Whether when assessee-club places surplus funds in form of FDs with its member-banks to earn interest income, since such funds are loaned out to third parties for earning higher interest income, it violates privity of mutuality - YES: SC

THE issues before the Bench are - Whether when the assessee-club places its surplus funds in the form of FDs with its member-banks to earn interest income, since such funds are loaned out to third parties for earning higher interest income, it violates the privity of mutuality; Whether in such a case there is a lack of identity between the contributors and the participators and Whether when the banks loan out the funds placed by the assessee to third parties it can be said that the funds were not utilied for the benefit of its members and thus went beyond the principle of mutuality. And the verdict goes in favour of the Revenue.

Facts of the case

The Bangalore Club, the appellant, is an unincorporated Association of Persons, (AOP). In relation to the assessment years 1989-90, 1990-91, 1993-94, 1994-95, 1995- 96, 1996-97, 1997-98, 1998-99 and 1999-2000, the assessee sought an exemption from payment of income tax on the interest earned on the fixed deposits kept with certain banks, which were corporate members of the assessee, on the basis of doctrine of mutuality. However, tax was paid on the interest earned on fixed deposits kept with non-member banks. The assessing officer rejected the assessee’s claim, holding that there was a lack of identity between the contributors and the participators to the fund, and hence treated the amount received by it as interest as taxable business income. On appeal by the assessee, the Commissioner of Income Tax (Appeals)-II, Bangalore reversed the view taken by the assessing officer, and held that the doctrine of mutuality clearly applied to the assessee’s case. On appeal by the revenue the Income- Tax Appellate Tribunal, affirmed the view taken by the CIT (A).

On appeal, answering both the questions in favour of the revenue, the High Court reversed the decision of the Tribunal and restored the order of the assessing officer. Hence, this appeal by the assessee.

On appeal to the Apex Court, the counsel for the assessee argued that the assessee met all the requirements, as laid down in The English & Scottish Joint Co-operative Wholesale Society Ltd. Vs. The Commissioner of Agricultural Income Tax, Assam AIR 1948 PC 142 (E), as affirmed by this Court in Chelmsford Club Vs. Commissioner of Income Tax, Delhi (2002-TIOL-687-SC-IT) in order to fall within the ambit of the principle of mutuality. According to the counsel, there was a complete identity between the contributors to the fund and the assessee and the recipients from the funds, in as much as the interest earned by the assessee from the surplus fund invested in fixed deposits with member banks were always available and were used for the benefit of members alike. It was asserted that there was no commercial motive involved in the dealings of the assessee with its members, including the banks concerned. It was also argued that the interest earned on such deposits with the member banks was always available for use and benefit of the members of the assessee, in as much as the said interest merged with the common fund of the club.

The ASG, on the other hand, contended that the fundamental principle for applicability of the doctrine of mutuality is a complete identity between the contributors and the participators, which was missing in this case. It was submitted that in the present case, the surplus funds in the hands of the assessee were placed at the disposal of the corporate members viz. the banks, with the sole motive to earn interest, which brought in the commerciality element and thus, the interest so earned by the assessee had to be treated as a revenue receipt, exigible to tax. It was pleaded that transaction between the assessee and the member banks concerned was in the nature of parking of funds by the assessee with a corporate member and was nothing but what could have been done by a customer of a bank and therefore, the principle that “no man could trade with himself” was not applicable.

Having heard the parties, the Apex Court held that,

++ the principle of mutuality relates to the notion that a person cannot make a profit from himself. An amount received from oneself is not regarded as income and is therefore not subject to tax; only the income which comes within the definition of Section 2(24) of the Act is subject to tax (income from business involving the doctrine of mutuality is denied exemption only in special cases covered under clause (vii) of Section 2 (24) of the Act). The concept of mutuality has been extended to defined groups of people who contribute to a common fund, controlled by the group, for a common benefit. Any amount surplus to that needed to pursue the common purpose is said to be simply an increase of the common fund and as such neither considered income nor taxable. Over time, groups which have been considered to have mutual income have included corporate bodies, clubs, friendly societies, credit unions, automobile associations, insurance companies and finance organizations. Mutuality is not a form of organization, even if the participants are often called members. Any organization can have mutual activities. A common feature of mutual organizations in general and of licensed clubs in particular, is that participants usually do not have property rights to their share in the common fund, nor can they sell their share. And when they cease to be members, they lose their right to participate without receiving a financial benefit from the surrender of their membership. A further feature of licensed clubs is that there are both membership fees and, where prices charged for club services are greater than their cost, additional contributions. It is these kinds of prices and/or additional contributions which constitute mutual income;

++ the doctrine of mutuality finds its origin in common law. One of the earliest modern judicial statements of the mutuality principle is by Lord Watson in the House of Lords, in 1889, in Styles (Surveyor of Taxes) Vs. New York Life Insurance Co. [1889] 2 TC 460;

++ one of the first Indian cases that dealt with the principle was Commissioner of Income-Tax, Bombay City Vs. Royal Western India Turf Club Ltd. AIR 1954 SC 85. It quoted with approval three conditions stipulated in The English & Scottish Joint Co-operative Wholesale Society Ltd. The first condition requires that there must be a complete identity between the contributors and participators. In short, there has to be a complete identity between the class of participators and class of contributors; the particular label or form by which the mutual association is known is of no consequence. Therefore, in the case of Royal Western India Turf Club Ltd. , since the club realized money from both members and non- members, in lieu of the same services rendered in the course of the same business, the exemption of mutuality could not be granted;

