled foreign companies;

•

controlled foreign trusts; and

•

controlled foreign corporate limited partnerships.

[Schedule 1, item 1, section 820-745; Schedule 2, item 14, definition of Australian controlled foreign entity in subsection 995-1(1)]

7.12 CFCs and CFTs are defined by reference to their meanings in Part X. Controlled foreign corporate limited partnerships are defined in subsection 820-760(2). [Schedule 2, items 20 and 24, definitions of controlled foreign company and controlled foreign trust in subsection 995-1(1)]

What is a controlled foreign company?

7.13 The term controlled foreign company takes its meaning from section 340 of the ITAA 1936. This definition contains 3 sequential control tests for testing whether the company is Australian controlled. These tests are that at a particular time:

•

a group of 5 or fewer Australian 1% entities have an aggregate associate-inclusive control interest in the foreign company of 50% or more;

•

a single Australian entity has an associate-inclusive control interest of 40% or more in the foreign company, and the foreign company is not controlled by another group of entities; or

•

a group of 5 or fewer Australian entities either alone or together with associates control the foreign company.

[Schedule 2, item 20, definition of controlled foreign company in subsection 995-1(1)]

7.14 However, the definition of CFC has been modified for thin capitalisation purposes to exclude corporate limited partnerships [Schedule 1, item 1, section 820-745] . Special provisions have been included for corporate limited partnerships that adapt the CFC rules. These are discussed in paragraphs 7.16 and 7.17.

What is a controlled foreign trust?

7.15 The term controlled foreign trust also takes its meaning from Part X. A foreign trust is a controlled foreign trust if either:

•

a group of 5 or fewer Australian 1% entities have an aggregate associate-inclusive control interest in the foreign trust of 50% or more; or

•

there is an eligible transferor in respect of the trust (an eligible transferor is defined by reference to sections 343 to 348 of the ITAA 1936).

[Schedule 2, item 24, definition of controlled foreign trust in subsection 995-1(1)]

What is a controlled foreign corporate limited partnership?

7.16 There are 3 requirements that a partnership must meet before it will be a controlled foreign corporate limited partnership . These are:

•

it must be a corporate limited partnership;

•

it must not be an Australian entity; and

•

either:

-

one or more general partners must be an Australian entity or an Australian controlled foreign entity; or

-

no more than 5 Australian entities (each of which holds a TC control interest of at least 1%) hold a total of TC control interests that is at least 50%.

[Schedule 1, item 1, subsection 820-760(2); Schedule 2, item 21, definition of controlled foreign corporate limited partnership in subsection 995-1(1)]

General partner is an Australian entity or controlled foreign entity

7.17 As the general partners are the entities that control a corporate limited partnership, if a general partner is either an Australian entity or an Australian controlled foreign entity, the corporate limited partnership itself will be a controlled foreign corporate limited partnership .

Not more than 5 Australian entities hold 50% or more control interests

7.18 The other circumstance in which a corporate limited partnership will be a controlled foreign corporate limited partnership is where aggregate TC control interests of 50% or more are held by no more than 5 Australian entities (each of which holds at least 1%). Generally, an entitys TC control interest in a corporate limited partnership is the sum of the:

•

TC direct control interests held by the entity and its associate entities (this is the greater of the percentage of assets or capital contributed or percentage of rights to distributions of capital, assets or profits); and

•

TC indirect control interests held by the entity and its associate entities (this is essentially the percentage of control arrived at by tracing interests through interposed entities).

[Schedule 1, item 1, subsection 820-760(2) and sections 820-815 and 820-865]

What is an Australian entity?

7.19 An Australian entity is a term defined in section 336 of Part X to include:

•

an Australian partnership;

•

an Australian trust; or

another entity (other than a partnership or trust) which is a Part X Australian resident within the meaning of section 317 of the ITAA 1936. [Schedule 2, item 16, definition of Australian entity in subsection 995-1(1)]

What is an Australian controller of a controlled foreign company?

7.20 An entity will be an Australian controller of a controlled foreign company if at that time either:

•

the entity holds a TC control interest in the CFC of 10% or more; or

•

the entity is one of not more than 5 Australian entities which alone or together with associate entities control the CFC, and the entity holds a TC control interest in the CFC of at least 1%.

[Schedule 1, item 1, section 820-750; Schedule 2, item 15, definition of Australian controller in subsection 995-1(1)]

7.21 TC control interests are discussed in paragraphs 7.55 to 7.85. Unlike the definition of associate-inclusive control interest in Part X of ITAA 1936, TC control interest does not include the interests of all possible associates but only those of a subset called associate entities . Associate entities are explained in paragraphs 7.86 to 7.98. If these requirements are satisfied, the Australian entity is an outward investing entity for the purposes of the thin capitalisation rules. [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table]

Example 7.1: Australian controller of a CFC

Aust Co will be an Australian controller as it has a TC control interest in Sub2 Co of 100% by virtue of its associate entitys (Sub Co) direct control interest of 100%. Sub Co is also an Australian controller as it has a TC control interest in Sub2 Co of 100% by virtue of its direct control interest in Sub2 Co.

