[Opinion] Mutuality – Evolution and Erosion

R P Garg – [2024] 158 taxmann.com 397 (Article)

Income Concept

General dictionary meaning of the word income, which has been adopted in tax legislative power is, what comes in. Also, if it could be dissected (sandhi-vichhed, like in Sanskrit) as ‘in’ and ‘come’, conveys the same meaning. Income is thus that comes in from outside, from other than himself. It is a common law principle resaid as a ‘common sense principle’ that: ‘No man can make a profit out of himself’. Income comes in when it is derived from source outside sans self. It is judicially echoed as early as in 1889 that “for income to be taxable, its source must be external to the Assessee.”

The High Court of Australia first considered the mutuality principle in Bohemians Club in 1918 as:

“A man is not the source of his own income … A man’s income consists of moneys derived from sources outside of himself. Contributions made by a person for expenditure in his business or otherwise for his own benefit cannot be regarded as his income … The contributions are, in substance, advances of capital for a common purpose, which are expected to be exhausted during the year for which they are paid.”

In 1953 Supreme Court reiterated that a person cannot transact with himself. It is only after the asset is dealt with a third party can a profit or loss be ascertained on the basis thereon. “Cut away the fictions and one reach the position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income-tax law.”

Mutuality Incept

From oneself, the concept of mutuality winged to defined mutual benefit groups of people who contribute to a common fund, controlled by the group, for a common benefit by Style (supra):

“When a number of individuals agree to contribute funds for a common purpose … and stipulate that their contributions, so far as not required for that purpose, shall be repaid to them. I cannot conceive why they should be regarded as traders, or why contributions returned to them should be regarded as profit….. They are not income of the collective body of members any more than the calls paid by members of a company upon their shares are income of the company. If anything is left unexpended it is not income or profits, but savings, which the members may claim to have returned to them… (Even) the fact that the Fund is a legal entity (for certain purposes) does not matter for, it represented the aggregate of its members and the members are the participators of its profits.”

It is one of the earliest modern judicial statements of the mutuality principle in 1889 by Lord Watson in the House of Lords in Styles (Surveyor of Taxes) Vs. New York Life Insurance Co. The fact that the Fund is a legal entity (for certain purposes) does not matter for, in the language of Lord Watson, it represented “the aggregate of its members and the members are the participators of its profits.It may be noticed that in that case the members had associated themselves together for the purpose to ensure each other’s life on the principle of mutual assurance, that is to say, they contributed annually to a common fund out of which payments were to be made, in the event of death, to the representatives of the deceased members. Those persons were alone the owners of the common fund and they alone were entitled to participate in the surplus. This surplus was obtained partly from the profits arising from non-participating policies and other business. It was held that that portion of the surplus which arose from the excess contributions of the holders of participating policies was not an assessable profit. It was therefore, held to be a case of mutual assurance. The individuals insured and those associated for the purpose of receiving their dividends and meeting other stipulated requisites under the policies were identical. It was held that that identity was not destroyed by the incorporation of the company. Lord Watson even went to the extent of saying that the company in that case did not carry on any business at all.

This statement of Lord Watson was refined by the House of Lords in a subsequent judgment in Cornish Mutual Assurance Co. Ltd. by stating that a mutual concern may be held to carry on a business or trade with its members, though the surplus arising from such trade is not income or profit (obviously because of mutuality). 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, of the Assurance Company and of the policyholders as well. The receipt by the contributors from that common fund or surplus was not income but a receipt of their own money.

The way an amount received from oneself is not regarded as income and is therefore not subject to tax, it is so by the group for the receipts from members, or vice versa i.e., by members from the group. 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.

The House of Lords in South-West Lancashire Association again ruled that a mutual insurance association, where the surplus goes back to the in-sured, whether in cash or in reduction of his premium or in enhancement of the sum insured or on winding up, it is in essence a mere return of his own money which he has overpaid and is not a profit at all. ‘Sooner or later, in meal or in malt, the whole of the association’s receipts must go back to the policyholders as a class, though not precisely in the proportions in which they have contributed to them and the association does not in any true sense make a profit out of their contributions’.

Halsbury Laws of England states the concept as:

“Where a number of persons combine together and contribute to a common fund for the financing of some venture or object and will in this respect have no dealings or relations with any outside body, then any surplus returned to those persons cannot be regarded in any sense as profit. There must be complete identity between the contributors and the participators…..Members’ clubs are an example of a mutual undertaking; but, where a club extends facilities to non-members, to that extent the element of mutuality is wanting….”

Simon’s Taxes on the point says:

“It is settled law that if the persons carrying on a trade do so in such a way that they and the customers are the same persons, no profits or gains are yielded by the trade for tax purposes and therefore no assessment in respect of the trade can be made.”

British Tax Encyclopaedia points out the area of the applicability of the doctrine in three fields. First, it applies to mutual insurance companies; secondly, it applies to certain municipal undertakings and, thirdly, to members’ clubs, and mutual associations generally, whether incorporated or unincorporated, except registered industrial and provident societies.

Kanga & Palkhivala culled out from Indian decisions and explains it thus:

“The contributors to the common fund and the participators in the surplus must be an identical body. That does not mean that each member should contribute to the common fund or that each member should participate in the surplus or get back from the surplus precisely what he has paid’. The Madras, Andhra Pradesh and Kerala High Courts have held that the test of mutuality does not require that the contributors to the common fund should willy-nilly distribute the surplus amongst themselves: it is enough if they have a right of disposal over the surplus, and in exercise of that right they may agree that on winding up the surplus will be transferred to a similar association or used for some charitable objects.”

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