In view of the circular no.11/2008 dated 19-12-2008 issued by the department of Income Tax to make certain changes with respect to taxation of certain assesses claming exemption under section 11 as charitable institution as well as mutual organization the concept of mutual organization is going to play a vital role in near future while making assessment of these organizations by the income tax department.
Since the above circular is a shift in policy it emphasis on the need of separation of income of a charitable institution into taxable and non taxable parts. Thus while implementing the legislation to identify the taxable and non taxable income; the principle of mutuality is going to play a vital role.
The principle of mutuality derives from the concept that income earned by a person from external sources is taxable. Thus income derived from oneself cannot be treated as income thus cannot be taxed. This concept has evolved over a period of time be it through legal precedents and or through assessments. Concept of mutuality was developed in late 1800’s. Mutuality organizations have been in existence since the period unknown and have played vital role in the development of the society. Presently we can see such organizations existing in the shape of insurance companies, societies, clubs, associations etc. Initially mutual organizations were created with the sole purpose of compensating members by providing insurance without any motive to earn profits or gains. The concept of mutuality was legally argued in a court of law in The Glasgow Corporation Waterworks Acts V IRC (1875) ITC 28. The courts held that the concept of mutuality in based on the fact the there is existence of an association of persons joined together to achieve a common objective by mutually contributing to the same with absolute and clear mind not to earn any profits or gains. Thus the essential elements of a mutual organization are:
a) It is an association of people called members
b) There is a common cause
c) Every member makes his contribution and
d) The aim of the activity is not to earn profits or gains
Usually income tax exemptions and or concessions are given under the Act to certain institutions within the nonprofit sector such as charitable institutions. These legislations are not based on any principle of law but are made available to such organizations to recognize their efforts to pursue a cause which ultimately is beneficial to the society at large. On the other hand, the application of mutuality principle is based on the principles of common law which states that individual members cannot be subject to tax on their own income. Thus tax concessions given to entities within nonprofit sector as charitable institutions are based on both the principles i.e. to recognize their social ethics and based on the concept of mutuality.
Tax concessions and exemptions were being enjoyed by these charitable institutions for number of years but lately it was felt that the manner in which these institutions have grown and the activities they have added to their existing list have in few cases started defeating the very basic concept of their creation. It is due to this reason that the authorities thought of bringing changes into the legislation to curb activities of institutions which don’t stand the test of the basic concept of mutuality principle. An example of such institutions can be a club which was granted tax exemption on the mutuality concept to serve common interests of its members contributing by way of membership fee started earning 75% of its gross revenue through gaming. The principle of just and equality demands that such institutions need to be treated at par with those organizations who are running gaming business and
pay taxes as per the law. A rational approach was adopted in certain countries like USA and Canada where a club can be exempted from paying tax in case its income from membership is not less than 75% of it gross revenue. Thus it is debatable to review the appropriateness of the application of the mutuality principle as an instrument of Government policy. In view of the present scenario the mutuality principle should not be viewed as providing tax privileges but nonetheless due to the lack of understanding it probably requires justification to allay any misgivings and provide understanding so as to provide a sound just and fair framework. There may be need to review the current structure of existing mutual entities with respect to their activities, but with the passage of time and with the adoption of new and creative solutions the impact of new changes in the legislation will get absorbed.
The above position can be better understood by referring the following judgments:
Yum! Restaurants (Marketing) Private Limited versus Commissioner of Income Tax Delhi High Court ITA No.1433/2008 Judgment delivered on 01-04-2009:
The brief facts of the case are: Parent company , having license arrangement with foreign companies , use to market ready to eat food items through franchisees formed a new subsidiary company to take care of publicity on behalf of the franchisees with the proper permission of the state authorities. The parent company was granted permission on the condition that the subsidiary would be a non-profit enterprise and that it would not repatriate its dividends. Thus a new company was formed under tripartite agreement with the condition that all the franchisees will be members and will pay 5% of the gross sales in order to carry on co-operative advertisements to promote all the brands of which parent company was a licensee for the mutual benefit of the franchisees. It was expressly stated that surplus if any left in the accounts will not be distributed but will be carried forward for future use as per the terms of the agreement. A return was filed showing income as nil despite the fact that there was a surplus but as per the views of the company the same was not taxable on the principles of mutuality and on no-profit basis. The case was discussed at the assessment stage and the assessing officer was of the view that despite the fact that the company was being run on the basis of mutuality concept but contributions received were not in accordance with the terms of agreement and the existence of the company was not to deal with a social/charitable cause. The main object of the said company was to promote business on behalf of members for better sales and consequently to earn more and more profit.
An appeal was filed with the commissioner of income tax (appeals). The observations made by commissioner of income tax appeals were that since the company was set up with a commercial purpose to take care of activities which are crucial for running a successful business and is linked to the profit on sale of franchisees. Further the company was in no way created for any social or cultural activity where the idea of profit or trade does not exit. The only restriction as per the agreement was not to deal with the outside body to make it a mutual concern. Thus the CIT (A) was of the view that the underlying purpose was solely for commercial consideration and excess of income over expenditure should be brought to the tax.
The above view was confirmed by the Tribunal as well as the High Court of Delhi while dealing with the appeals filed by the aggrieved assessee-company.
Dilip K Raina
Chartered Accountant & Microsoft Certified Professional –Navision & Axapta.
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