What is an Australian controller of a controlled foreign trust?

7.22 An entity will be an Australian controller of a CFT if the entity is an Australian entity with a TC control interest in the trust of at least 10% [Schedule 1, item 1, section 820-755; Schedule 2, item 15, definition of Australian controller in subsection 995-1(1)] . TC control interests are discussed in paragraphs 7.55 to 7.85. If the requirements are met, the entity is an Australian controller and an outward investing entity for the purposes of the thin capitalisation rules [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table] .

What is an Australian controller of a controlled foreign corporate limited partnership?

7.23 An entity will be an Australian controller of a controlled foreign corporate limited partnership if:

•

it is an Australian entity which is a general partner; or

•

it is an Australian entity that holds a TC control interest in the partnership that is 10% or more.

[Schedule 1, item 1, subsection 820-760(1); Schedule 2, item 15, definition of Australian controller in subsection 995-1(1)]

7.24 Once again, because of the type of control a general partner exercises over a corporate limited partnership, any Australian entity which is a general partner, will be an Australian controller in relation to the limited partnership. The Australian entity will then be an outward investing entity for the purposes of the thin capitalisation rules. [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table]

7.25 An Australian entity will also be an Australian controller if it holds a TC control interest of at least 10%. This test mirrors one of the circumstances in which an entity will be an Australian controller of a CFC and the test for a CFT (see paragraphs 7.20 to 7.22).

7.26 In essence, every Australian controller of a CFC, CFT or controlled foreign corporate limited partnership will therefore be subject to the thin capitalisation provisions. These entities, either alone or together with others, control the foreign entity and the location of debt funding.

What is a foreign controlled Australian entity?

7.27 Paragraphs 7.11 to 7.18 deal with the provisions that identify entities controlled by Australian taxpayers. This determines whether the Australian taxpayer is an outward investor. A similar set of rules is required for determining whether an Australian entity is controlled by foreign entities in order to apply the (non-ADI) inward investing entity rules. It should be noted that the thin capitalisation rules apply to foreign controlled Australian entities and there are no direct implications for their foreign controllers.

What is a foreign entity?

7.28 A foreign entity is an entity which is not an Australian entity as defined in section 336 of Part X. [Schedule 2, item 37, definition of foreign entity in subsection 995-1(1)]

7.29 The categories of foreign controlled Australian entities are:

•

foreign controlled Australian companies;

•

foreign controlled Australian trusts; and

•

foreign controlled Australian partnerships.

[Schedule 1, item 1, section 820-780; Schedule 2, item 34, definition of foreign controlled Australian entity in subsection 995-1(1)]

What is a foreign controlled Australian company?

7.30 The definition is intended to mirror the definition of a CFC in section 340 of the ITAA 1936, discussed in paragraph 7.13. It contains 3 tests, which are to be applied sequentially. If the first test applies there is no need to consider the remaining tests.

7.31 The tests that will determine whether an Australian company is a foreign controlled Australian company are:

•

no more than 5 foreign entities (each holding a TC control interest in the company of at least 1%) hold an aggregate total TC control interest of 50% or more;

•

a foreign entity holds a TC control interest of at least 40% and no other entity or entities control the company (excluding associate entities of the foreign entity); or

•

no more than 5 foreign entities (and their associate entities) control the company.

[Schedule 1, item 1, subsection 820-785(1); Schedule 2, item 33, definition of foreign controlled Australian company in subsection 995-1(1)]

7.32 It should be noted that corporate limited partnerships are excluded from the definition of a foreign controlled Australian company because there are separate rules for them. [Schedule 1, item 1, subsection 820-785(1)]

7.33 The third test concerning control by 5 foreign entities does not require a calculation of TC control interests, but is instead directed towards an examination of facts relevant to the circumstances of each case. The term control is not defined for these purposes, but will include situations where foreign entities are capable of exercising control.

What is the exception?

7.34 An important difference from the outward investing entity rules is the exception contained in subsection 820-785(2). It applies where the Australian company is a foreign controlled company by virtue of the application of the tests in paragraphs 820-785(1)(a) or (b).

7.35 Despite the result of the tests in paragraphs 820-785(1)(a) or (b), if the total of the interests calculated using the method described in paragraph 820-785(2)(b) is less than 20%, then the company is not foreign controlled. Under section 820-875, control tracing interests are taken to be 100% in certain circumstances, for the purpose of determining whether control exists over an entity when tracing through a series of one or more interposed entities. The purpose of paragraph 820-785(2)(b) is to overcome the operation of the deeming rule in certain cases. [Schedule 1, item 1, subsection 820-785(2)]

7.36 When calculating the TC interests for the purpose of the exception, the effect of the deeming rules on the control tracing interests is disregarded and the following interests are aggregated:

•

the foreign entitys TC direct and indirect control interests; and

•

the associate entities direct and indirect TC control interests other than where they have been counted in a foreign entitys TC indirect interest.

