House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 2 - Extension of mutuality principle

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure certain not-for-profit entities are not subject to tax on income as a result of the Federal Court of Australia (the Federal Court) decision in Coleambally Irrigation Mutual Co-Operative Ltd v Commissioner of Taxation
[2004] FCAFC 250 (7 September 2004) ( Coleambally ). The amendments effectively restore the longstanding benefits of the mutuality principle to those not-for-profit entities affected by the Coleambally decision.

2.2 Under the mutuality principle, a long established principle in tax law, membership subscriptions and receipts from other mutual dealings with members are not usually included in taxable income. Not-for-profit entities that benefit from the mutuality principle include clubs, professional associations and some friendly societies.

2.3 The Federal Court decision in Coleambally held that the principle of mutuality does not apply where the members of an entity are prevented from obtaining the value of the entity's assets. This, in effect, excludes the application of the mutuality principle to not-for-profit entities.

Context of amendments

2.4 Mutuality is a legal principle based on the proposition that a taxpayer cannot derive income from itself. Under the mutuality principle, if members contribute to a common fund created and controlled by them for a common purpose, and those contributing members are essentially the same as those who participate in the fund, then the member contributions and receipts from member dealings are not taxable income. Under the principle of mutuality, all or essentially all, the contributors to a common fund must be entitled to participate in any surplus of the common fund. ^[F1]

2.5 However, in order to qualify as a not-for-profit entity under state and territory legislation, an entity's constituent documents must prohibit the distribution of surplus funds to members, either on a winding up or during operation of the entity.

2.6 The Australian Taxation Office's (ATO) longstanding practice has been to treat the mutuality principle as applying to not-for-profit community organisations (eg, licensed clubs, clubs for particular activities such as motorcycle clubs, craft clubs and animal breeding societies, professional associations, medical defence organisations and friendly societies to the extent that their receipts do not relate to life insurance), despite the inclusion of clauses that prohibit the distribution of surplus funds to members.

2.7 The application of this ATO practice was called into question by the Coleambally decision of the Federal Court. The Federal Court found that the clauses that prevented a cooperative from distributing its surplus funds to members precluded the mutuality principle from applying. The Federal Court held that the clauses broke the connection between those who contribute to the fund and those who participate in the fund. In effect, this means that not-for-profit entities are not covered by the mutuality principle. The ATO estimates that some 200,000 to 300,000 not-for-profit entities would be affected.

Summary of new law

2.8 These amendments ensure that not-for-profit entities are not subject to income tax on ordinary income from their members solely because they are prohibited from distributing surplus funds to members. Ordinary income of a not-for-profit entity from members that, but for clauses prohibiting distribution of funds to members, would have been mutual receipts is non-assessable non-exempt income.

Comparison of key features of new law and current law

Detailed explanation of new law

2.9 Contrary to the ATO's longstanding practice, the Federal Court decision in Coleambally held that the principle of mutuality does not apply where the members of an entity are prevented from obtaining the value of the entity's assets, effectively excluding the application of the principle to not-for-profit entities (such as those listed in paragraph 2.6). These are entities that have been established by members for a common purpose and not for the purpose of profit.

2.10 Mutual receipts are those receipts arising out of mutual dealings. ^[F2] The receipts that are to be considered mutual include those receipts from members in respect of:

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dealings for membership; or

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goods and services provided by the entity in mutual dealings in pursuance of one of its purposes.

2.11 If the only thing preventing an amount of ordinary income from being a mutual receipt is the fact that the entity's constituent document prevents the entity from making any distribution whether in money, property or otherwise to its members, then the amount is non-assessable non-exempt income. [Schedule 2, item 3, section 59-35]

2.12 Income that is already statutory income is not affected. Such amounts do not become non-assessable non-exempt income. An example of such a statutory income provision is section 119 of Division 9 of Part III of the Income Tax Assessment Act 1936 - Co-operative and Mutual Companies.

Application and transitional provisions

2.13 These amendments have no adverse effect on taxpayers and simply reinstate the previously accepted treatment prior to the Coleambally decision that income received by not-for-profit entities, such as from membership subscriptions, was treated as mutual receipts and not as assessable income. The amendments provide that these amounts are treated as non-assessable non-exempt income.

2.14 These amendments are retrospective to 1 July 2000 as they are designed to ensure the taxation status of not-for-profit entities is not adversely affected by the Federal Court's decision in Coleambally , and will cover the ATO's four-year time limit for the amendment of assessments.

Consequential amendments

2.15 Section 11-55 lists the provisions in the ITAA 1997 which make amounts non-assessable non-exempt income. A new table item is included to indicate the provision which affects amounts that would be mutual receipts but for the distribution prohibition. [Schedule 2, item 1 , ' mutual receipts' in the table]

2.16 Section 25-75 allows an entity to deduct rates and land taxes if its premises are used in producing mutual receipts. In order to restore the tax treatment of not-for-profit entities affected by the Coleambally decision, this section is extended to the use of premises in producing amounts that would be mutual receipts but for the distribution prohibition. [Schedule 2, item 2, paragraphs 25-75(1 )( e) and (f )]