The concept of affiliates and connected entities plays a crucial role around the small business CGT concessions.
Affiliates and Connected Entities
While connected entities are quite clear cut, affiliates are full of grey zones.
Affiliates
Section s328-130 (1) Income Tax Assessment Act 1997 (ITAA 97) sets out the meaning of an affiliate.
s328-130 (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.
But s328-130 (2) ITAA 97 qualifies that broad statement:
s328-130 (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.
And then gives some examples.
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.
A trust can never be an affiliate. Why? Because a trust is not a separate legal entity as such. The same applies to a partnership.
Spouse and Children
s152-47 ITAA 97 can deem spouses and children under 18 to be affiliates. It increases access to the concessions in a wider range of situations than the application of s328-130 would.
But it might also reduce access because the extended range of connected entities may cause the maximum net asset value test to be failed.
Grey Zone
In practice, it can be really difficult to tell whether an entity is an affiliate or not. There is so much grey. Connected entitites are much easier to work out.
Connected Entities
The concept of the connection is very wide, encompassing individuals, companies and trusts. The concept is set out in s328-125 ITAA 97.
s328-125 (1): An entity is connected with another entity if:
(a) either entity controls the other entity …; or
(b) both entities are controlled …by the same third entity.
The concept of connected entities is important for two reasons around the small business CGT concessions in Division 152. You need to know a taxpayer’s connected entitites to determine whether:
a) They pass the maximum net asset value or aggregated turnover test, and
b) The relevant CGT asset is an active asset
Control
Different to associates, establishing control is a numbers game. You either hold a 40% right to income or capital or you don’t.
s328-125 (2): An entity (the first entity ) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates:
(a) …own…interests in the other entity that carry between them the right to receive a percentage …that is at least 40% of:
(i) any distribution of income by the other entity; or
(ii) if …a partnership – the net income of the partnership; or
(iii) any distribution of capital by the other entity; or
Indirect control
An entity that directly controls another entity is taken to control any entity that is controlled by the other entity whether directly or by application of the indirect control rule (s 328-125(7)).
However, you can’t trace through publicly listed companies and publicly traded unit trusts (s328-125 (8)).
Commissioner Discretion
When the control percentage of an entity is between 40 and 50%, the Commissioner has a discretion. They can determine that the entity does not control the other entity.
If the control percentage is 50% or more in any of the relevant years, the Commissioner has no discretion (s 328-125 (7)).
Companies
The 40% threshold also applies to companies. For companies it is the voting power that counts.
s328-125 (2): An entity (the first entity ) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates:
(b) if the other entity is a company–own…equity interests in the company that carry …at least 40% of the voting power …
Discretionary Trusts
Discretionary trusts are different since beneficiaries have no equitable right in the trust. So different rules apply to establish whether a discretionary trust is a connected entity. There are two different tests.
First Test
The first one mirrors the concept of affiliates.
s328-125 (3) An entity (the first entity ) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates, or the first entity together with its affiliates.
Whether or not the trustee (or directors of a corporate trustee) act in accordance with the directions or wishes of a person is a question of evidence. The concept of affiliates only applies to individuals and companies that carry on business.
Second Test
The second test in s328-125 (4) is a distribution test. It looks at trust distributions over the past 4 years.
(4) An entity (the first entity ) controls a discretionary trust for an income year if, for any of the 4 income years before that year:
(a) the trustee of the trust paid to, or applied for the benefit of:
(i) the first entity; or
(ii) any of the first entity’s affiliates; or
(iii) the first entity and any of its affiliates; any of the income or capital of the trust; and
(b) the percentage (the control percentage ) of the income or capital paid or applied is at least 40% of the total amount of income or capital paid or applied by the trustee for that year.
Just pushing the distribution beyond year-end won’t work. Consistent with the Commissioner’s former long standing administrative practices, distributions that are paid to, or applied for the benefit of, the entity within two months following the end of an income year will generally, and subject to the terms of the trust deed, be taken to be paid or applied for the preceding income year.
Exempt or DGR
An exempt entity or deductible gift cannot control a discretionary trust under the pattern of distributions control test (s 328-125 (5)).
But distributions to an exempt entity or a deductible gift recepient are taken into account in determining whether another beneficiary controls the discretionary trust under the pattern of distributions control test.
No Distribution
If a trust makes a loss or has no trust income, then there is nothing to distribute. What do you do then? The answer is a special rule in s152-78.
s152-78 (2) The trustee of a discretionary trust may nominate not more than 4 beneficiaries as being controllers of the trust for an income year …for which the trustee did not make a distribution of income or capital if the trust had a tax loss, or no net income, for that year.
The nomination must be in writing and signed by the trustee and by each nominated beneficiary.
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