Edited version of private ruling

Authorisation Number: 1011628791709

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Ruling

Subject: Mutuality

What this ruling is about:

Are the Termination Fees paid by members of Mutual when transferring their entitlements outside the membership base, subject to the principles of mutuality in the circumstances where the member paying the Termination Fee will remain a member (albeit an inactive member) of the Mutual?

Ruling:

Are the Termination Fees paid by members of Mutual when transferring their entitlements outside the membership base, subject to the principles of mutuality in the circumstances where the member paying the Termination Fee will remain a member (albeit an inactive member) of the Mutual?

Answer:

No, the Termination Fees are not subject to the principle of mutuality when the member paying the Termination Fee will remain a member (albeit an inactive member) of the Mutual.

Year(s) of income or period(s) to which this ruling applies:

1 July 2007 to 30 June 2008

1 July 2008 to 30 June 2009

Commencement date of scheme:

1 July 2007

The scheme that is the subject of the ruling:

The Mutual is a non trading co-operative responsible for the replacement and refurbishment of the asset infrastructure for the benefits of members and to provide future funding for the replacement and refurbishment of the asset infrastructure.

The Mutual is seeking a private binding ruling (PBR) confirming that the principal of mutuality applies to Termination Fees paid by members when transferring their entitlements outside of the membership base, when the member paying the Termination Fee will remain a member (albeit an inactive member) of the Mutual.

The members of the Mutual pay an annual levy. The levies are to be used to finance the future replacement of the long life (up to 100 years) asset infrastructure for the benefit of the current and future members of the Mutual. These levies are considered mutual income and are exempt from income taxation.

The members of the Mutual are charged the levy in proportion with the members' holdings of entitlements.

The situation has arisen, and will continue to arise, where a member of the Mutual will sell all, or a portion of, their entitlements to purchasers outside the Mutual's membership base.

This has raised a problem for the Mutual in that the whole infrastructure is required to be maintained even though there may be less members contributing to the maintenance of the infrastructure by paying ongoing levies.

Therefore a special levy (Termination Fee) is charged where a member sells an entitlement to a body outside of the Mutual's membership. The quantum of the termination fee/levy bears relationship to the annual levy paid by the member and the charging methodology is approved by the Australian Competitor & Consumer Commission (ACCC).

Membership

The Mutual's rules provide that a member is an active member if the member is an active member of an Associated Entity and the member pays a membership fee to the Mutual each year. The membership is cancelled if the member is not presently an active member and has not been an active member at any time during the past two (2) years immediately before the date of cancellation.

The Mutual's rules is consistent with section 127 of the Co-operatives Act 1992 which provides that a Board of a co-operative must declare the membership of a member cancelled if a member is not currently an active member of the co-operative and the member has not been an active member of the co-operative at any time during the required period immediately before that time. Subsection 127(6) of the Co-operatives Act 1992 provides that the required period may be three (3) years or such shorter period as is specified in the rules of the co-operative.

As a consequence of the transfer of all of the member's entitlements, and the cancellation of the associated delivery entitlements, to a purchaser who is outside the membership base of the Mutual, the member will become an inactive member of the Mutual.

The rights of an active member and inactive member in the Mutual are identical in all respects except that an inactive member is unable to vote at a general meeting or be a director of the Mutual. Only active members of a co-operative are eligible to vote or be directors of a co-operative.

If a member of the Mutual remains inactive in the Entity for a period of two (2) years, the Board must declare the membership of the member cancelled. At any time during the two (2) year period, an inactive member may again become an active member of the Entity by for example becoming an active member of the Mutual.

Relevant provisions:

Income Tax Assessment Act 1997 Section 59-35.

Income Tax Assessment Act 1997 Section 6-5.

Explanation: (This does not form part of the notice of private ruling)

Are the Termination Fees paid by members of Entity when transferring their entitlements outside the membership base, subject to the principles of mutuality in the circumstances where the member paying the Termination Fee will remain a member (albeit an inactive member) of the Entity?

Mutuality

Case Law Overview

Mutuality is a common law principle developed in the United Kingdom and first considered in connection with mutual insurance companies.