The result should be the equivalent of the foreign entitys indirect interest in the Australian entity without the operation of the deeming rule.

Example 7.2: Exception provided by subsection 820-785(2)

Step 1: Is Aust Co 3 a foreign controlled Australian company?

Foreign company is taken to have a TC control interest in Aust Co 3 of 55% via application of sections 820-815, 820-820 and 820-855, subsection 820-870(5) and section 820-875. Hence, Aust Co 3 is a foreign controlled Australian company.

Step 2: Does the exception in paragraph 820-785(2)(b) apply?

As Foreign company does not have any TC direct control interests, it has a total TC interest of 16.6% consisting of a multiplication of its actual indirect control interests of 55% 55% 55% = 16.6%. Hence, Aust Co 3 will not be a foreign controlled company. As the TC control interests held by Foreign company in Aust Co 1 and Aust Co 2 according to the exception exceed 20%, even with this special rule, this exception will not apply to them.

What is a foreign controlled Australian trust?

7.37 An Australian trust will be a foreign controlled Australian trust if, when applied sequentially, any one of 4 tests is met. These tests are that:

•

no more than 5 foreign entities (each holding a TC control interest in the trust of at least 1%) hold an aggregate total TC control interest in the trust of 50% or more;

•

a foreign entity holds a TC control interest in the trust of 40% or more, and no other entity or entities (excluding the foreign entity and its associate entities) control the trust;

•

all of the following subparagraphs apply:

-

at least one of the objects or beneficiaries of the trust is a foreign entity;

-

there has been one or more distributions of income or capital of the trust made to such an object or beneficiary, whether directly or indirectly, during that income year or the preceding 2 years; and

-

the total TC control interests in the trust held by beneficiaries that are Australian entities (that are not foreign controlled) does not exceed 50%; or

•

a foreign entity is in a position to control the trust.

[Schedule 1, item 1, subsection 820-790(1); Schedule 2, item 36, definition of foreign controlled Australian trust in subsection 995-1(1)]

What is an Australian trust?

7.38 A trust will be an Australian trust if the requirements of section 338 of the ITAA 1936 are met. These requirements are that:

•

at any time in the immediately preceding 12 months any trustee was a Part X Australian resident, or the central management and control of the trust was in Australia; or

•

the trust is a corporate unit trust or a public trading trust within the meaning of Divisions 6B and 6C of Part III of the ITAA 1936.

7.39 The first 2 tests to determine whether an Australian trust is foreign controlled are similar to the tests for foreign controlled companies. The third test in paragraph 820-790(1)(c) requires that each condition be met for the trust to be a foreign controlled Australian trust. That is, at least one of the foreign objects or beneficiaries is a foreign entity which has received a distribution in the current or either of the preceding 2 income years andAustralian entities do not hold a majority of interests in the trust.

7.40 Subsection 820-790(2) sets out the circumstances for the fourth test, in which a foreign entity will be considered to be in a position to control a trust. It is only necessary for one of the circumstances to be met by a foreign entity for the foreign entity to be in a position to control the trust. The particular circumstances in which a foreign entity will be considered to be in a position to control an Australian trust are where:

•

the foreign entity or an associate entity, whether alone or together with other associate entities, has the power to obtain the beneficial use of the trusts capital or income. This beneficial use may arise irrespective of whether or not a power of appointment or revocation is exercised, and whether or not another entitys consent is given;

•

the foreign entity is able, directly or indirectly, to control the application of the trusts capital or income in any manner;

•

the foreign entity is able, under a scheme, to do any of the things mentioned in the above 2 dot points;

•

a trustee of the trust is accustomed or is under an obligation (whether formal or informal) or might reasonably be expected, to act in accordance with the foreign entitys directions, instructions or wishes; or

•

the foreign entity is able to remove or appoint a trustee of the trust.

[Schedule 1, item 1, subsection 820-790(2)]

7.41 TC control interests in relation to trusts are dealt with in sections 820-815 to 820-835, 820-860, 820-870 and 820-875. Associate entities are explained in paragraphs 7.86 to 7.98.

Exception

7.42 A similar exception applies to trusts, as is available to foreign controlled companies. The exception operates in the same manner as the exception provided for foreign controlled companies. [Schedule 1, item 1, subsection 820-790(3)]

What is a foreign controlled Australian partnership?

7.43 A foreign controlled Australian partnership is defined differently depending on whether the partnership is a corporate limited partnership or a general partnership.

