Edited version of your written advice

Authorisation Number: 1051372994490

Date of advice: 15 May 2018

Ruling

Subject: Applicability of the Principle of Mutuality

Question 1

Does the existence of a significant number of the Company’s members that are entitled to member benefits through the purchase of a new product/service from one of the Company’s subsidiary companies preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Answer

Yes.

Question 2

Does the existence of a significant number of members of the Company that have membership voting rights with the Company through the purchase of a new product/service from one of the Company’s subsidiary companies preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Answer

Yes.

Question 3

Does the existence of a significant number of members of the Company that are entitled to member benefits through the purchase of a new product/service from one of the Company’s subsidiary companies, and the changes to the business objectives for the Company’s original product following the membership changes, impede the association of members of the Company comprising the common fund from operating for the common purpose, and thus preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Answer

Yes.

This ruling applies for the following periods

Income years ended 30 June 20XX to 30 June 20XX.

The scheme commences on

1 July 20XX

Relevant facts and circumstances

Background/Overview of business

The Company is a public company limited by guarantee and is governed by its Constitution, By-Laws, the Corporations Act 2001 (Cth) and common law principles. It is the parent entity in its Group (which includes the Company and its wholly owned subsidiaries). The Company has not elected to form an income tax consolidated group.

Historically, the members of the Company contributed to the entity through the purchase of the Company’s original product. These members were the only contributors to the Company, and they were the only members who received member benefits. The objective of the original product was for a common (non-profit) purpose. The principle of mutuality therefore used to apply in respect of such mutual receipts. The majority of these members were ordinary voting members.

However, the Company now offers new types of products and services sold through its subsidiary companies, in addition to the original product sold by the Company.

Following a recent review of the Company’s membership, the Company has resolved to expand its membership base and change the way in which its membership is structured.

Where a person purchases a new type of product/service through one of the Company’s subsidiaries, and they do not already have membership of the Company through the purchase of the Company’s original product, that person can apply to become a member of the Company (the parent entity) for nil consideration, and also be entitled to the same member benefits as a member who purchased the Company’s original product. Such members are also now ordinary voting members of the Company.

Thus, as a result of the membership change, there are a significant number of members (approximately 20% of the membership base) who become members of the Company (and receive member benefits) by purchasing a new type of product/service from the Company’s subsidiaries, yet who do not contribute directly to the Company’s common fund

The Company has also changed the business objective of its original product from a common purpose (non-profit) to a more commercial/profit focus.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Question 1

Does the existence of a significant number of the Company’s members that are entitled to member benefits through the purchase of a new product/service from one of the Company’s subsidiary companies preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Summary

The existence of a significant number of the Company’s members that are entitled to member benefits through the purchase of a new product from the Company’s subsidiary company would preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product. As such, those amounts would be assessable for income tax purposes.

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.

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.

This principle is further explained by McTiernan J in Revesby Credit Union Co-Operative Ltd v. Federal Commissioner of Taxation (1964-1965) 112 CLR 566, as follows:

The principle of mutuality seems to me to be settled. Where a number of people contribute to a fund created and controlled by them for a common purpose any surplus paid to the contributors after the use of the fund for the common purpose is not income but is to be regarded as a mere repayment of the contributor's own money: The Bohemians Club v. Acting Federal Commissioner of Taxation (1918) 24 CLR 334. What is required is that the fund must have been created for the common purpose and owned or controlled wholly by the contributors. If it is owned or controlled by anyone else, the principle cannot apply: The Equitable Life Assurance Society of the United States v. Bishop (1900) 1QB 177.

Davies J in FCT v. Australian Music Traders Association 90 ATC 4536 at 4538 held that:

…in a social club, one finds a number of persons associated together not to trade with each other or for profit, but to acquire and maintain a social facility benefiting all members. In mutual insurance, one finds a common fund in which all contributors are entitled to participate more or less equally having regard to their contributions and contractual rights. Their mutual dealings do not give rise to a profit. Although the concept has not been definitely delineated, its crux is an association of persons who have joined together not for trade or profit but to achieve a common end or benefit in which all members participate or are entitled to do so.

The decisions in Federal Commissioner of Taxation v. Australian Music Traders Association (1990) 21 ATR 471 (Music Traders) and Royal Automobile Club of Victoria v. Federal Commissioner of Taxation [1974] VicRp 80 (RACV) indicate that indirect contributions to the fund do not amount to a contribution into the common fund.

In Coleambally Irrigation Mutual Co-operative Ltd v. FC of T 2004 ATC 4835 (Coleambally Irrigation), Beaumont, Merkel and Hely JJ referred to the primary judge in Coleambally Irrigation Mutual Co-operative Ltd v. FC of T 2004 ATC 4126 at 4132 to 4133 on the relevant concepts of the mutuality principle, in particular, the meaning of contributors.