A number of authorities have established the application of the mutuality principle in Australia. They include The Bohemians Club v. Acting Federal Commissioner of Taxation (1918) 24 CLR 334 (the Bohemians Club Case), Revesby Credit Union Co-operative Ltd v. FC of T (1965)112 CLR 564 (the Revesby Credit Case), The Social Credit Savings & Loan Society Ltd v. FC of T (1971) 125 CLR 560; (1971) 2 ATR 612; 71 ATC 4232 (the Social Credit Case), Sydney Water Board Employees Credit Union Ltd v. FC of T (1973) 129 CLR 446; (1973) 4 ATR 157; 73 ATC 4129 (the Sydney Water Case), R.A.C.V. v. FC of T (1973) 4 ATR 567; 73 ATC 4153 (the RACV Case), and FC of T v. Australian Music Traders Association (1990) 21 ATR 471; 90 ATC 4536 (the Music Traders Case).

The principle is based on the proposition that accretions to a common fund are not income: income is not derived by adding to one's own funds. In the case of entities with members, the principle recognises that contributions by the members to their own common funds are not in the nature of income because 'income consists of monies derived from sources outside of the taxpayer' (the Bohemians Club Case at 337).

The basic formulation of the mutuality principle is that any surplus that arises from the contributions of members to a mutual association is not assessable income, because it merely represents, in substance, the contributors' own unexpended money. Whether a mutual association exists between persons depends upon the nature of their relationship, and whether amounts are accretions to a common fund depends on the nature of their transactions and dealings.

A mutual association has all of the following essential characteristics:

§ a voluntary association of persons (contributors) who make contributions out of their own moneys to a common fund (which they create, own, control and all have an interest in) for a common purpose (which may also be for their personal benefit as participators) and that purpose is not undertaken for profit (merely to cover expenses);

§ contributions are based on an estimate of expected expenses of the common purpose (mutual liabilities), and are made on the stipulation that any surplus (the unused or unexpected amount) will be, sooner or later, returned/repaid to the contributors (in their capacity as contributors) in some form or other (however under section 59-35 of the Income Tax Assessment Act 1997 (ITAA 1997) an amount of ordinary income is non-assessable non-exempt income where the only thing preventing it from being a mutual receipt is a prohibition on actual distribution to the members);

§ complete identity as a class between the contributors and the participators; and

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

Other propositions developed by the case authorities relevantly include the following:

§ being a member in a formal or company law sense is not essential provided that the contributors (as a class) are entitled to get their surplus contributions back (see Faulconbridge v National Employers' Mutual General Insurance Association Ltd [1952] 33TC103).

§ it is possible for a mutual association to also engage in business activities with members and with outsiders in addition to its mutual dealings with members. The excess generated from such business dealings with members and non-members will be income, severable from any mutual receipts and assessable to the mutual concern.

§ contractual payments or subscriptions paid by individual members which afford them benefits individually rather than through effectuating a common purpose are not contributions to a common fund e.g. the Sydney Water Case (interest payments to discharge legal obligations under individual contracts of loan to members were not mutual receipts).

§ the return of surplus to the contributors need not occur on an annual or other scheduled basis, nor must it be returned in any particular form. All that is required is the collective entitlement that it be returned 'sooner of later, in meal or in malt' (see Jones v. The South-West Lancashire Coal Owners Association Ltd (1927) 11 TC 790 (the Jones Case) per Viscount Cave at 832). Therefore, the application of contributions/surplus to build up reserves need not displace the presence of mutuality. See also Taxation Ruling IT 2505.

§ the incorporation of an association 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. However, mutuality will not apply if the corporation has its own independent existence separate from its members. A company can make assessable profits from trading, even exclusively, with its own members. (See The Liverpool Corn Trade Association, Limited v Monks (H M Inspector of Taxes) - 10 TC 442; English and Scottish Joint Co-operative Wholesale Society Ltd. v. Commissioner of Agriculture Income-Tax, Assam (1948) AC 405 (the Assam Tea Case).) See also TR 2004/5.

§ if the true nature of the transactions/dealings of the association amounts to the carrying on of a trading operation for profit, the mutuality principle will not apply to proceeds of such dealings with members: see Fletcher v. Income Tax Commissioner (Jamaica) [1971] 3 All ER 1185.

However, an entity's dealings with its members are not always mutual.

There is a point at which the relationship of mutuality ends and that of trading begins. Lord Wilberforce in Fletcher v. Income Tax Commissioner 1972 A.C.414 at page 421 stated -

So the issue is better framed as one question rather than two: 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.

