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Edited version of your written advice

Authorisation Number: 1012928784932

Date of advice: 19 January 2016

Ruling

Subject: Principle of Mutuality

Question

Does the mutuality principle apply to receipts in the form of fees received from its Shareholding Members so that they do not constitute assessable income of the entity for Australian income tax purposes?

Answer

No

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

1 July 2016 to 30 June 2017

1 July 2017 to 30 June 2018

1 July 2018 to 30 June 2019

1 July 2019 to 30 June 2020

The scheme commences on:

1 July 2015

Relevant facts and circumstances

Shareholder Entities Agreement

Parties

Background:

Operative Provisions

Relevant legislative provisions

Income Tax Assessment Act 1997, section 6-5

Anti-avoidance rules

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part IVA general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Summary

The entity is a service company which provides services to Shareholding and Non-Shareholding members as customers in the nature of trade. The entity's dealings with Shareholder Members are not considered to be mutual dealings because:

Principle of Mutuality

Section 6-5 of the ITAA97 provides that assessable income includes income according to ordinary concepts, which is called ordinary income. Whether a receipt is income depends upon its quality in the hands of the recipient.

The term income is not defined in the Income Tax Assessment Act 1936 (ITAA36) or ITAA97. In The Bohemians Club v The Acting Federal Commissioner of Taxation [1918] 24 CLR 334, Griffith CJ stated at 337-338:

The exposition by Griffith CJ has formed the basis of the principle of mutuality as it applies to Australia. As such, a receipt by a taxpayer will not have the quality of ordinary income if the mutuality principle applies to it.

The essence of the mutuality principle is that you cannot derive any gain, and therefore income, from dealings with yourself. The mutuality principle provides that where a number of people associate for a common purpose and contribute to a common fund in which they are all interested, any surplus of those contributions remaining after the fund has been applied to the common purpose that is then distributed to the contributors, is a return of funds and not income or profit.

The mutuality principle was described succinctly by McTiernan J in Revesby Credit Union Cooperative Ltd v Federal Commissioner of Taxation (1965) 112 CLR 564 (Revesby Credit Union) at 574-575:

Mutual receipts versus receipts in the nature of trade

The courts recognised that a company can trade with its members and the dealings can still be mutual. However where the dealings undertaken between members and the company are in the nature of trading producing profit membership or non-membership is of no significance.

In Fletcher v. Income Tax Commissioner [1971] 3 All ER 1185 (Fletcher) The Privy Council considered whether the mutuality principle applied to receipts from hotel members of a bathing club who joined the bathing club in order to provide access for their hotel guests to an attractive bathing beach. Lord Wilberforce in Fletcher at 1189 stated that:

In concluding that the fees from the hotel members were not mutual receipts the court in Fletcher stated at 1191:

The Privy Council considered whether a company could derive a profit from its members in English and Scottish Joint Co-operative Wholesale Society Ltd v Assam Commissioner of Agricultural Income Tax [1948] 2 All ER 395 (Assam Tea). The following facts as described in the High Court judgment, from which the taxpayer appealed to the Privy Council, were accepted by Lord Normand at 397-398:

In considering whether or not the principle of mutuality applied in this case, the Privy Council concluded that profits were not only likely to arise from the sales of tea to members, but that the generation of profits was in fact contemplated by the rules that provided for their application (at 398). The court went on to say that it was difficult to distinguish the company, in its dealings with members, from an ordinary trading company (at 398):

This case highlights three points of relevance to mutuality. Firstly, the company's constituent documents in contemplating that profits will be derived are an indication that the company is trading. Secondly, when the business operations of the company conform so closely to an ordinary profit-making business, it would also indicate that the company is trading with its members. Thirdly, this case supports the proposition that just because an association's dealings are with its members, it does not necessarily mean that the association's receipts arising from those dealings have a mutual character.

In FC of T v Australian Music Traders Association (1990) 90 ATC 4536 (Music Traders), the Full Federal Court considered whether fees paid by members of an association to a third party in return for exhibition space at a trade fair, which were then on-paid to the association constituted contributions to a common fund by the members and thus subject to the principle of mutuality, or whether they were in the nature of profit derived in the course of trading. The Australian Music Traders Association was established for the promotion of the interests of people engaged in dealing in musical instruments, records and associated equipment; and the conduct of music trade fairs for the exhibition of goods dealt in by members and others. In the relevant income year, the Association engaged a third party company to organise a trade fair on its behalf. The company sold exhibition space to traders, some of whom were members of the association. Each trader that took exhibition space entered into a written agreement which set out the cost and size of the floor space to be taken. The agreement between the Association and the trade fair organiser entitled the Association to receive out of monies paid by member traders, an amount determined in accordance with a formula relating to floor space occupied. The court was required to determine if the resulting sum payable to the Association was it to be characterised as income, or whether it was subject to the principle of mutuality, and thus not income.

