M/S. BANGALORE CLUB vs. COMMISSIONER OF INCOME TAX

REPORTABLE IN THE SUPREME COURT OF INDIA CIVIL APPELLATE JURISDICTION

VERSUS

JUDGMENT CIVIL APPEAL NO.275 OF 2013 (Arising out of S.L.P.(Civil) No. 16882 of 2010) CIVIL APPEAL NOS.276-277 OF 2013 (Arising out of S.L.P.(Civil) Nos. 16883-16884 of 2010) AND CIVIL APPEAL NO.278 OF 2013 (Arising out of S.L.P.(Civil) No. 16879 of 2010) 1 Page 1 J U D G M E N T D.K. JAIN, J. 1. Leave granted in Special Leave Petitions. 2. This batch of appeals arises from a common judgment and order pronounced by the High Court of Karnataka, in Income Tax Appeals No. 115 of 1999 along with 70 of 2000, 3095 of 2005, 1547 of 2005, 1548 of 2005, 3091 of 2005, 3089 of 2005 along with 3093 of 2005, and 3088 of 2005. Since these appeals entail the same issue, they are JUDGMENT being disposed of by this common judgment. 3. The facts necessary for the purpose of appreciating the controversy involved in the appeal are as follows: 2 Page 2 The Bangalore Club (hereinafter referred to as the “assessee”), the appellant herein, is an unincorporated Association of Persons, (AOP). In relation to the assessment

an exemption from payment of income tax on the interest earned on the fixed deposits kept with certain banks, which were corporate members of the assessee, on the basis of doctrine of mutuality. However, tax was paid on the interest earned on fixed deposits kept with non-member banks. The assessing officer rejected the assessee’s claim, holding that there was a lack of identity between the JUDGMENT 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 (Appeals)-II, Bangalore (“CIT (A)” for short) 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 3 Page 3 Income-Tax Appellate Tribunal (for short “the Tribunal”), affirmed the view taken by the CIT (A), observing thus (ITA No. 2440/Ban/1991):

JUDGMENT On an application by the Commissioner of Income Tax, Bangalore under Section 260A of the Income Tax Act, 1961 (for short “the Act”), the High Court entertained the appeal and framed the following two substantial questions of law for its adjudication :- 4 Page 4 “(1) Whether, a sum of Rs. 7,87,648/- received by the assessee as interest from fixed deposit made by the assessee in four banks who are members in the assessee club amounted to its income and constituted a revenue receipt as per the provision of Income Tax Act.

Answering both the questions in favour of the revenue, the High Court held :- “12. On the facts of this case and in the light of the legal principles it is clear to us that what has been done by the 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. The relationship is one of a banker and a customer.” JUDGMENT 5 Page 5 Consequently, the High Court reversed the decision of the Tribunal and restored the order of the assessing officer. Hence, this appeal by the assessee.

not the interest earned by the assessee on the surplus funds invested in fixed deposits with the corporate member banks is exempt from levy of Income Tax, based on the doctrine of mutuality? 5. Mr. Joseph Vellapally, learned senior counsel appearing for the assessee strenuously urged that the assessee meets all the requirements, as laid down in The English & JUDGMENT Scottish Joint Co-operative Wholesale Society Ltd. Vs. The Commissioner of Agricultural Income Tax, 1 Assam , as affirmed by this Court in Chelmsford Club 2 Vs. Commissioner of Income Tax, Delhi in order to fall within the ambit of the principle of mutuality. According to the learned counsel, there is a complete 1 AIR 1948 PC 142 (E) 2 (2000) 3 SCC 214 6 Page 6 identity between the contributors to the fund and the assessee and the recipients from the funds, in as much as the interest earned by the assessee from the surplus