32. It seems to be essential to the application of mutuality that the monies contributed are and remain ‘in substance’ the monies of the contributors. Cf per Mason J, with whom Barwick CJ, Menzies, Walsh and Stephen JJ agreed in Sydney Water Board Employees Credit Union v. FC of T ATC 4129 at 4134-4135; (1973) 129 CLR 446 at 456. In the simple case of the members’ unincorporated club the monies belong to the members in the normal sense of that expression. If the monies are not expended the members will have the right to have them returned to them. It is clear, however, that the word ‘belong’ as used in the above proposition is not used in its normal sense. In the case of an incorporated club the monies of the incorporated club will belong in law to the incorporated club itself, yet that will not deny mutuality for in substance the assets of the incorporated club can be seen to belong to its members.

[…]

34. In the Social Credit Savings and Loans Society case it was held that a lending body which made loans to members at a rate of interest and was entitled to apply its surplus in paying benefits to employees, to provide interest rebates to borrowing members and subject thereto for distribution to all members, whether or not they borrowed, was not entitled to be regarded as subject to the doctrine of mutuality this was because there was lacking the requirement of identicality between the contributors to the common fund and the participators in it. The common fund there was the payments of interest and the borrowers, therefore, the contributors. Many members were not borrowers, however. Further, the surplus (even after an amendment was made to the rules in an attempt to have the taxpayer comply with the mutuality principle by ensuring that any surplus could not be paid to members who did not borrow) could be paid to employees or the whole of the members. Gibbs J was of the view that the fact that the whole surplus could be paid to employees meant that there was not identity between the contributors and the possible participators. In other words, the surplus did not belong to the contributors. See too Revesby Credit Union Co-operative Ltd v. FC of T (1965) 112 CLR 564.

The cases of Coleambally Irrigation and Music Traders commented on the relevant case law concerning the meaning of participants or participators in (or beneficiaries of) the common fund.

In Coleambally Irrigation:

18. In Sydney Water Board Employees Credit Union v. FC of T 73 ATC 4129; (1973) 129 CLR 446 Barwick CJ said (at ATC 4131; CLR 450) that the description “mutuality principle” is used, unfortunately in his Honour’s opinion, to express the reason for the conclusion that the return to a taxpayer of a share of the surplus of a fund to which the taxpayer has contributed with others, after the fund has been used for a purpose agreed between the contributors, is not income. What distinguishes the amount refunded in such circumstances from profit or income is that the payment is made out of monies which are in substance the monies of the contributors. Similarly, Mason J (with whose judgment Menzies, Walsh and Stephen JJ agreed) said (at ATC 4133; CLR 454) that according to the mutuality principle, when a group of persons subscribe to a common fund for a common purpose, a return to the contributors of surplus contributions, that is, money in excess of what is required for the common purpose, does not constitute assessable income in their hands. A refund to contributors of part of their own money which they had overpaid is not ‘income’ in the hands of the recipients in the ordinary sense of that word.

The Music Traders case referred to Sydney Water Board Employees Credit Union Ltd v. FC of T 73 ATC 4135 (Sydney Water Board), where Mason J commented:

Conformably with the original concept that the return of surplus funds is a refund to the contributors of their own money, it has been said that there must exist an ‘identity’ between the contributors and the participators. In Municipal Mutual Insurance Ltd v. Hills…at p. 448, Lord Macmillan said there must be a ‘complete identity’. On other occasions, it has been pointed out that the identity required is not an identity between individuals but an identity between classes… Again, with the same end in view, although it has not been insisted that the refund to contributors should be in precisely the same proportions in which they have contributed to the fund, it has been said that there must be ‘a reasonable relationship’ between what a member contributes and what he may be expected or entitled to receive from the fund…

…the “so-called ‘contributors’, the borrowing members”, were a proportion only of the total class of members.

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.

In Social Credit Savings & Loan Society Ltd v. FCT (1971) 125 CLR 560; 2 ATR 612 (Social Credit Savings), the Court took the view that the identity required is not an identity between individuals, but an identity between classes of individuals. In Faulconbridge (Inspector of Taxes) v. National Employers' Mutual General Association Ltd (1952) 33 TC 103 at 125, it was stated that:

….at any given moment of time the persons who are contributing must be identical with the persons who are entitled to participate; whereas it follows, in my judgement, that it matters not that the class has been diminished by persons going out of the scheme or that others may come in their place in the future.

This principle was also held in the Coleambally Irrigation case.

There must also 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.

This requirement that there be a reasonable relationship has been subsequently confirmed in a number of Australian decisions, including the Sydney Water Board and Music Traders cases.

By way of summary of the various legal principles established by case law surrounding the mutuality principle, as discussed above, the ATO’s publication entitled ‘Mutuality and taxable income’ on the ATO’s website provides a summary of the typical characteristics of organisations that can access mutuality. These elements of a mutual arrangement include:

● The organisation is carried on for the benefit of its members collectively, not individually.