The majority found that the receipts were not subject to the mutuality principle. Davies J, who was a member of the majority, quoted from the judgment of Lord Wilberforce in Fletcher at 1189 in posing the question to be answered: 'is the activity, on the one hand, a trade, or an adventure in the nature of trade, producing a profit, or is it, on the other, a mutual arrangement which, at most, gives rise to a surplus?'. Davies J concluded that the activity and the fee received in connection with the activity were not mutual in nature. He said at 4538-39:

Davies J in the course of characterising the fee paid by the organisers, sought to determine whether the payment was a contribution into a common fund by the members by reference to what purpose the individual traders had in participating in the fair. Put another way, Davies J addressed the question of whether members were making a contribution to a fund for a common purpose or were participating in the fair and making the payments for another purpose. He concluded that the members were participating to generate profits for their own businesses.

Wilcox J, the other member of the majority, in concluding that the members were not making contributions to a common fund said at 4546:

The decision in Music Traders emphasised the importance of determining the purpose of the members making the payments in ascertaining whether those payments are to be properly characterised as contributions to a common fund. The question to be asked here is whether each member's purpose in paying the membership fees is to contribute to the common fund, or whether, as in Music Traders, there is no common purpose but rather each member makes the payment for their own purpose.

The entity is established as a private company limited by shares. The background section of the Shareholders Agreement makes it clear that:

The entity provides the following services to its Shareholding Members and Non-Shareholding members:

Members pay the entity based either on a fee for service basis or on their level of turnover, which demonstrates a relationship between services provided by the entity and the rate of payment for these services. In essence members are paying the entity for services rendered. Just as with Music Traders, Shareholding Members and Non-Shareholding Members alike each contribute to the entity in order to gain access to services to advance their individual business interests. The services provided by the entity are by their very nature inherently linked to the business activities of members.

Based on the facts, Shareholding members are in business as professional businesses and are paying the entity as a service company for services rendered. There is no distinction between shareholding members and non-shareholding members in the provision of services by the entity. It is accepted by the entity that receipts from Non-Shareholding Members are not mutual receipts.

Because the Shareholding Members are in business there would be strong commercial reasons for operating a service company to provide common services for shareholders. The independent pursuit of business objectives is a private activity of each shareholder which is unrelated to any common purpose or mutual activity they may have as a group. In circumstances such as these as explained in Fletcher, and Assam Tea membership or non-membership is of no significance, rather it is the nature of the transactions which matters.

In this instance the entity is trading with professional firms to provide services to assist its members (who also happen to be predominately the entity shareholders) to advance their individual business interests. This represents dealings in the nature of trade and is inconsistent with the principle of mutuality applying to the entity.

Identity between the contributors and the participants

The principle of mutuality is dependent upon the existence of an 'identity' between contributors to the fund and those who are entitled to participate in it. The mutuality principle may be displaced where there is a difference of identity between those who contribute and those who can receive a distribution of surplus, or where the distribution of surplus is disproportionate to the amount contributed.

In Coleambally, Beaumont, Merkel and Hely JJ said at 4842:

Furthermore, Beaumont, Merkel and Hely JJ said at 4844:

In Liverpool Corn Trade Association Limited v. Monks (HM Inspector of taxes) (1926) 2 KB 110 (Liverpool Corn Trade), the King's Bench where tasked with considering the nature of the dealings between the Liverpool Corn Trade Association and their members in relation to mutuality. The association in Liverpool Corn Trade provided common infrastructure and provided services to members and other persons using market facilities on an equal footing. Of relevance in Liverpool Corn Trade, the members were also shareholders of the association which was incorporated as a company. Rowlatt J at 121 and 122 of Liverpool Corn Trade states:

While going on to acknowledge the principle in New York Life Insurance Co v. Styles 14 App. Cas. 381 of an incorporated entity being a mere entity of convenience for its members, Rowlatt J went on to say at 123 that:

Liverpool Corn Trade illustrates the principle that in circumstances where members are dealing with a corporation in which they also happen to be shareholders there will be a lack of identity between what the members, as customers contribute, and what they may stand to receive as shareholders or owners of the company.

In order for mutuality to exist there must be a reasonable relationship between contributions made by members and what they can expect to benefit from the fund. In circumstances where the owners of a company are dealing with a company as customers, it is unlikely that identity will be present.

The entity exists as a service company which provides services to shareholders (referred to as Shareholder Members) and non-members alike. The payment for the services provided to the entity are based on the level of turnover of the Shareholder Member entities or based on the type of service provided. This relationship is in the nature of a customer using the services of a service provider.