It is accepted that a corporation can make a taxable profit from dealings even if it is limited to dealing with its members. In English and Scottish Joint Co-operative Wholesale Society Ltd. v. Commissioner of Agriculture Income-Tax, Assam (1948) AC405 an incorporated society which produced tea and sold it predominantly to its members at a market value was taxable on those profits there being no common fund to which members contributed and participated. In Liverpool Corn Trade Association Limited v. Monks 1926 2 KB 110 it was held that the principle of mutuality did not apply to an association that provided a corn exchange, market, newsroom and facilities for carrying on a business to both members and non-members on the basis it carried on a trade.

However, in Jones (Inspector of Taxes) v South-West Lancashire Coal Owners' Association Ltd [1927], 11 TC 790, a company limited by guarantee insured members (mining companies) in respect of fatal accidents to workmen. Contributions were calculated in proportion to wages bills. Surpluses were transferred annually to reserve. Members were called to provide extra funds if a deficit arose. It was held that the association was not liable to tax in respect of the surplus of contributions over expenses.

In Federal Commissioner of Taxation v. Australian Music Traders Association (Music Traders) 90 ATC 4536, Davies J at 4528:

The activities with which we are concerned in this appeal centre around the holding of a music traders' trade fair. In years prior to the subject year of income, the Association itself organised the trade fairs and leased stalls to music traders. Although the rental received by the Association from such stall-holders as were members of the Association was accepted by the Commissioner of Taxation to be mutual, nevertheless, as the individual traders displayed and sold their wares to members of the public, it may be doubted whether the fairs had a mutual character. Each trader, many of whom were not members of the Association, carried on his individual business. The rental paid was calculated according to the space occupied and was the charge made for the space leased by the stall-holder for the purposes of his own business activity. Even in respect of those years, it is difficult to distinguish the facts from those which were the subject of the decisions in the Assam Tea case and Sydney Water Board.

In Sydney Water Board Employee's Credit Union Ltd v F C of T Mason J when determining that the principle had no application to a credit union with borrowing and depositing members looked at the nature of the payments made by contributing members. He determined that the payment was made out of a legal obligation and not to meet a mutual liability. At page 4136 he stated -

payment by a borrower is not in any sense a pre-estimate of the amount which will be required to meet his proportion of mutual liabilities incurred on behalf of all borrowers.

In Re Ku-Ring-Gai Co operative Building Society (No 12) Ltd. (1978) 36 FLR 134 the court determined that the mutuality principle applied notwithstanding that the lending of money, receipt of payments and the like have a regularity that is the hallmark of a trade. It was stated at page 142 that -

The presence of that mutuality may be derived from a whole complex of factors, not solely the absence of profit. It excludes the commercial element which is a necessary part of trade or commerce.

Application to the Entity's termination payments by 'inactive members'

Inactive membership is not defined in the rules of either the Entity or the Associated Entity's rules or in the Co-operatives Act 1992. Inactive members by deduction are members who are not active members and whose membership may not be cancelled under the Entity's rules.

The expenditure to which the fees are to be ultimately applied goes beyond mere administrative costs associated with 'termination' of delivery entitlements. The fees become part of the pool of funds to be used for the Entity's primary activity - replacement and refurbishment of its infrastructure and the management of the sinking fund. Inactive members, in comparison to active members could not be said to benefit from the termination fee contribution. The contribution has in effect been paid to meet the mutual liabilities of the active members. Any future benefit should the inactive member become an active member is no more than a non-member becoming an active member.

It is accepted that a termination fee, if received from an 'inactive' member may have mutual features:

§ all members contribute to the Entity's fund

§ the charges are based on an estimate of expected future outlays and bear the burden of its costs as members.

§ in the hypothetical situation that members could access surplus funds, in the absence of rules in the constitution providing for the distribution of surpluses, the common law would most likely provide that any surplus should be distributed in accordance with members' contributions.

It is considered however that the termination fees as described in the arrangement are not mutual receipts in terms of section 59-35 of the ITAA 1997 as:

§ there is not a complete identity as a class between the contributors (the 'inactive' members and the active members) and the participators (the active members); and

§ there is no reasonable relationship between what an 'inactive' member contributes and what an 'inactive' member may be expected or entitled to receive in respect of the fund to which they have contributed; including any notional amount that may be received on winding up.

Conclusion

The Termination Fees paid by members of the Entity when transferring their entitlements outside of the membership base of the Entity, are not considered to be subject to the principles of mutuality in the circumstances where the member paying the Termination Fee will remain a member (albeit an inactive member) of the Entity.