Edited version of private advice

Authorisation Number: 1051617274331

Date of advice: 6 December 2019

Ruling

Subject: Mutuality principle

Question

Where an incorporated private company forms a tax consolidated group with a club as the head entity, will the principle of mutuality apply to the income received by the private company from members of the club?

Answer

No

This ruling applies for the following period

Year ending 30 June 20XX

The scheme commences on:

XX XXXX

Relevant facts and circumstances

The Club is a non-profit organisation.

The governing documents state that the Club is established as a social and sporting club.

The governing documents of the Club contain a suitable non-profit clause and winding up clause.

The governing documents contain rules concerning the management and control of the Club.

Full members of the Club are entitled to vote at Annual General Meetings or General Meetings of members. In these meetings elections to the Club Board are conducted.

The Club is a company limited by guarantee, and is taxable at the company tax rate however, the mutuality principle applies to relevant receipts.

A private company operates accommodation and its income is fully taxable. The Club owns the private company.

The Club is considering forming a tax consolidated group with the Club as the head entity and the private company as a subsidiary.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 701-1 of the Income Tax Assessment Act 1997

Reasons for decision

Principle of Mutuality

Section 6-5 of the ITAA 1997 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 (Scott v Federal Commissioner of Taxation (1966) 117 CLR 514).

The term income is not defined in the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997. In The Bohemians Club v The Acting Federal Commissioner of Taxation [1918] 24 CLR 334, Griffith CJ stated at 337-338:

A man is not the source of his own income, though in another sense his exertions may be so described. A man's income consists of moneys derived from sources outside himself. Contributions made by a person for expenditure in his business or otherwise for his own benefit cannot be regarded as his income unless the Legislature expressly so declares.

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 (Social Credit Savings and Loans Society Ltd v Federal Commissioner of Taxation (1971) 125 CLR 560).

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:

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...Incorporation of the fund is not relevant...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...Furthermore any contributions to the fund derived from sources other than the contributors' payments, such as interest from the investment of part of the fund, or income from a business activity conducted by the members, cannot be taken into account in computing the surplus...Also the cases establish that the principle cannot apply unless at any given point in time the contributors to the fund are identical with the beneficiaries of the distribution of the surplus.

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 in English and Scottish Joint Co-operative Wholesale Society Ltd v Assam Commissioner of Agricultural Income Tax [1948] 2 All ER 395 (Assam Tea). However it was concluded in Inland Revenue Commissioners v. Ayrshire Employers Mutual Insurance Association Ltd (1946) 1 All ER 637 that 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:

Cases in which groups of persons making contributions towards a common purpose have been held not liable for tax on any surplus over expenditure fall under a number of heads. The expression 'the mutuality principle' has been devised to express the basis for exemption of these groups from taxation. It is a convenient expression, but the situations it covers are not in all respects alike In some cases the essence of the matter is that the group of persons in question is not in any sense trading, so the starting point for an assessment for income tax in respect of trading profits does not exist. In other cases, there may be in some sense trading activity, but the objective or the outcome, is not profits, it is merely to cover expenditure and to return any surplus, directly or indirectly, sooner or later, to the members of the group. These two criteria often, perhaps generally, overlap; since one of the criteria of a trade is the intention to make profits, and a surplus comes to be called a profit if it derives from a trade. 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?

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

What is, and always has been, of significance is not the fact of membership or non-membership but the nature of the transactions: if these were trading transactions, the addition of membership makes no difference.

The Privy Council considered whether a company could derive a profit from its members in 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:

...the society is incorporated in the United Kingdom under the Industrial and Provident Societies Act, 1893. It has an unlimited capital divided into shares of £5 each... Its objects, as set out in its rules, inter alia, are: 'To carry on the business of planters, growers, producers, merchants and manufacturers and brokers of tea.' The society consists of two members, viz., the Co-operative Wholesale Society, Ltd. and the Scottish Co-operative Wholesale Society, Ltd. The society owns the Deckiajuli estate where it grows and manufactures tea. Except a small portion of produce, which is unfit for export and which is sold locally, the whole of the society's output of tea is sold to its two members at market rates and is exported to England and Scotland. Each year the members of the society pay, by way of advances to the society, sums of money to meet the cost of tea supplied by the society to the members. The market prices of the tea, with which the members are supplied, are debited against these payments. The supplies are recorded as sales to the members. Out of the proceeds from the sales, the expenses of production and management and the interest on loans are paid or provided. By the rules of the society its net profits are applied (a) in depreciation of land... (b) payment of interest not exceeding 6 per cent. per annum on the share capital; (c) appropriation to a reserve fund; (d) appropriation to a special fund for making grants as determined in general meeting; (e) payment of a dividend to members rateable in proportion to the amount of purchases made by them from the society; and (f) the remainder, if any, carried forward to the next account.

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):

The application of net profits... is, in essentials, not different from the application of net profits which might be made by any trading company, and it need not result in the distribution of all profits among the members of the society. Thus, any net profits applied under heads (a), (c), (d) and (f) would be retained by the appellant society. When the constitution, rules and business practice of the appellant society so closely conform to the pattern of an ordinary profit-making concern, how can it plausibly be maintained that no profits can result?

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 inposing 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:

The fee paid by the organisers of the fair to the Association was not a fee payable by members of the Association into a common fund. And the fair, though it benefited members of the association, was not a mutual, non-profit activity. Its essence was that of trading for profit by individual traders, though through the medium of a common activity, the fair.

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 point, of course, is that the decisions made by individual members as to the extent of their payments depended not upon any wish or need to make members' contributions to the Association but rather upon the display space which they wished to take.