++ the second feature demands that the actions of the participators and contributors must be in furtherance of the mandate of the association. In the case of a club, it would be necessary to show that steps are taken in furtherance of activities that benefit the club, and in turn its members. Therefore, in Chelmsford Club , since the appellant provided recreational facilities exclusively to its members and their guests on “no-profit-no-loss” basis and surplus, if any, was used solely for maintenance and development of the club, the Court allowed the exception of mutuality;

++ the mandate of the club is a question of fact and can be determined from the memorandum or articles of association, rules of membership, rules of the organization, etc. However, the mandate must not be construed myopically. While in some situations, the benefits may be evident directly in the short-run, in others, they may be accruable to an organization indirectly, in the long-run. Space must be made for both such forms of interactions between the organization and its members. Therefore, as Finlay J. observed in National Association of Local Government Officers Vs. Watkins (1934) 18 TC 499; 503, 506, where member of a club orders dinner and consumes it, there is no sale to him. At the same time, as in case of Commissioner of Income Tax, Bihar Vs. Bankipur Club Ltd. (2002-TIOL-834-SC-IT), where a club makes ‘surplus receipts’ from the subscriptions and charges for the various conveniences paid by members, even though there is no direct benefit of the receipts to the customers, the fact that they will eventually be used in furtherance of the services of the club must be considered as a furtherance of the mandate of the club;

++ thirdly, there must be no scope of profiteering by the contributors from a fund made by them which could only be expended or returned to themselves. The locus classicus pronouncement comes from Rowlatt, J’s observations in Thomas Vs. Richard Evans & Co. Ltd. (1927) 11 TC 790 wherein, while interpreting Styles case, he held that if profits are distributed to shareholders as shareholders, the principle of mutuality is not satisfied;

++ in the present case, the assessee is an AOP. The concerned banks are all corporate members of the club. The interest earned from fixed deposits kept with non- member banks was offered for taxation and the tax due was paid. Therefore, we are required to examine the case of the assessee, in relation to the interest earned on fixed deposits with the member banks, on the touchstone of the three cumulative conditions, enumerated above. Firstly, the arrangement lacks a complete identity between the contributors and participators. Till the stage of generation of surplus funds, the setup resembled that of a mutuality; the flow of money, to and fro, was maintained within the closed circuit formed by the banks and the club, and to that extent, nobody who was not privy to this mutuality, benefited from the arrangement. However, as soon as these funds were placed in fixed deposits with banks, the closed flow of funds between the banks and the club suffered from deflections due to exposure to commercial banking operations. During the course of their banking business, the member banks used such deposits to advance loans to their clients. Hence, in the present case, with the funds of the mutuality, member banks engaged in commercial operations with third parties outside of the mutuality, rupturing the ‘privity of mutuality’, and consequently, violating the one to one identity between the contributors and participators as mandated by the first condition. Thus, in the case before us the first condition for a claim of mutuality is not satisfied;

++ the second condition demands that to claim an exemption from tax on the principle of mutuality, treatment of the excess funds must be in furtherance of the object of the club, which is not the case here. In the instant case, the surplus funds were not used for any specific service, infrastructure, maintenance or for any other direct benefit for the member of the club. These were taken out of mutuality when the member banks placed the same at the disposal of third parties, thus, initiating an independent contract between the bank and the clients of the bank, a third party, not privy to the mutuality. This contract lacked the degree of proximity between the club and its member, which may in a distant and indirect way benefit the club, nonetheless, it cannot be categorized as an activity of the club in pursuit of its objectives. It needs little emphasis that the second condition postulates a direct step with direct benefits to the functioning of the club. For the sake of argument, one may draw remote connections with the most brazen commercial activities to a club’s functioning. However, such is not the design of the second condition. Therefore, it stands violated;

++ the facts at hand also fail to satisfy the third condition of the mutuality principle i.e. the impossibility that contributors should derive profits from contributions made by themselves to a fund which could only be expended or returned to themselves. This principle requires that the funds must be returned to the contributors as well as expended solely on the contributors. True, that in the present case, the funds do return to the club. However, before that, they are expended on non- members i.e. the clients of the bank. Banks generate revenue by paying a lower rate of interest to club-assessee, that makes deposits with them, and then loan out the deposited amounts at a higher rate of interest to third parties. This loaning out of funds of the club by banks to outsiders for commercial reasons, in our opinion, snaps the link of mutuality and thus, breaches the third condition;

++ there is nothing on record which shows that the banks made separate and special provisions for the funds that came from the club, or that they did not loan them out. Therefore, clearly, the club did not give, or get, the treatment a club gets from its members; the interaction between them clearly reflected one between a bank and its client. This directly contravenes the third condition as elucidated in Styles and Kumbakonam Mutual Benefit Fund Ltd. cases. Rowlatt J., in our opinion, correctly points out that if profits are distributed to shareholders as shareholders, the principle of mutuality is not satisfied;

++ we may add that the assessee is already availing the benefit of the doctrine of mutuality in respect of the surplus amount received as contributions or price for some of the facilities availed by its members, before it is deposited with the bank. This surplus amount was not treated as income; since it was the residue of the collections left behind with the club. A façade of a club cannot be constructed over commercial transactions to avoid liability to tax. Such setups cannot be permitted to claim double benefit of mutuality. We feel that the present case is a clear instance of what this Court had cautioned against in Bankipur Club;

++ in our opinion, unlike the aforesaid surplus amount itself, which is exempt from tax under the doctrine of mutuality, the amount of interest earned by the assessee from the afore-noted four banks will not fall within the ambit of the mutuality principle and will therefore, be exigible to Income-Tax in the hands of the assessee-club.