Corporate limited partnership

7.44 A corporate limited partnership will be a foreign controlled Australian partnership if:

•

it is an Australian entity; and

•

either:

-

five or fewer foreign entities, each of which holds a TC control interest of at least 1%, hold between them TC control interests of 50% or more;

-

at least one general partner is a foreign entity; or

-

at least one general partner is a foreign controlled Australian entity.

[Schedule 1, item 1, subsection 820-795(1); Schedule 2, item 35, definition of foreign controlled Australian partnership in subsection 995-1(1)]

50% TC control interest test

7.45 What constitutes a TC control interest is discussed further in paragraphs 7.55 to 7.85. A summary in relation to partnerships is provided in paragraph 7.18.

7.46 However, the partnership will not be a foreign controlled Australian partnership if the exception discussed in paragraph 7.54 applies. This exception mirrors that available to Australian companies and trusts.

General partner is a foreign entity or a foreign controlled Australian entity

7.47 As the general partners control a corporate limited partnership, if a general partner is either a foreign entity or an Australian entity which is foreign controlled, the partnership will itself be a foreign controlled Australian partnership .

Example 7.3: Foreign controlled corporate limited partnership

Step 1: Is the corporate limited partnership an Australian entity?

The definition of an Australian entity includes Part X Australian resident within the meaning of section 317 of the ITAA 1936 which refers to a resident within the meaning of section 6(1) of the ITAA 1936, subject to certain conditions. Assume that the corporate limited partnership satisfies section 94T of the ITAA 1936 for it to be a resident within the meaning of section 6(1) of the ITAA 1936. Therefore, the corporate limited partnership is an Australian entity.

Step 2: Is the general partner a foreign controlled Australian entity?

Aust Co, the general partner, is not a foreign entity. Because Foreign company holds a TC control interest of 100% in Aust Co, Aust Co is a foreign controlled Australian company under paragraph 820-785(1)(a). A general partner of the partnership is therefore a foreign controlled Australian entity making the partnership itself a foreign controlled Australian partnership by virtue of subparagraph 820-795(1)(b)(ii).

Partnership

7.48 A partnership that is not a corporate limited partnership will be a foreign controlled Australian partnership if it is an Australian partnership and either:

•

five or fewer foreign entities, each of which holds a TC control interest of at least 1%, hold between them total TC control interests of 50% or more; or

•

one foreign entity holds a TC control interest of at least 40% and no other entity or group of entities (not including the foreign entity or its associate entities) controls the partnership.

[Schedule 1, item 1, subsection 820-795(2); Schedule 2, item 35, definition of foreign controlled Australian partnership in subsection 995-1(1)]

What is an Australian partnership?

7.49 An Australian partnership has the same meaning as in section 337 of Part X. It is a partnership in which at least one of the partners is an Australian entity.

50% or more TC control interests

7.50 The first control test provides that where 5 or fewer foreign entities together hold a 50% or greater TC control interest in the partnership, the partnership will be foreign controlled. For example, where there are 4 foreign resident partners who each hold 20% of the rights to distributions of partnership income, the partnership will be a foreign controlled partnership.

40% or more TC control interests

7.51 The second test is an assumed control test. That is, where an entity has a TC control interest of at least 40%, control of the partnership is assumed unless some other entity actually controls the partnership.

7.52 For example, if a foreign entity holds a TC control interest of 45% and an Australian entity holds a TC control interest of 55%, the assumed control test is not, on an objective basis, met because the Australian entity has a greater proportion of control. However, if the partnership always deferred to the foreign entity in relation to management and control decisions, then the Australian entity does not actually control the partnership. The partnership would then be a foreign controlled Australian partnership under the assumed control test.

7.53 When determining whether there is some other entity or entities that control the partnership, the foreign entity itself and associate entities of the foreign entity are not included.

Example 7.4

A foreign entity, not being a partner, has a TC control interest of 40% in an Australian partnership (it has 2 foreign associate entities who are both partners and hold direct interests of 20% each). When looking at whether any other entities hold a controlling interest for the purposes of the 40% control test, these 2 associate entities will be disregarded.

Exception

7.54 In determining whether the requisite level of TC control interests is held by foreign entities in an Australian partnership, there is an exception to the control rules which mirrors the exception for Australian companies and trusts. [Schedule 1, item 1, subsection 820-795(3)]

Defining and measuring thin capitalisation control interests

7.55 In ascertaining whether an Australian entity is subject to the thin capitalisation rules, it is necessary to consider whether the entity falls into one of the categories of foreign controlled Australian entity or Australian controller of an Australian controlled foreign entity, as described in paragraphs 7.11 to 7.54. Rules are included in Subdivision 820-H to describe and measure control interests for these purposes. These control interests are described as TC control interests, and measure an entitys direct and indirect control interests in the company, trust or partnership, as well as direct and indirect control interests held by the entitys associate entities in the company, trust or partnership. The term associate entityis explained in paragraphs 7.86 to 7.98.

What is the general rule for an entitys thin capitalisation interest in a company, trust or partnership?

