2013 (1) TMI 343 - SC - Income Tax

Unincorporated AOP's Fixed Deposit Interest Not Exempt Under Doctrine of Mutuality, Section 2(15) Applied

M/s. BANGALORE CLUB Versus COMMISSIONER OF INCOME TAX & ANR.

The SC held that the appellant, an unincorporated AOP, could not claim exemption from income tax on interest earned from fixed deposits with certain banks ... Exemption from payment of income tax on interest earned - fixed deposits kept with certain banks which were corporate members of the assessee club - claim of invoking doctrine of mutuality - appellant is an unincorporated Association of Persons (AOP) - claim rejected on lack of identity between the contributors and the participators to the fund - High Court allowed the appeal of revenue - Held that:- 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. As 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. The surplus funds were not used for any specific service, infrastructure, maintenance or for any other direct benefit for the member of the club. 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. As 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, 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 - 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. ISSUES: Whether interest earned by an unincorporated association of persons (AOP) on fixed deposits placed with corporate member banks qualifies for exemption from income tax under the doctrine of mutuality.Whether the principle of mutuality applies when the fund is raised from multiple members including corporate banks, but the interest income is utilized by several members of the association.Whether the relationship between the association and its member banks constitutes mutuality or a commercial banking relationship.Whether the three cumulative conditions for exemption under the doctrine of mutuality-(i) identity of contributors and participators, (ii) actions in furtherance of the association's mandate, and (iii) absence of profiteering by contributors-are satisfied in the context of interest earned on fixed deposits with member banks. RULINGS / HOLDINGS: The interest earned by the association on fixed deposits with corporate member banks does not qualify for exemption under the doctrine of mutuality and is taxable as income. The High Court's reversal of the Tribunal's decision was upheld, holding that '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.'The first condition of mutuality, requiring 'complete identity between the contributors and the participators,' is not satisfied because the member banks used the deposited funds for commercial lending to third parties, thereby rupturing the 'privity of mutuality.'The second condition, that the use of surplus funds must be 'in furtherance of the object of the club,' is violated since the funds were placed at the disposal of third parties by the banks, constituting independent commercial contracts outside the club's mandate.The third condition, that contributors should not derive profits from their own contributions except as expenditure or return of funds, is breached because the banks earned profits by loaning out the club's funds to outsiders, severing the link of mutuality.The doctrine of mutuality exempts only those surpluses which are 'returned to the contributors' or 'expended for their benefit' without commercial profit motive; the interest earned here bears the taint of commerciality and is therefore taxable. RATIONALE: The Court applied the established legal framework of the doctrine of mutuality as articulated in leading precedents including the Styles case, Royal Western India Turf Club Ltd., and Kumbakonam Mutual Benefit Fund Ltd., which require three cumulative conditions for exemption: (1) identity of contributors and participators, (2) actions in furtherance of the association's mandate, and (3) absence of profiteering.The Court emphasized that mutuality arises only where 'a person cannot make a profit from himself' and the surplus represents an increase in the common fund, not taxable income.The Court distinguished commercial banking operations from mutual dealings, noting that when member banks loan out deposited funds to third parties, the 'closed circuit' of mutuality is broken and the relationship resembles that of a bank and customer, not a mutual association.The decision reaffirmed that incorporation or legal entity status does not alter the substance of mutuality, but the presence of profit-making commercial transactions with third parties negates mutuality exemption.The Court recognized the 'difficult and vexed question' of when mutuality ends and trading begins but found on facts that the interest income here is 'tainted with commerciality' and thus taxable.The Court rejected the attempt to claim double benefit of mutuality by exempting both the surplus amount collected from members and the interest earned on deposits placed with member banks, holding that a 'façade of a club cannot be constructed over commercial transactions to avoid liability to tax.'