Edited version of your written advice

Authorisation Number: 1013051528458

Date of advice: 27 July 2016

Ruling

Subject: Application of Principle of Mutuality - Final Distribution by Company Liquidator

Question 1

Would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as a return of mutual income under the principle of mutuality?

Answer

Yes.

Question 2

If the answer to Question 1 is 'No', would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as the payment of a dividend?

Answer

Not Applicable.

Question 3

If the answer to Questions 1 and 2 is 'No', would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as the payment of capital?

Answer

Not Applicable.

Period to which your private ruling applies

1 July 2016 to 30 June 2017

Date upon which the scheme commences

1 July 2016

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below.

The Company owns a building within which the Company has operated a business over a number of years.

The Company is a public company with X fully-paid Ordinary Shares on issue with X different shareholders (as at the date of liquidation). Under the Company's constitution, the shareholders of the Company are also required to be members of the Company's business.

To become a member of the business, each member would pay an initial sum. In addition to the purchase price, members are also required to pay an annual levy to the Company for the continued operation and maintenance of the business (such levies are subsequently passed on to the Body Corporate).

In a broad sense, the Company issues three classes of shares; Ordinary Shares, Y Shares and one Election Share.

An Ordinary Share carries voting rights and - upon payment of one dollar ($1.00) to the Election Shareholder - the right to receive the one dollar ($1.00) back on the winding up of the Company.

Y Shares have defined rights in relation to occupancy; the right to a dividend or other share in the profits of the Company; and - upon payment of one dollar ($1.00) to the Election Shareholder - the right to receive a share of the net assets of the Company on winding up of the Company. The Y Shareholder also has a duty to contribute to the annual levy.

The Election Shareholder has the right, with the approval of the Body Corporate, to appoint or remove Directors of the Company, and amongst other rights has the right, on winding up of the Company, to receive one dollar ($1.00) in preference to the claims of Ordinary Shareholders and Y Shareholders.

Each Ordinary Shareholder also holds a bundle of Y Shares.

Ownership of the Company's shares have changed hands many times since the commencement of the business.

The annual levies received by the Company have been treated as non-assessable and non-exempt income under the principle of mutuality. Expenses directly incurred by the Company in deriving mutual income are treated as non-deductible. The Company also derives assessable income from interest on bank accounts and unpaid levies, and other income each year from the operation of the business. Other expenses are apportioned between mutual and non-mutual income using a calculation that is based on its ability to derive assessable income each year.

Each year, surplus mutual income was transferred from retained profits to a reserve fund account on the Company's balance sheet. The reserve fund account was maintained to provide for the ongoing maintenance of the building.

A resolution was recently passed by the members resolving to terminate the business, and a contract for the sale was entered into shortly thereafter. The Company made a gain for the sale and indexation was applied to the building's cost base for capital gains tax (CGT) purposes. A liquidator was subsequently appointed to liquidate the Company. The liquidator has made an interim distribution to shareholders that was paid solely from the share capital of the Company.

Following the sale, the Company's retained profits consisted of capital profits that have been subject to company income tax; capital profits that have not been subject to company income tax; and net surpluses from annual levies received that were treated as mutual income.

The liquidator intends to make a final distribution to shareholders to complete the winding up of the Company.

The Company's constitution states that in the event the business is wound up prior to the 'termination date', the Company will place itself into voluntary liquidation and be wound up in accordance with the relevant State or Territory Company Code and Articles of Association annexed to the Company's constitution.

The Articles of Association annexed to the Company's constitution provides that:

• Ordinary Shareholders:

• have the right to vote at general meetings of shareholders of the Company on matters other than the appointment of Directors

• after payment of one dollar ($1.00) to the holder of the Election Share, the right to receive on a winding up of the Company one dollar ($1.00) per Ordinary Share held, and

• have no right to share in any dividend declared.

• Y Shareholders:

• have the right of occupancy during the period of the business referred to in the Company's constitution

• have the right to any dividend or other share in the profits of the Company

• after payment of one dollar ($1.00) to the holder of each Ordinary Share and to the holder of the Election Share, the right in a winding up to receive a share of the net assets of the Company in that proportion which the number of Y Shares held bears to the number of Y Shares issued, and

• no right to vote at general meetings of the Company.

• The Election Shareholder has:

• the right to appoint Directors of the Company

• the right to remove from office at any time and from time to time any Director appointed by the holder of the Election Share

• the right of occupancy until those rights lapse in accordance with these Articles;

• the right in a winding up of the Company to receive one dollar ($1.00) in preference to the claims of Ordinary Shareholders and Y Shareholders, and

• no right to share in any dividend declared.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 6(1)

Income Tax Assessment Act 1936 Subsection 44(1)

Income Tax Assessment Act 1936 Section 350

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 6-15

Income Tax Assessment Act 1997 Section 6-20

Income Tax Assessment Act 1997 Section 10-5

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Question 1

Would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as a return of mutual income under the principle of mutuality?