The entity constitution provides for the declaration of dividends at the discretion of its directors, this relationship is based on the ownership of the company and is not inconsistent with any other profit making company with owners. While it is possible to look through the corporate veil to view an incorporated entity as an entity of convenience for the members, in circumstances where shareholders are trading with a corporate entity as customers, to advance their individual business interests it is not appropriate to do so.

Based on this it is not accepted that there is identity between what the Shareholder Members contribute to the entity as customers and what they stand to receive from the entity as shareholders or owners.

Existence of a common fund controlled by the contributors for a common purpose

For the principle of mutuality to apply there must be a common fund. It can be described as a fund established by contributors for a common purpose in which contributing members as a class have rights. The fund must be owned or controlled wholly by the contributors. If it is owned and controlled by anyone else the principle cannot apply.

In Sydney Water Board Employees' Credit Union v FCT 73 ATC 4129 (Sydney Water Board) the taxpayer unsuccessfully argued that interest paid by borrowing members of the credit union constituted a common fund paid for the common purpose of enabling the credit union to meet its administrative and operating expenses, with any surplus refundable to borrower members. Interest paid was not maintained as a common fund in which the borrowing members as a class had any rights. Interest was paid by borrowers in discharge of their legal obligations and became part of the general funds of the credit union. It was not paid as a contribution to the mutual liabilities on behalf of the borrowers. Mason J. noted at 4136 that the borrowing members did not have any right to a refund of part of the interest which they have paid; on the contrary:

The existence of a common fund is premised on the existence of identity between what a member of the fund contributes to the fund and the benefit they stand to receive from the fund. Sydney Water Board illustrates the principle that where a member deals with an association as a customer they are not contributing to a common fund, rather they are contracting on an individual basis with the provider of a service on their own account.

The entity provides services to its Shareholding and Non-Shareholding members as customers. The entity's Shareholding Members, as owners of the entity, have the right to dividends and distributions of capital from the entity as shareholders. The customers of the entity as a class, being their Shareholding Members and Non-Shareholding, who contribute in order to receive services and benefits from the entity are not the same as the Shareholding Members of the entity as shareholders who as a class stand to receive dividends and capital distributions as owners. While it is acknowledged that the entity states that they do not pay dividends and intend to distribute capital upon dissolution based on their contributions; this does not diminish from the fact that Shareholding Members are owners of the entity with all the rights of ordinary shareholders to control the entity and receive dividends and capital distributions as owners.

Applying the principle in Sydney Water Board it is not possible to accept that the Shareholder Members, as customers of the entity are contributing to a common fund for their common purpose.

Membership

The relevance of membership to the principle of mutuality was considered by Lord MacMillian in the case Inland Revenue Commissioners v Ayrshire Employers Mutual Insurance Association Ltd (1946) 1 ALL ER 637 at 640 where he indicated:

This approach was adopted in Royal Automobile Club of Victoria (RACV) v Federal Commissioner of Taxation 73 ATC 4153 (RACV), where the taxpayer was a company limited by guarantee that provided certain services and facilities in relation to motor vehicles. They received payments from a number of sources including both members and non-members in relation their services and facilities, together with commissions, interest on investments and rent from property. The court looked at each activity to determine if it had the quality of mutuality. It was held that mutual dealings and business dealings had to be distinguished and apportionment applied. Activities relating to business dealings were considered in the nature of trade and assessable, while activities that were mutual in nature, were mutual receipts even if only some members took advantage of the facility.

Applying the principles in RACV, Shareholder Members and Non-Shareholder Members alike are dealing with the entity as customers to advance their individual business interests, these dealings are business dealings in the nature of trade and do not exhibit the characteristics of a mutual relationship.

An incorporated entity must be an entity for the convenience of its members

The incorporation of an organisation will not of itself affect the operation of the mutuality principle so far as the company has been incorporated as a mere convenient agent or instrument of the common purpose of its members. In Coleambally, Beaumont, Merkel and Hely JJ said at 4842:

This should be contrasted with the position taken in Liverpool Corn Trade, where it was not considered appropriate to look through the corporate veil in circumstances where the shareholders of a corporate entity were trading with that entity as customers, in this instance the corporate entity was more than a mere entity of convenience.

The entity is an incorporated entity which provides services to Shareholder Member and Non-Shareholder Members as customers. As with Liverpool Corn Trade, there is little to distinguish the services provided by the entity to its members and non-members, compared to the role of Shareholder Members as shareholders who have all the normal rights of the owners of a company. In circumstances such as these it is not appropriate to look behind the corporate veil and view the entity as a mere entity of convenience for its members.

Conclusion

The entity is a service company which provides services to Shareholding and Non-Shareholding members as customers in the nature of trade. The entity's dealings with Shareholder Members are not considered to be mutual dealings because:

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