● The members of the organisation share a common purpose in which they all participate or are entitled to do so.

● The main purpose for which the organisation was established, and is operated, is the common purpose of the members.

● There is a common fund that gives effect to the common purpose and all the members contribute to it.

● All the contributions to the common fund are applied for the collective benefit of all the members, in line with the common purpose.

● Different classes of memberships may exist with varying subscription rates, rights and entitlements to facilities.

● The members have ownership and control of 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.

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. Paragraph 19 of IT 2505 and paragraph 71 of TR 2015/3 each 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.

Application of the relevant law to the Company’s circumstances

The elements of a mutual arrangement (as identified above), as they apply to the Company’s circumstances, are discussed below. In considering these factors, it is necessary to take note of the following statement by Anderson J in Royal Automobile Club of Victoria (R.A.C.V.) v. Federal Commissioner of Taxation 73 ATC 4153 at 4157:

Many criteria have been considered in the numerous cases where one or another criterion has been regarded as determining or not determining the issue [of mutuality]. Lord Wilberforce expressed the opinion that, except in the simplest cases, no single criterion was likely to be decisive.

Common purpose

Members of the Company who are holders of the Company’s original product are considered to be contributing to the common fund that is linked to the Company’s common purpose.

However, as discussed in the response to Question Three below, as a consequence of the implementation of the membership changes, the primary purpose of members purchasing new products from the Company’s subsidiary companies is not to contribute to a common fund to advance the Company’s objects, but to obtain the benefits attached to that product as part of a commercial transaction for their own private use.

As such, there is a significant shift by the association of ordinary members comprising the common fund towards undertaking activities (that is, the provision of member benefits) for commercial purposes rather than the common purpose.

Contributions to a common fund to give effect to the common purpose

As a result of the Company’s membership changes, the only contributions the Company receives directly from members are contributions in respect of their original product. The Company’s subsidiary companies receive contributions from members in respect of the new types of products and services they provide.

As such, there are members (for example, a customer who had not purchased the Company’s original product in that year, but purchased a new type of products/services through one of the Company’s subsidiaries) who do not contribute directly to the Company.

In applying the principles outlined in Music Traders and RACV in respect of whether there have been contributions made by members into the common fund, any indirect contribution is not a contribution to the common fund.

Identity between contributors to, and participants of, the common fund

As established above, the contributors to the common fund following the Company’s membership changes are those members of the Company who provide direct contributions in respect of the Company’s original product. Members who provide contributions indirectly through the Company’s subsidiary companies in respect of those companies’ new types of products and services are not contributors to the common fund.

The participants or beneficiaries of the common fund following the Company’s membership changes are all the product holders, which includes holders of the Company’s original product and the subsidiary companies’ new products/services. All product holders are now ordinary voting members of the Company, and ordinary voting members are entitled to receive membership benefits. All participators of the fund receive the same member benefit inclusions.

Therefore, there is a lack of identity between the contributors of the common fund (being the holders of the Company’s original product) and those with the right to participate in the standard membership benefits associated with the common fund (being the holders of all products, including the Company’s original product and the subsidiary companies’ new products/services).

Reasonable relationship between what a member contributes and what the member may be expected or entitled to receive in respect of the common fund

As discussed above, whilst holders of the Company’s original product directly contribute to the common fund and receive commensurate benefits, there are some members who do not make a direct contribution into the fund, yet are still entitled to receive membership benefits.

As per the facts, there are a significant number of these members that do not make a contribution to the common fund.

Consequently, the significance of members who do not make a contribution to the common fund is such that there is a distinct disparity between the contributors to the fund (being the holders of the Company’s original product) and the participators in (beneficiaries of) the fund (being all product holders). It is considered likely that such a disparity will be ongoing as new memberships stemming from the sale of the subsidiary companies’ new products/services are expected to continue to grow.

Therefore, it is considered that there is not a reasonable relationship between what all members contribute to the common fund and their expected participation in the fund.

Conclusion

There are a significant number of members who do not make a contribution into the common fund, yet are still entitled to receive standard membership benefits.

As such, there is a lack of common identity between members that receive benefits from the common fund (being all product holders) and those that contribute to the fund (being only those members who are holders of the Company’s original product). There is no reasonable relationship between what all members contribute to the common fund and their expected participation in the fund.

As a result, the principle of mutuality would not apply to amounts received by the Company for the sale of its original product, such that those amounts would be assessable for income tax purposes.

Question 2

Does the existence of a significant number of members of the Company that have membership voting rights with the Company through the purchase of a new product/service from one of the Company’s subsidiary companies preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Summary

The existence of a significant number of members of the Company that have membership voting rights with the Company through the purchase of a new product/service from the Company’s subsidiary company would preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product. As such, those amounts would be assessable for income tax purposes.