Summary

The following elements of a mutual arrangement are present in the current circumstances:

• Each of the shareholders (the Y Shareholders) of the Company, as members of the business, share in a common purpose (being the enjoyment of the rights attached to the occupancy).

• To give effect to this purpose, the Y Shareholders make contributions to a 'common fund' in the form of payment of annual levies.

• Each Y Shareholder of the Company holds a direct controlling interest in the Company equal to the percentage the Y Shareholder holds of the total rights to distributions of capital or profits of the Company on winding up (that is, the net assets of the Company, which incorporate the common fund). Therefore, the contributors (the Y Shareholders) to the common fund are considered to have ownership and control of the Company and the common fund.

• There is a complete identity between the contributors to, and the participants of, the Company's common fund as a class.

As such, the principle of mutuality applies to those activities of the Company that are of a mutual nature. The annual levies paid by the Y Shareholders to the Company are mutual income under the principle of mutuality to the extent that the net assets of the Company are derived from the annual levies paid by the Y Shareholders.

Therefore, a final distribution paid by the liquidator to the Company's shareholders, sourced solely from retained profits representing mutual income received by the Company, would be reported in the Company's books as a return of mutual income under the principle of mutuality.

Detailed reasoning

Relevant law

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources. 'Ordinary income' is defined in that section to mean 'income according to ordinary concepts'.

Principles and tests for ascertaining whether a receipt has the character of income according to ordinary concepts have been identified by the courts over the years. One of these principles is the 'principle of mutuality'.

The principle of mutuality applies when a number of persons agree to contribute funds for a common purpose. The principle of mutuality recognises that one cannot make a profit out of oneself and that income can only be derived from sources outside of oneself. Such receipts are called 'mutual receipts'.

Receipts that are to be considered mutual include those receipts from members in respect of dealings for membership, or goods and services provided by a mutual entity in mutual dealings in pursuance of one of its purposes. In the case of a body corporate, for example, mutual income would include amounts of subscriptions or levies imposed by the body corporate to enable it to carry out functions on behalf of its members, such as managing and administering the common property, maintaining and repairing the common property and insuring the buildings and common property.

The principle of mutuality was established in New York Life Insurance Company v. Styles (1889) 14 App. Cas. 381. In that case, the members of a life insurance company were participating policy holders, each of whom were entitled to a share of the assets and liable to all losses. The surplus on premiums paid by policy holders were returned annually to them as bonuses or by way of reduction of future premiums. Any balance was carried forward and held for the benefit of the general body of members. The ratio of the decision was expressed in the following passage taken from the speech of Lord Watson (at p. 394):

When a number of individuals agree to contribute funds for a common purpose, such as the payment of annuities, or of capital sums, to some or all of them, on the occurrence of events certain or uncertain, and stipulate that their contributions, so far as not required for that purpose, shall be repaid to them, I cannot conceive... why contributions returned to them should be regarded as profits.... a member of the appellant company, when he pays a premium, makes a rateable contribution to a common fund, in which he and his co-partners are jointly interested, and which is divisible among them.... He pays according to an estimate of the amount which will be required for the common benefit; if his contribution proves to be insufficient he must make good the deficiency; if it exceeds what is ultimately found to be requisite, the excess is returned to him.

It is a principal requirement of mutuality that contributors to the common fund can be identified with those participants who receive a benefit from the fund. There must therefore be complete identity between the contributors and the participators in surplus mutual receipts, at least as a class. This was established in Municipal Mutual Insurance Ltd v. Hills (1932) 16 TC 430 at 448, where Lord Macmillan stated:

The cardinal requirement is that all the contributors to the common fund must be entitled to participate in the surplus and that all the participators in the surplus must be contributors to the common fund; in other words, there must be complete identity between the contributors and the participators. If this requirement is satisfied, the particular form which the association takes is immaterial.

This principle was also held in Coleambally Irrigation Mutual Co-operative Ltd v. FC of T 2004 ATC 4835.

There must be a 'reasonable relationship' between the contribution of a member to an association and the amount of any actual or possible payment by the association to the member. As noted by the Privy Council in Fletcher v. Income Tax Commissioner [1972] AC 414:

It may not be an essential condition of mutuality that contributions to the fund and rights in it should be equal; but if mutuality is to have any meaning there must be a reasonable relationship, contemplated or in result, between what a member contributes and what, with due allowance for interim benefits of enjoyment, he may expect or be entitled to draw from the fund: between his liabilities and his rights.