7.56 In measuring whether an entity has a thin capitalisation control interest in another entity, 4 different categories of control interests are aggregated. These categories are:

•

the entitys TC direct control interest in the company, trust or partnership;

•

the entitys TC indirect control interest in the company, trust or partnership;

•

TC direct control interests in the company, trust or partnership held by the entitys associate entities; and

•

TC indirect control interests in the company, trust or partnership held by the entitys associate entities.

[Schedule 1, item 1, section 820-815; Schedule 2, item 63, definition of TC control interest in subsection 995-1(1)]

7.57 Direct control interests and indirect control interests are defined terms discussed in paragraphs 7.58 to 7.72 and special rules to prevent double counting and to remove uncertainty are discussed in paragraphs 7.73 to 7.85. Associate entity is a defined term discussed in paragraphs 7.86 to 7.98.

What are TC direct control interests and indirect control interests?

What is a TC direct control interest in a company?

7.58 An entitys thin capitalisation direct control interest , or TC direct control interest , in a company is determined by reference to section 350 of the ITAA 1936 and relevant definitions in Part X, subject to particular modifications necessary to enable that section to apply for the purposes of Subdivision 820-H.

7.59 Section 350 details the interests that are taken into account in calculating a direct control interest in a company. These are holdings of paid-up share capital, rights to vote or participate in decision making on specified issues, rights to distributions of capital or profits on winding-up, or otherwise than on winding-up. Subsections 350(6) and (7) are modified to apply for the purpose of calculating direct control interests over Australian companies held by foreign entities. These subsections are relevant when the test in paragraph 820-785(1)(c) has been used to establish control by 5 or fewer foreign entities (discussed in paragraph 7.33). In addition, section 350 is modified so that references to associate are changed to associate entity in order to avoid unintended applications of the provisions. [Schedule 1, item 1, section 820-855; Schedule 2, item 65, definition of TC direct control interest in subsection 995-1(1)]

What is a TC direct control interest in a trust?

7.60 In a similar fashion, TC direct control interests in trusts held by entities are to be calculated in accordance with specified modifications to the application of section 351 of the ITAA 1936 necessary for thin capitalisation purposes. Section 351 defines the interests in income or corpus of trusts that are taken into account in determining a beneficiarys direct control interest.

7.61 The modifications will operate to apply the section for the purposes of Subdivision 820-H and to ensure that subsections 351(3) and (4) do not apply. These subsections are concerned with eligible transferors that have transferred property or services to a trust. That concept has not been adopted for these purposes. [Schedule 1, item 1, subsections 820-860(1) and (2); Schedule 2, item 65, definition of TC direct control interest in subsection 995-1(1)]

7.62 The rules in subsection 820-860(3) are for the purposes of determining TC indirect interests held in other entities or held by other entities through an Australian trust (see paragraphs 7.66 to 7.72). If it is established that a foreign object or beneficiary has control of the Australian trust (paragraph 820-790(1)(c)), then for the purposes of calculating the foreign entitys indirect control interest in another Australian entity, the foreign entity will be taken to have a TC direct control interest of 100% in the trust. Similarly, where a foreign entity is in a position to control a trust covered by paragraph 820-790(1)(d), then the TC direct control interest used to calculate the foreign entitys TC indirect control interest in an entity other than the interposed trust is 100%. [Schedule 1, item 1, subsection 820-860(3)]

What is a TC direct control interest in a partnership?

7.63 Specific rules are also to be included to measure what will be TC direct control interests in partnerships since these are not dealt with in Part X of the ITAA 1936. In the case of a corporate limited partnership, if the entity is a general partner of the partnership it will have a TC direct control interest of 100% in that partnership. If the partnership is not a corporate limited partnership then the entitys TC direct control interest will equal its percentage control of voting power in the partnership. [Schedule 1, item 1, paragraphs 820-865(a) and (b); Schedule 2, item 65, definition of TC direct control interest in subsection 995-1(1)]

7.64 Alternatively, for both corporate limited partnerships and other partnerships, an entity will have a TC direct control interest equal to the following matters that the entity holds or is entitled to acquire in the partnership:

•

the total amount of assets or capital contributed to the partnership;

•

the total rights the partner has to distribution of capital, assets or profits on dissolution; or

•

the total rights the partner has to distribution of capital, assets or profits otherwise than on dissolution.

[Schedule 1, item 1, paragraph 820-865(c)]

7.65 If the percentages calculated under the alternatives listed in paragraphs 7.63 and 7.64 vary, then the greatest percentage shall be taken to be the TC direct control interest. [Schedule 1, item 1, section 820-865]

What is a TC indirect control interest in a company, trust or partnership?

