Principle of mutuality – Interest earned on surplus funds placed by the members club with members bank not covered by mutuality principle, liable to be taxed in the hands of the club.

The Bangalore Club (“the “assessee”), an unincorporated association of persons, (AOP), in relation to the assessment years 1990-91, 1993-94, 1994- 95, 1995-96, 1996-97, 1997-98 and 1999-2000, had sought an exemption from payment of incometax on the interest earned on the fixed deposits kept with certain banks, which were corporate members of the assessee, on the basis of the doctrine of mutuality. However, tax was paid on the interest earned on fixed deposits kept with non-member banks.

The Assessing Officer rejected the assess’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 (Appeal) 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 Commissioner of Income-tax (Appeals).

The High Court reversed the decision of the Tribunal and restored the order of the Assessing Officer holding that on the facts of this case and in the light of the legal principles it was clear to us what has been done by club is nothing but what could have been done by a customer of a bank. The principle of ‘no man can trade with himself’ is not available in respect of a nationalised bank holding a fixed deposit on behalf of its customer.

On appeal to the Supreme Court by the assessee, the Supreme Court observed that the assessee was an association of persons. The concernedbanks were 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, it was 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.

The Supreme Court held that: 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 the mutuality; the flow of money, to and fro, was maintained within the closed circuit formed by the banks and the club, and to the 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 members banks used such deposits to advance loans to their clients. Hence, in the present case, with the funds of the mutuality, member bank engaged in commercial operations with third parting outside of the mutuality, rupturing the ‘privity of mutuality’, and consequently, violating the one to one identity between the contributors and participators. Thus, in the case before it the first condition for a claim of mutuality was 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 was 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, 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 members, which may in a distant and indirect way benefit the club, nonetheless, it cannot be categorised as an activity of the club in pursuit of its objectives. The second condition postulates a direct step with direct benefits to the functioning of the club. For the sake of arguments, 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 stood violated.

The facts at hand also failed 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 required that the funds must be returned to the contributors as well as expended solely on the contributors. 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, snaps the link of mutuality and thus, breached the third condition.

The Supreme Court further observed that there was nothing on record which showed 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.

According to the Supreme Court, in the present case, the interest accrued on the surplus deposited by the club like in the case of any other deposit made by an account holder with the bank.

The Supreme Court further observed that the assessee was already availing of the benefit of the doctrine of mutuality in respect of the surplus amount received as contributions or price for some of the facilities availed of by its members,before it was deposited with the bank. This surplus amount was not treated as income; since it was 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.

In the opinion of the Supreme Court, 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 banks would not fall within the ambit of the mutuality principle and would, therefore, be exigible to income-tax in the hands of the assessee-club.