Thus, the principle of mutuality applies where a number of persons make contributions out of their own money to a common fund that is created and controlled by them for a common purpose. All contributors to the common fund must be entitled to participate in any surplus and all participators in the surplus must be contributors to the common fund. That is, a mutual relationship must exist between the contributors and the benefactors of the common fund such that all contributions to the fund are applied for their collective benefit, in line with the common purpose.

The legal structure of an entity (incorporated or otherwise) is not a decisive factor in determining whether the principle of mutuality applies. The mutuality principle may still apply notwithstanding that an entity is a corporation. This is because a corporation is merely an entity that is used for the benefit of the members (Royal Automobile Club of Victoria v. FC of T 4 ATR 567; 73 ATC 4153). This is supported by Gibbs J in Social Credit Savings, who stated that the mutuality principle may apply notwithstanding that the people thus associated have been incorporated, for the corporation is treated as a 'mere entity for the convenience of the members..., as an instrument obedient to their mandate'.

Under the principle of mutuality, receipts derived by a taxpayer from mutual dealings with its members are not assessable income. Taxation Ruling IT 2505 entitled Income Tax: Bodies corporate constituted under strata title legislation (IT 2505) and Taxation Ruling TR 2015/3 entitled Income tax: matters relating to strata title bodies constituted under strata title legislation (TR 2015/3) each contain a discussion of the mutuality principle. Both paragraph 19 of IT 2505 and paragraph 71 of TR 2015/3 state the following:

Under the principle of mutuality, where proprietors have contributed to any administration, reserve or special purpose fund to meet common expenses, and any surplus contributions are returned to those proprietors in their capacity as contributors, such surpluses are not assessable income. However, any distributions to proprietors out of profits derived by the body corporate constitute dividends which are assessable income of the proprietors under subsection 44(1) [of the Income Tax Assessment Act 1936 (ITAA 1936)].

The nature of a mutual surplus is therefore different from a non-mutual surplus. Likewise, the law applying to a distribution from a mutual surplus to members is different from the law that applies to a distribution to members from a non-mutual surplus. A distribution from a mutual surplus is not assessable income, while a distribution from a non-mutual surplus is assessable income.

Subsection 995-1(1) of the ITAA 1997 defines 'assessable income' to have the meaning given by sections 6-5, 6-10, 6-15, 17-10 and 17-30 of the ITAA 1997.

Section 6-15 of the ITAA 1997 provides that an amount is not assessable income if it is not ordinary income and is not statutory income. As iterated above, 'ordinary income' is defined in section 6-5 of the ITAA 1997 to mean income according to ordinary concepts. Mutual receipts, by their nature (as explained above), do not constitute income according to ordinary concepts. As ordinary income is not derived for income tax purposes unless it is received from an external source, a payment to oneself cannot be income. Section 6-10 of the ITAA 1997 provides that assessable income includes some amounts that are not ordinary income (which are called 'statutory income'), as per provisions listed in section 10-5 of the ITAA 1997. Mutual receipts are not listed in section 10-5 of the ITAA 1997 and as such do not constitute statutory income. Therefore, as mutual receipts do not constitute ordinary income or statutory income as defined in sections 6-5 and 6-10 of the ITAA 1997 respectively, mutual receipts are not assessable income pursuant to section 6-15 of the ITAA 1997.

Section 6-20 of the ITAA 1997, which defines 'exempt income', is referred to in section 6-10 of the ITAA 1997. As mutual receipts have not been made exempt from income tax pursuant to section 6-20 of the ITAA 1997, mutual receipts are not exempt income.

Application to the Company

If the elements of a mutual arrangement (as identified above) are present, then the principle of mutuality will apply to those activities of the Company that are of a mutual nature. These elements, as they apply to the Company's circumstances, are discussed below.

Common purpose

The purpose of the Company is to manage a business in respect of the building it owns. Under the Company's constitution, all members of the business are also required to be shareholders of the Company. Each of the shareholders of the Company share in a common purpose, being the rights of occupancy.

Contributions to a common fund to give effect to that purpose

To give effect to the abovementioned common purpose, the Company is required under the Company's constitution to pay to the Body Corporate an annual levy for the continued operation and maintenance of the building.

Each Y Shareholder of the Company (each of whom is a member of the business) pays a proportion of the total estimated or actual levy to the Company annually to enable the Company to meet its obligations to the Body Corporate.

Control of the common fund by the contributors

Each year, surplus levies are transferred from the Company's retained profits to a reserve fund account on the Company's balance sheet. The reserve fund account is maintained to provide for the ongoing maintenance of the building. The Company's retained profits, as well as the reserve fund account, each form part of the net assets of the Company.