7.66 A TC indirect control interest is a measure of an entitys control over another entity determined by tracing through controlled interposed entities. For these purposes there may be an unlimited number of interposed entities. The interposed entity (or entities) must be:

•

a foreign controlled Australian entity if the purpose of the test is to determine whether another entity is a foreign controlled Australian entity; or

•

an Australian controlled foreign entity if the test is intended to determine whether an entity is another Australian controlled foreign entity or an Australian controller of such an entity.

[Schedule 1, item 1, subsection 820-870(1); Schedule 2, item 66, definition of TC indirect control interest in subsection 995-1(1)]

What are interposed entities for this purpose?

7.67 As the name suggests, an interposed entity is an entity interposed between 2 other entities where:

•

the first entity holds a TC control tracing interest in the interposed entity; and

•

the interposed entity in turn holds a TC control tracing interest in the second entity.

[Schedule 1, item 1, subsection 820-870(2)]

7.68 The term TC control tracing interest is defined in section 820-875 and is discussed in paragraph 7.72.

What are the method statements to use for this purpose?

7.69 Three method statements are provided to determine an entitys indirect control interest in a company, trust or partnership. The method statement to use will depend upon whether there is one, 2 or more than 2 interposed entities. [Schedule 1, item 1, subsection 820-870(3)]

Method statement for one interposed entity only

7.70 This method statement is used to determine an entitys TC indirect control interest in another entity where there is only one interposed entity between the entity and the company, trust or partnership.

Step 1: Calculate the TC control tracing interest that the first entity holds in the interposed entity at that time.

Step 2: Multiply that result by the TC control tracing interest that the interposed entity holds in the company, trust or partnership at that time.

[Schedule 1, item 1, subsection 820-870(4)]

Example 7.5: One interposed entity

Under step 1, Foreign Co has a TC control tracing interest in Interposed Aust Co of 100% as per subsection 820-875(1). For step 2, Interposed Aust Co has a TC control tracing interest in Aust Co of 100% as per paragraph 820-875(2)(a). Multiplying the result of step 1 by this amount gives Foreign Co a TC indirect control interest of 100% in Aust Co. That is, 100% 100% = 100%.

Method statement for 2 or more interposed entities

7.71 This process is applied in like fashion to determine an entitys TC indirect control interest in another entity if there are 2 or more interposed entities between the entity and the company, trust or partnership. Each entitys control tracing interest in the next entity is multiplied by the latters control tracing interest in the next entity, and so on, until multiplying by the final control tracing interest held in the company, trust or partnership. [Schedule 1, item 1, subsections 820-870(5) and (6)]

What is a TC control tracing interest in a company, trust or partnership?

7.72 A TC control tracing interest is a term that is relevant to the calculation of indirect control interests in companies, trusts or partnerships. In general, a TC control tracing interest held by an entity in another entity is the TC direct control interest in that other entity. However, instead of simply multiplying percentage interests where one entity controls or is taken to control an interposed entity, it will be taken to have a TC control tracing interest of 100% in that interposed entity. This occurs where:

•

the entity and its associate entities hold total TC direct control interests in the company, trust or partnership of 50% or more;

•

the entity and its associate entities hold total TC direct control interests in the company, trust or partnership (excluding corporate limited partnerships) of 40% or more, and no other entity or entities (except the entity and its associate entities) controls the company, trust or partnership; or

•

the entity, and its associate entities if applicable, controls the company, trust or partnership.

[Schedule 1, item 1, section 820-875; Schedule 2, item 64, definition of TC control tracing interest in subsection 995-1(1)]

What are the special rules for calculation of TC control interests held by an entity?

7.73 The categories of control interests detailed in paragraph 7.56 may overlap in some cases, for example, where an entitys indirect control interest, and an associate entitys direct control interest, both relate to one particular shareholding in a company. This could lead to double counting of an entitys TC control interests in that company. To alleviate this, and similar potentially inappropriate results, special rules are included [Schedule 1, item 1, section 820-820] . These rules also mirror those in Part X.

Special rules to prevent double counting

7.74 In calculating an entitys TC control interest, the first special rule reduces the entitys TC indirect control interest in a company, trust or partnership to the extent that it is calculated by reference to an associate entitys TC direct or indirect control interest in that same other entity. [Schedule 1, item 1, subsection 820-820(2)]

7.75 A similar rule reduces an associate entitys TC indirect control interest to the extent that it is determined by reference to direct or indirect control interests held by the entity or other associate entities and which are already counted. Associate entities are explained in paragraphs 7.86 to 7.98. [Schedule 1, item 1, subsection 820-820(3)]

7.76 The third special rule operates to take into account only one of:

•

a TC direct control interest held by the entity, or by another entity;

•

an entitlement to acquire that TC direct control interest,

where both would otherwise be counted in calculating an entitys TC control interest. [Schedule 1, item 1, subsection 820-820(4)]

7.77 An entitlement to acquire is defined at section 322 of the ITAA 1936. An example of the application of this special rule would be where an entity holds shares in a company, and an associate entity holds options to purchase those shares and so would be considered to have an entitlement to acquire those shares for TC control purposes. The effect, in the absence of a special rule, would be that both the entity and the associate entity hold a TC direct control interest in respect of the same shares. As this would involve double counting of the same interest only one of the 2 interests is to be taken into account. The determination of which one of these 2 interests is to be taken into account is determined in accordance with section 820-835, discussed in paragraphs 7.83 and 7.84.

