The Hindu Business Line : Mutuality revisited

The hallmark of mutuality is that it must be a closed club whose doors are not open to outsiders either for contribution to capital or for enjoyment of the fruits of its labour.

S. Murlidharan

In Chelmsford Club vs CIT (2000 109 Taxmann 215), the Supreme Court held that rent received from club members towards hiring of rooms was not the income of the club for the simple reason that there was a complete identity between the contributors of the funds and participants in the income of the club.

This then is the principle of mutuality — no man can make profit from himself. The key requirement of course is complete identity between contributors and participants. This, however, does not mean that there should be a one-to-one relationship between the contributions made and the benefits enjoyed by a member of a mutual association — what is required is that members as a class should contribute to a common fund and participants as a class must be able to participate in the surplus (UP State Nagariya Sahkari Bank Ltd vs ITO 2007 108 ITD 332 Lucknow).
For members only

The accent is, therefore, on class and not on individual members. Thus a residents’ welfare association would make the grade as mutuality for tax exemption only if its surplus arose out of the contributions made by members alone, because the benefits accruing from the activities of the association are meant strictly for members and their families.

However, should the association receive contributions from outsiders by way of advertisements in the souvenir brought out by the association on some occasion, such mutuality would be lost and, hence, strictly speaking the association would have to offer its income to tax.

The hallmark of mutuality is that it must be a closed club whose doors are not open to outsiders either for contribution to capital or for enjoyment of the fruits of its labour. Thus the Bombay High Court had no hesitation allowing the hallowed status of mutuality on association of cement manufacturers (CIT vs Cement Allocation & Coordinating Org. ) when it found that it conformed to this litmus test.
What about mutual funds?

Where does this leave the mutual fund industry? Well, the fact that Parliament has carved out a specific exemption for approved mutual funds vide Section 10 (23D) shows that there is after all nothing mutual about the idea of mutual funds — they do not make profit from their members but from the bourses.

In other words, a mutual fund makes profits by dealing in shares and other securities in the market. Thus the mutual fund industry does not owe its tax-free status to mutuality, but because of the exemption granted by Parliament.

However, the Delhi High Court verdict in Yum Restaurants (Marketing) Private Ltd vs CIT delivered in April 2009 has an unsettling effect on the fairly clear and well-settled position on what constitutes mutuality so as to be beyond the reach of income-tax.

The assessee was a 100 per cent subsidiary of YRIPL and its mandate was to organise advertisements on behalf and benefit of the franchisees of the parent company as well as for those of the parent itself. Seemingly, therefore, the assessee had all the accoutrements of a mutual association.
But the High Court rent asunder the cloak of mutuality when it found that the parent company itself was under no obligation to contribute to the funds of the assessee-subsidiary on a par with the franchisees and that contributions were made by the parent at its sweet discretion.
Tax shelter
Implicitly, the court held this as a tax avoidance technique without of course saying in so many words. In short, the court found the argument of mutuality one of convenience, especially when it found that the surplus of the assessee, Rs 44.44 lakh, was in fact the discretionary contribution of the parent company leaving no one in doubt as to the true motive for such contribution — to save on the tax bill of the group.
The court thus has denied the tax shelter of mutuality to those who use it as a matter of discretion depending upon the exigencies. This is welcome. Another pertinent observation made by the court was that the principle of mutuality is not applicable to those associations whose activities are tinged with commercial purpose. Implicitly, the High Court has shut the doors of mutuality to those whose activities have wider ramifications beyond the protection of the closely-knit club of members.
In the instant case, managing the advertising briefs of the franchisees went far beyond the welfare of the franchisees and impacted their bread and butter operations. Therefore, while the contributions made by them to the Special Purpose Vehicle (SPV) created for the exclusive purpose of organising the advertising efforts more efficiently and pointedly would make the grade as expenditure in computing their income, the SPV itself cannot take shelter under the facile plea that it is a mutual association because its brief impacted on the commercial success or failure of its members.
Of course, this view of the court on a mutual association remaining non-commercial, as it were, so as to be eligible for tax exemption is likely to raise a stir. But the judgment does put paid to the abuse of mutuality for nonce.

(The author is a Delhi-based chartered accountant.)

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