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 Club member's purpose in paying for the accommodation is to contribute to a 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 purchase of accommodation) and it is in the nature of trade.

The purpose of the proprietary company inferred from its activities, is to provide accommodation at a commercial rate. For the payment of a fee, people receive accommodation at the private company; they do not receive any rights or entitlements in the Club. Membership in the Club, by a person purchasing accommodation, does not change this purpose.

As such, buyers of accommodation from the proprietary company make the purchase for the purpose of receiving accommodation. The payment (purchase of accommodation) is not a contribution to the common fund of the Club (it is not a contribution for the Club's common purpose).

Further, the contribution from the purchasers of accommodation is not a contribution to a common fund held by the proprietary company that would satisfy the principle of mutuality.

If the proprietary company is said to have a fund, payments made to purchase accommodation would be the contributions to the fund, and the contributors would be the people who buy accommodation.

However, for the principle of mutuality to apply the following elements are required:

·         There must be contributors to the common fund for the common purpose

·         The contributors must participate or be entitled to participate in the common purpose

·         The contributors must control and have an interest in the common fund for the common purpose

·         There must be identity between those that contribute to the common fund and those that participate in the common fund.

The contributors to the proprietary company's fund (the purchasers of accommodation) are not entitled to control or share in the surplus of the fund. The proprietary company is a wholly owned subsidiary of the Club and it is the Club that controls and shares in the surplus of the proprietary company. As such, there is no identity between the contributors to the proprietary company (people purchasing accommodation) and those that control and share in the fund (the Club).

The principle of mutuality does not apply to funds paid by purchasers of accommodation to the proprietary company; there is no identity between the contributors to the common fund and those that benefit from the common fund.

Conclusion - mutuality principle

The purchase of accommodation from the proprietary company by Club Members is not considered to be a mutual dealing because:

·         The transactions are for the purchase of accommodation, and people who buy accommodation receive no rights or entitlements in respect of the Club. A payment for accommodation at the proprietary company is not a contribution to the common fund of the Club.

·         If the purchase of accommodation from the proprietary company gives rise to a fund, there is no identity between the people that buy accommodation at the proprietary company (the contributors) and the people that control and benefit from the proprietary company (the Club).

Intention to Form a Consolidated Group

The Club is established as a company limited by guarantee. Its subsidiary is a proprietary company and there is an intention to form a consolidated group but this does not alter the nature of the transactions being business dealings in the nature of trade.

Detailed reasoning

The principle of mutuality and its application to the head company of a consolidated group needs to be viewed within the context of the Single Entity Rule (SER) in section 701-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Section 701-1 of the ITAA 1997 provides:

701-1 Single entity rule

701-1(1) If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period.

The meaning and application of the SER are considered in Taxation Ruling 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997. The ruling explains the SER principle and its application to members of consolidated groups as follows:

3. Section 701-1 of the ITAA 1997 is a key provision of the consolidation regime. It is the means by which the members of a consolidated group are treated as a single entity (being the head company) for income tax purposes.

4. The intended operation of the SER is to apply the income tax laws to a consolidated group as if it were a single entity.

...

Consequences of the SER

7. For income tax purposes the SER deems subsidiary members to be parts of the head company rather than separate entities during the period that they are members of the consolidated group.

8. As a consequence, the SER has the effect that:

(a) the actions and transactions of a subsidiary member are treated as having been undertaken by the head company;

(b) the assets a subsidiary member of the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group;

...

17. The principle underlying the SER is to treat a consolidated group as a single entity, with the head company being that entity for income tax purposes. To this end the SER deems the subsidiary members of the consolidated group to be parts of the head company rather than separate entities.

Where a mutual association forms a consolidated group with its subsidiary, the SER applies to treat the subsidiary as part of the head mutual association (Head Company). Any transactions of the subsidiary will be treated as transactions of the Head Company.

Paragraph 31 of TR 2004/11 explains as follows:

31. A consequence flowing from the SER is that while an entity is a subsidiary member of a consolidated group, actions and transactions of that member are treated as having been undertaken by the head company. In addition, the assets owned by subsidiary members of the group are taken to be owned by the head company.

However, not all receipts from club members will be mutual receipts, and it is necessary to consider the nature of the transaction to determine if a receipt is a mutual receipt. In North Ryde RSL Community Club Ltd v FC of T 2002 ATC 4293 the court stated

... not all receipts by a club from members or from a third party on account of services or facilities made available to members are necessarily mutual receipts... They may be no more than trading receipts. It is the nature of the actual transactions in question, and not the fact that a benefit was received or a service used by members that will determine whether receipts derived are liable to, or immune from, tax (at 4306).

In considering the nature of the transaction Lord Wilberforce in Fletcher v Income Tax Commissioner (1971) 3 ALL ER 1185 drew a distinction between mutual activity and trading activity, and stated (at 1189):

...the issue is better framed as one question...: 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?

Under the proposed arrangement the Club as a company limited by guarantee and the proprietary company wholly owned by the Club will form a consolidated group. The Club will be the head company of the consolidated group with the Company as the subsidiary. In accordance with the SER, the transactions/receipts of the Company will be treated as transactions/receipts of the Club.

Whether the amounts paid by members of the Club to the Company for accommodation operated by the subsidiary company are mutual receipts depends on the nature of the transaction giving rise to the receipt. Each transaction must be considered separately.

Based on the discussion of the mutuality principle earlier, these payments are not considered to have the character of mutual receipts. They are not contributions to a common fund for a common purpose they are in the nature of trade.

Conclusion

It is not accepted that the mutuality principle applies to the monies received by the subsidiary company in relation to members' accommodation charges. These monies are assessable as income under section 6-5.