7.78 This section contains a further special rule to ensure that if the entity is included in a group of entities, then this section will not prevent section 820-825, that deals with groups of entities (discussed in the next paragraph), from operating [Schedule 1, item 1, subsection 820-820(5)] . Note that this is not referring to a group under the grouping rules in Subdivision 820-F, but rather to the 5 or fewer entities whose interests are aggregated to determine control.

Special rules for groups

7.79 In some circumstances, the total TC control interests of a number of entities may have to be aggregated to determine whether an entity is foreign or Australian controlled. Double counting of TC control interests may arise where, in determining the aggregate TC control interest of a group of entities, a particular control interest is included in the TC control interest of more than one (as an associate entity of one or more members of the group). The rule will operate to take into account the particular TC direct control interest or TC indirect control interest only once. [Schedule 1, item 1, subsection 820-825(2)]

7.80 In addition, a rule will operate to take into account only one of a TC direct control interest held by an entity or an entitlement to acquire that TC direct control interest, where both would otherwise be counted in calculating the TC control interest held by a group of entities. The determination of which one of these 2 interests is to be taken into account is ascertained in accordance with section 820-835 as discussed in paragraphs 7.83 and 7.84. [Schedule 1, item 1, subsection 820-825(3)]

7.81 As with section 820-820, a final special rule will be included to ensure that the application of this section will not prevent section 820-820, which deals with single entities, from operating. [Schedule 1, item 1, subsection 820-825(4)]

Special rules for determining the percentage of TC control interest held

7.82 Double counting of TC control interests may also arise in considering whether an entity is controlled by another entity, or group of entities, where an entity has a TC direct control interest, or TC control tracing interest of 100%, and other entities also have a TC direct control interest or TC control tracing interest of 100% in the same company, trust or partnership. Only one entity will be taken to hold the TC direct control interest or TC control tracing interest of 100%, and the other entity or entities, will not be taken to hold the relevant control interest. [Schedule 1, item 1, section 820-830]

Example 7.6: Application of section 820-830

In considering whether Sub2 Co is a foreign controlled Australian company, For Co will have a TC direct control interest of 50% in Sub Co. For tracing purposes under subsection 820-875(2), For Co will have a TC control tracing interest of 100% in Sub Co, and hence, a TC indirect control interest in Sub2 Co of 100% via application of subsections 820-870(4) and 820-875(2). For2 Co, (not an associate entity of For Co) also has a TC direct control interest of 50% in Sub Co which under subsection 820-875(2) would also equate to a TC control tracing interest of 100%. Section 820-830 operates so that only one of For Co or For2 Co will be taken to hold this TC control tracing interest of 100%. Section 820-835 operates to give the power to the Commissioner to determine which entity will be chosen for this purpose (see paragraph 7.84). Irrespective of which foreign company is taken to have an indirect interest in Sub2 Co, the Australian company is foreign controlled.

Commissioners power

7.83 The Commissioner will have the power to decide which control interest is to be taken into account for the purposes of calculating TC control interests so as to prevent double counting. Unless there are special circumstances relevant to the applicable case, the Commissioners decision would be made in a manner to achieve the result that an entity will be a foreign controlled company, trust or partnership, or an Australian controller in respect of a controlled foreign entity. [Schedule 1, item 1, paragraph 820-835(a)]

7.84 The Commissioner also will have the power to decide which entity is to be selected to hold a 100% TC direct control interest or control tracing interest in an entity for the purposes of paragraph 820-830(2)(a) (see discussion in paragraph 7.82). [Schedule 1, item 1, paragraph 820-835(b)]

7.85 As the exercise of these powers will directly affect an entitys assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.

Associate entities

7.86 A definition of associate entity is introduced in Subdivision 820-I for the purposes of the thin capitalisation legislation. This narrows the Part X definition of associate to ensure that only those entities with a sufficient influence on another entity will be subject to the new regime. In particular, paragraph 318(2)(d) of the ITAA 1936 determines that in certain circumstances a company is an associate of its subsidiary. The effect of the narrower definition is that under the thin capitalisation rules a company will not normally be an associate entity of its subsidiary.

7.87 An associate entity of an entity can be an individual or another entity. If an entity is an Australian associate entity of another Australian entity that is itself an outward investor, the associate entity will be an outward investor [Schedule 1, item 1, subsection 820-85(2), items 3 and 4 in the table and paragraph 820-300(2)(c)] . Another effect is that an associate entitys TC direct and indirect control interests are included in the calculation of another entitys TC control interest in a company, trust or partnership as explained in paragraph 7.56 [Schedule 1, item 1, section 820-815] .