Detailed reasoning

As per the response to Question One, there are a significant number of members of the Company who do not make a contribution into the common fund, yet are still entitled to receive membership benefits. It was concluded in that response that the principle of mutuality would not apply to amounts received by member of the Company for the sale of the Company’s original product due to there being a lack of common identity between members that receive benefits from the common fund (being all product holders) and those that contribute to the fund (being only those members who are holders of the Company’s original product).

On the basis of that conclusion, and having regard to the fact that all product holders are now ordinary voting members of the Company – and that ordinary voting members have the right to vote at the Company’s general meeting – the common fund is not wholly controlled by the contributors due to the disparity between the contributors to the common fund and the participators in (beneficiaries of) the fund.

Therefore, the principle of mutuality would not apply to amounts received by the Company for the sale of its original product, such that those amounts would be assessable for income tax purposes.

Question 3

Does the existence of a significant number of members of the Company that are entitled to member benefits through the purchase of a new product/service from one of the Company’s subsidiary companies, and the changes to the business objectives for the Company’s original product following the membership changes, impede the association of members of the Company comprising the common fund from operating for the common purpose, and thus preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product (such that those amounts are assessable for income tax purposes)?

Summary

The existence of a significant number of members of the Company that are entitled to member benefits without making a direct contribution to the Company (through the purchase of a new product/service from one of the Company’s subsidiary companies), and the changes to the business objectives for the Company’s original product following the membership changes, would impede the association of members of the Company comprising the common fund from operating for the common purpose. This would thus preclude the application of the principle of mutuality to amounts received by the Company for the sale of the Company’s original product. As such, those amounts would be assessable for income tax purposes.

Detailed reasoning

Relevant law

In the Music Traders case, it was held by Davies J that the mutuality principle is based on an association of persons who have joined together, to achieve, through their mutual contributions, a common end or benefits (that is, a common purpose) in which all members participate (or are entitled to do so).

As per the ATO’s publication entitled ‘Mutuality and taxable income’ on the ATO’s website, and as held in the Music Traders case, not all dealings involving members are mutual dealings. In particular, the principle of mutuality does not apply to dealings between an organisation and members that go beyond a mutual arrangement and are in the nature of trade. In this situation, the fact an organisation is dealing with a member is not relevant.

The definition of 'business' under tax law includes 'a trade'. The terms 'business' and 'trade' are commonly used to refer to activities that are commercial in nature and intended to produce a profit. These activities are usually for a taxable purpose.

Lord Wilberforce in Fletcher v. Income Tax Commissioner (1971) 3 All ER 1185 (Fletcher) held that when an organisation transacts with its members, it must ask itself if the activity is either:

● a trade or something in the nature of trade producing a profit (a taxable purpose), or

● a mutual arrangement which, at most, gives rise to a surplus of funds to the organisation (a non-taxable purpose)?

Application of the relevant law to the Company’s circumstances

Members of the Company who are holders of the Company’s original product contribute to the common fund so as to participate in the benefits of that fund in the future. These members are making a contribution that is linked to the Company’s common purpose.

In contrast, the primary purpose of members purchasing a new product/service offered by one of the Company’s subsidiary companies is not to contribute to a common fund to advance the Company’s objects, but to obtain the benefits attached to that product as part of a commercial transaction for their own private use.

As the Company is changing its membership by including product holders whose underlying transaction with the Company is of a commercial nature, its membership and their objectives are becoming more commercial in nature.

This is particularly demonstrated by the Company attracting new and retaining existing business to its group through customers’ entitlement to membership benefits for no consideration upon the purchase of a new type of product/service through one of its subsidiary companies. It is considered that customers’ entitlement to membership benefits upon such purchases is predominantly acquired for their own private use rather than to contribute to advancing the Company’s objects.

Further, as a consequence of the Company’s implementation of the membership changes, and the change in the business objectives for the Company’s original product to a balance between profitability and member value, it is considered that the Company’s original product is becoming more of a commercial product.

There is a significant shift by the association of ordinary members comprising the common fund towards undertaking activities (that is, provision of member benefits) for commercial purposes rather than the common purpose.

Conclusion

Due to the significant number of members of the Company who do not make a contribution into the common fund; the change in business objectives of the Company’s original product to be more of a commercial product; and the Company’s membership becoming more commercial in nature, the association of members of the Company comprising the common fund no longer operates for the common purpose of its members.

Therefore, in applying the principles in Fletcher and Music Traders, it is considered that, following the implementation of the membership changes, given the commerciality of the Company’s original product, the Company’s activities now reflect a more ‘trade or profit’ nature as opposed to a ‘mutual, non-profit’ nature.

Consequently, the principle of mutuality would not apply to amounts received by the Company for the sale of its original product, such that those amounts would be assessable for income tax purposes.

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