Negativing control – implications of the tax authority’s view of control for Australian infrastructure investment
June 2015 | PROFESSIONAL INSIGHT | CORPORATE TAX
Financier Worldwide Magazine
The Australian Taxation Office (ATO) is currently undertaking consultation with the infrastructure sector on the issue of ‘negative control’ – i.e., when a power to veto certain corporate decisions delivers ‘control’ of a company – with a view to providing guidance on this issue. The provision of guidance on this and other tax uncertainties forms part of the ATO’s ‘reinvention’ strategy, where the ATO seeks to identify acceptable boundaries so that taxpayers can safely ‘swim between the flags’.
The issue arises in the context of infrastructure projects, where unit trusts are often used to pool funds and invest in projects. This is generally done with the intention that the trusts will be flow-through entities, and that any tax will be paid by the ultimate investors having regard to their tax profile, rather than in the hands of the trustee of the trust. Under Division 6C of the Income Tax Assessment Act 1936 (ITAA 1936), however, such trusts may be taxed like companies if they carry on a trading business or control (or are able to control) a company which carries on a trading business.
In ATO Interpretative Decision 2011/11, the ATO provided guidance as to its view that negative control can amount to control for these purposes in the context of a particular arrangement. If the ATO confirms that this view applies more broadly, it could have a significant effect on infrastructure investment in Australia. It carries the risk of causing investors to choose to invest elsewhere. Alternatively, investors may limit the ‘veto rights’ they ask for, in order to ‘fit between the flags’, even if it is not in their economic interests to do so. Further, if investors proceed to invest, the consequent impact on the project tax profile may increase the necessary return demanded by both the investors and their financiers.
Given the absence of case law or clear legislative guidance regarding the meaning of control in this context, the ATO’s anticipated stance is highly controversial.
When the relevant provisions were inserted into the ITAA 1936 in 1985, the Explanatory Memorandum indicated that: “Paragraph (b) is a safeguarding provision against arrangements to circumvent the operation of Division 6C by having activities that would constitute a trading business of a public unit trust carried on by an associated entity. By taking income from the associate in the form of eligible investment income, the trustee could otherwise ensure that the relevant trust did not qualify as a trading business and so avoid the operation of Division 6C”.
This suggests that the provision is anti-avoidance in nature, designed to capture arrangements where a company is inserted to avoid a trust being regarded as carrying on a trading business itself. In that context, it is not immediately apparent that it was intended to (or should) extend to situations involving a minority shareholder with veto rights.
In the absence of a definition, or legislative or case guidance, it is necessary to consider whether the concept of control: (i) refers to legal or de facto control; (ii) requires positive control, or if negative control is sufficient; and (iii) extends to passive as well as active control.
The traditional view, at least in a tax context, is that control means legal control “in the sense of capacity to carry an ordinary resolution at a general meeting of shareholders” (Canwest Global Communications Corporation vs. Australian Broadcasting Authority). A broader approach has been taken in some recent decisions, albeit in a non-tax context, suggesting that control extends to de facto control (for example, in Canwest and Re The News Corporation Ltd). It would also generally be accepted that a person can control a company if the company, and its directors, are accustomed to act in accordance with that person’s directions.
It is one thing, however, to say that a person controls a company when he or she always does (or can) get his or her way. It is quite another thing to say that a person controls the company where all the person can do is prevent certain actions being taken by the company where such actions would be harmful to that person’s economic interests.
It is true that in the News Corporation decision, the Court said that “a power to veto is a power to restrain, and hence to control”. However, this comment needs to be viewed in the context of the applicable legislation, which concerned media ownership rather than tax, and included a ‘legal control’ test set at 15 percent. The relevant person also had the power to appoint half the board, coupled with the power to prevent any other party obtaining an interest in the company. In that sense, the relevant person clearly had an ability to control the company in the manner contemplated by the legislation, the purpose of which was to ensure diverse media ownership.
It is an unusual situation, however, for shareholders to have veto powers that go so far as to give that shareholder control over all or most of the day-to-day activities of the company. Rather, veto powers are usually designed to protect the economic interests of a minority party and so go to matters of significant economic substance, such as the issuing of new shares, disposal of the business, etc.
Indeed, the view in ATO ID 2011/11, that the veto powers there delivered control of the company, is even more extreme. The relevant investor was one of four equal investors, each of whom had the same veto powers such that no one investor could ever force the company to do anything. This seems inconsistent with case authority that has interpreted control in a positive sense. In the seminal case of Mendes vs Commissioner of Probate Duties, for example, the Court indicated the reference to control in the relevant provisions was applicable – “not where a company was partially controlled by the deceased, or was controlled by him in respect of most topics, or in respect of the most important topics or those of most common occurrence or even all topics that might relate to the ordinary operation of the company as a going concern, but where it was controlled by the deceased.”
It follows that negative control should only be seen to give rise to ‘control’ for these purposes in those rare situations where it actually delivers to a particular trust the ability to positively impact the way a company goes about its day-to-day business. Such an approach is consistent with the evident purpose of the legislation, and addresses the mischief that led to its introduction.
Resolving the uncertainty
Tax legislation in Australia is full of complicated and unresolved issues, particularly in relation to the tax treatment of trusts. The ATO should be applauded for taking steps to provide practical guidance and safe harbours in relation to a range of these matters, as this should reduce compliance costs and minimise disputes.
However, this also needs to be balanced against the risk that the ATO’s guidance becomes quasi-law. In relation to an issue where the law is open to different interpretations, and the proper approach to interpretation is hotly debated, there may be better ways of delivering certainty.
Legislative change to clarify the intended scope may be one possibility. Alternatively, it might be possible to seek guidance from the courts, potentially through the innovative use of declaratory relief proceedings.
Such an approach may be warranted in this case, given the potential impact of the ATO’s guidance on infrastructure investment in Australia.
There is uncertainty as to whether, and in what circumstances, veto rights can deliver a person control over another company. In a tax context, however, the case law and guidance which does exist suggests this would only be in limited and rare circumstances. While resolving uncertainty in tax matters is desirable, there is a danger that the approach proposed by the ATO proves to be counterproductive, with serious repercussions for infrastructure investment in Australia. Perhaps this is a situation where the old adage ‘make haste slowly’, is apt.
Reynah Tang is a partner and Millicent Allan is a law clerk at Johnson Winter & Slattery. Mr Tang can be contacted on +61 3 8611 1352 or by email: firstname.lastname@example.org.
© Financier Worldwide
Reynah Tang and Millicent Allan
Johnson Winter & Slattery