What is sufficient influence?

7.88 Sufficient influence is a term explained in subsection 318(6) of the ITAA 1936. It may arise in circumstances where an entity has influence or may reasonably be expected to have influence over another entity or its directors, partners, trustees or committees of management respectively, to direct the actions of the entity either directly or through interposed entities. This influence may arise formally, informally, because of obligation, custom or via membership of a corporate group.

7.89 For the purposes of thin capitalisation rules, sufficient influence is confined to influence over decisions made in relation to financial matters of the entity.

What is an associate entity?

Individuals

7.90 An individual will be an associate entity of another entity if:

•

it is an associate, as defined in section 318, of another entity; and:

•

the individual is accustomed or under an obligation (whether formal or informal) or might reasonably be expected to act in accordance with:

-

the directions, instructions or wishes of that other entity, in relation to the individuals financial affairs; and

-

whether those directions, instructions or wishes are or may reasonably be expected to be communicated directly or through interposed entities.

[Schedule 1, item 1, subsection 820-905(2)]

Entities other than individuals

7.91 For an entity to be an associate entity it must be an associate of a second entity and either of the following conditions applies:

•

the second entity holds an associate interest of 50% or more in the entity; or

•

the entity is accustomed or under an obligation (whether formal or informal) or might reasonably be expected, to act in accordance with the directions, instructions or wishes of that second entity in relation to either:

-

the distribution or retention of its profits; or

-

the financial policies relating to its assets, debt capital or equity.

Such directions, instructions or wishes may reasonably be expected to be communicated either directly or through interposed entities.

7.92 The first entity will also be an associate entity of the second entity when, if the first entity is a company, a director of that company is influenced by the second entity. Similarly, if the first entity is a partnership, it will be an associate entity of the second entity if a partner of the partnership acts in the manner stated in the preceding paragraph. The same principle will apply with respect to trustees of trusts, and members of committees of management of unincorporated associations or bodies. [Schedule 1, item 1, subsections 820-905(1) and (3)]

What is an associate interest in a company (excluding a corporate limited partnership)?

7.93 An entity holds an associate interest in a company (excluding corporate limited partnerships) equal to the percentage of the direct control interest it holds as determined by reference to section 350 of the ITAA 1936 as modified for these purposes. The types of interests that are taken into account are holdings of paid-up share capital, rights to vote or participate in decision making on specified issues, rights to distributions of capital or profits on winding-up, or otherwise than on winding-up. [Schedule 1, item 1, subsections 820-905(4) and (5); Schedule 2, item 13, definition of associate interest in subsection 995-1(1)]

What is an associate interest in a trust?

7.94 An associate interest in a trust held by an entity is equal to the percentage of the direct control interest it holds as determined by reference to section 351 of the ITAA 1936 as modified for these purposes. Section 351 defines the interests in income or corpus of trusts that are taken into account in determining a beneficiarys direct control interest. [Schedule 1, item 1, subsections 820-905(6) and (7); Schedule 2, item 13, definition of associate interest in subsection 995-1(1)]

What is an associate interest in a partnership?

7.95 An entity will also have an associate interest in a partnership in particular circumstances. In calculating the associate interest if the percentages calculated under the alternatives available vary, then the greatest percentage held will be the associate interest.

7.96 If the entity is a general partner of a corporate limited partnership it will have an associate interest of 100% in that partnership.

7.97 If the partnership is not a corporate limited partnership, then the entity will have an associate interest equal to its percentage control of voting power in the partnership at that time.

7.98 In other cases for both corporate limited partnerships and other partnerships, an entity will hold an associate interest in the partnership equal to the percentage that the entity holds, or is entitled to acquire, in any of the following:

•

the total amount of assets or capital contributed to the partnership;

•

the total rights the partner has to distribution of capital, assets or profits on dissolution; or

•

the total rights the partner has to distribution of capital, assets or profits otherwise than on dissolution.

[Schedule 1, item 1, subsection 820-905(8); Schedule 2, item 13, definition of associate interest in subsection 995-1(1)]

Example 7.7: Which entity is an associate entity of Australian Company C?

To be an associate entity of the test entity (Australian Company C), the entity must satisfy 2 conditions.

Firstly, be an associate, as defined in section 318 of the ITAA 1936.

Secondly, be an associate in which the test entity has an associate interest of at least 50%, or be an associate whose financial affairs the test entity can sufficiently influence.

All the entities are associates of Australian Company C under section 318, however, because of the second condition, probably only Foreign Company Z (by virtue of Australian Company Cs associate interest) and the partnership (as it is sufficiently influenced) will be associate entities of Australian Company C.

Application and transitional provisions

7.99 The issues discussed in this chapter are subject to the general application provisions discussed in Chapter 1.