For the purpose of determining whether a mutual arrangement applies in the circumstances, the component of the Company's net assets that represent the annual levies paid to the Company by the Company's Y Shareholders constitutes the 'common fund'. In accordance with the Company's constitution, all contributors to the common fund are the members of the Company's business, each of which are also shareholders of the Company within the definition of a 'shareholder' in subsection 6(1) of the ITAA 1936.

Section 350 of the ITAA 1936 provides that an entity holds a direct controlling interest in a company at a particular time, which is equal to the percentage that the entity holds, or is entitled to acquire, at that time of:

(a) the total paid-up share capital of the company; or

(b) the total rights of shareholders to vote, or participate in any decision-making, concerning any of the following:

(I) the making of distributions of capital or profits of the company to its shareholders;

(II) the constituent document of the company;

(III) any variation of the share capital of the company; or

(a) the total rights to distributions of capital or profits of the company to its shareholders on winding-up; or

(b) the total rights to distributions of capital or profits of the company to its shareholders, otherwise than on winding-up;

or, if different percentages are applicable under the preceding paragraphs, the greater or greatest of those percentages.

The Company's constitution states that in the event the business is wound up prior to the 'termination date', the Company will place itself into voluntary liquidation and be wound up in accordance with the relevant State or Territory Company Code and Articles of Association annexed to the Company's constitution.

Based on the Articles of Association annexed to the Company's constitution, section 350 of the ITAA 1936 is satisfied. This is because each Y Shareholder of the Company holds a direct controlling interest in the Company equal to the percentage the Y Shareholder holds of the total rights to distributions of capital or profits of the Company on winding up (that is, the net assets of the Company, which incorporate the common fund).

Therefore, the contributors (members of the Company's business) to the common fund are considered to have ownership and control of the Company and the common fund.

All contributors to the common fund must be entitled to participate in any surplus and all participators in the surplus must be contributors to the common fund

In a mutual arrangement, there must be complete identity between contributors and participants as a class, not individually, in the surplus of common funds. With respect to the annual levies paid by the Company's Y Shareholders to the Company, there must be complete identity between the members of the business who are paying the annual levies to the common fund, and those who are entitled to participate in surplus levies upon the Company's winding-up (as a class). Each class must be identical.

According to the Company's constitution, including the annexed Articles of Association, each of the Company's Y Shareholders (each of whom is also required to be a member of the business):

• must contribute to the common fund in the form of payment of annual levies to the Company, and

• hold the right in a winding-up of the Company to receive a share of the net assets of the Company in respect of the proportion of Y Shares owned by the Y Shareholder.

As per the facts, surplus levies are transferred from the Company's retained profits account on its balance sheet to a reserve fund account on the balance sheet. Both the retained profits and the reserve fund account form part of the Company's net assets. The Company's net assets incorporate a component that represents surplus levies paid by the Y Shareholders each year (that is, the 'common fund').

Therefore, the members of the Company's business collectively contribute to, and collectively benefit from, the common fund. The class of members who were required to contribute annual levies to the business are identical to the class of members who are entitled to participate in the surplus contributions of the scheme.

Accordingly, it is accepted that there is a complete identity between the contributors to, and the participants of, the Company's common fund (the component of the Company's net assets that represent the annual levies paid to the Company by the Company's Y Shareholders) as a class.

Pursuant to the ruling held in Faulconbridge, such a conclusion is irrespective of whether a return of surplus levies is made to the same members who originally made contributions/payment of annual levies at the time of inception of the Company's business, or made to members who did not originally make contributions (that is, those members that have not held their shares since the commencement of the business).

As each of the elements of a mutual arrangement - as discussed above - are present in the current circumstances, the principle of mutuality applies to those activities of the Company that are of a mutual nature. The annual levies paid by the Y Shareholders to the Company constitute mutual income under the principle of mutuality to the extent that the net assets of the Company are derived from the annual levies paid by the Y Shareholders.

Therefore, a final distribution paid by the liquidator to the Company's shareholders, sourced solely from retained profits representing mutual income received by the Company, would be reported in the Company's books as a return of mutual income under the principle of mutuality.

Question 2

If the answer to Question 1 is 'No', would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as the payment of a dividend?

Summary

As the response to Question 1 is 'Yes', this question is not applicable.

Question 3

If the answer to Questions 1 and 2 is 'No', would a final distribution paid by the liquidator to the Company's shareholders, sourced from retained profits representing mutual income received by the Company, be reported in the Company's books as the payment of capital?

Summary

As the response to Question 1 is 'Yes', this question is not applicable.

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