2013 (1) TMI 343 - SC - Income Tax

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.

Summary

Issues Involved:
1. Whether the interest earned by the assessee on fixed deposits with member banks is exempt from income tax based on the doctrine of mutuality.
2. The applicability of the principle of mutuality to funds deposited in member banks and the resulting interest.

Detailed Analysis of the Judgment:

Issue 1: Exemption from Income Tax Based on Doctrine of Mutuality

The primary issue was whether the interest earned by the assessee on surplus funds invested in fixed deposits with corporate member banks is exempt from income tax under the doctrine of mutuality. The assessee, an unincorporated Association of Persons, claimed exemption from income tax on the interest earned from fixed deposits kept with certain banks that were corporate members of the assessee. The assessing officer rejected this claim, treating the interest as taxable business income due to a lack of identity between the contributors and participators to the fund.

The Commissioner of Income Tax (Appeals) reversed the assessing officer's decision, applying the doctrine of mutuality. The Income Tax Appellate Tribunal affirmed this view, stating that the interest earned arose from mutuality. However, the High Court of Karnataka reversed the Tribunal's decision, holding that the relationship between the club and the banks was akin to that of a banker and a customer, thereby making the interest income taxable.

The Supreme Court upheld the High Court's decision, emphasizing that the arrangement lacked a complete identity between the contributors and participators. The funds placed in fixed deposits were used by the member banks for commercial operations with third parties, violating the principle of mutuality. Therefore, the interest earned on these deposits was not exempt from income tax.

Issue 2: Applicability of the Principle of Mutuality

The principle of mutuality is based on the notion that a person cannot make a profit from himself. For mutuality to apply, there must be a complete identity between contributors and participators, the funds must be used for the benefit of the contributors, and there should be no scope of profiteering from the contributions.

The Supreme Court analyzed the principle of mutuality in detail, referring to various cases and legal principles. The Court noted that the funds placed in fixed deposits with member banks were used for commercial purposes, breaking the closed circuit of mutuality. The interest earned was treated as a revenue receipt, taxable under the Income Tax Act, 1961.

The Court also highlighted that the surplus funds were not used for any direct benefit of the club members but were placed at the disposal of third parties, thus failing the second condition of mutuality. Additionally, the funds were expended on non-members (clients of the bank), violating the third condition of mutuality.

The Court concluded that the interest earned from fixed deposits with member banks had the taint of commerciality, making it taxable. The assessee could not claim double benefit of mutuality for the surplus amount and the interest earned from it.

Conclusion

The Supreme Court dismissed the appeals, holding that the interest earned by the assessee from fixed deposits with member banks is not exempt from income tax under the doctrine of mutuality. The arrangement lacked the necessary identity between contributors and participators, and the funds were used for commercial purposes, violating the principle of mutuality.