alike. It was asserted that there is no commercial motive involved in the dealings of the assessee with its members, including the banks concerned. It was also argued that the interest earned on such deposits with the member banks was always available for use and benefit of the members of the assessee, in as much as the said interest merged with the common fund of the club. JUDGMENT 6. Mr. A.S. Chandhiok, learned Additional Solicitor General of India, on the other hand, contended that the fundamental principle for applicability of the doctrine of mutuality is a complete identity between the contributors and the participators, which is missing in this case. It was submitted that in the present case, the surplus funds in the hands of the assessee were placed at the disposal of 7 Page 7 the corporate members viz. the banks, with the sole motive to earn interest, which brings in the commerciality element and thus, the interest so earned by the assessee

the member banks concerned was in the nature of parking of funds by the assessee with a corporate member and was nothing but what could have been done by a customer of a bank and therefore, the principle that “no man could trade with himself” is not applicable. 7. Before we evaluate the rival stands, it would be necessary to appreciate the general understanding of doctrine of JUDGMENT mutuality. The principle relates to the notion that a person cannot make a profit from himself. An amount received from oneself is not regarded as income and is therefore not subject to tax; only the income which comes within the definition of Section 2(24) of the Act is subject to tax (income from business involving the doctrine of mutuality is denied exemption only in special cases covered under 8 Page 8 clause (vii) of Section 2 (24) of the Act). The concept of mutuality has been extended to defined groups of people who contribute to a common fund, controlled by the group,

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. A common feature of mutual organizations in general and of JUDGMENT licensed clubs in particular, is that participants usually do not have property rights to their share in the common fund, nor can they sell their share. And when they cease to be members, they lose their right to participate without receiving a financial benefit from the surrender of their membership. A further feature of licensed clubs is that 9 Page 9 there are both membership fees and, where prices charged for club services are greater than their cost, additional contributions. It is these kinds of prices and/or

8. The doctrine of mutuality finds its origin in common law. One of the earliest modern judicial statements of the mutuality principle is by Lord Watson in the House of Lords, in 1889, in Styles (Surveyor of Taxes) Vs. New 3 York Life Insurance Co. (hereinafter referred to as the “Styles case”). The appellant in that case was an incorporated company. The company issued life policies of two kinds, namely, participating and non-participating. The JUDGMENT members of the mutual life insurance company were confined to the holders of the participating policies, and each year, the surplus of receipts over expenses and estimated liabilities was divided among them, either in the form of a reduction of future premiums or of a reversionary addition to the policies. There were no shares 3 [1889] 2 TC 460 10 Page 10 or shareholders in the ordinary sense of the term but each and every holder of a participating policy became ipso facto a member of the company and as such became

probable death rate amongst the members and the probable expenses and liabilities; calls in the shape of premiums were made on the members accordingly. An account used to be taken annually and the greater part of the surplus of such premiums, over the expenditure referable to such policies, was returned to the members i.e. (holders of participating policies) and the balance was carried forward as a fund in hand to the credit of the general body of members. The question was whether the JUDGMENT surplus returned to the members was liable to be assessed to income tax as profits or gains. The majority of the Law Lords answered the question in the negative. It may be noticed that in that case the members had associated themselves together for the purpose of insuring each other’s life on the principle of mutual assurance, that is to 11 Page 11 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

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 JUDGMENT 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, which perhaps was stating the position a little too widely as pointed out by Viscount Cave in a later case; but, be that as it may, all the Noble Lords, who formed the 12 Page 12 majority, were of the view that what the members received were not profits but their respective shares of the excess amount contributed by themselves. They held thus:

9. Lord Watson’s statement was explained by the House of Lords in The Commissioners Of Inland Revenue Vs. 4 The Cornish Mutual Assurance Co. Ltd. wherein it was held that a mutual concern may be held to carry on a business or trade with its members, though the surplus JUDGMENT arising from such trade is not taxable income or profit. 10. The High Court of Australia first considered the mutuality principle in The Bohemians Club Vs. The 5 Acting Federal Commissioner of Taxation in 1918: 4 [1926] 12 T.C. 841 (H.L.) 5 (1918) 24 CLR 334 13 Page 13

(Emphasis added) 11. One of the first Indian cases that dealt with the principle was Commissioner of Income-Tax, Bombay JUDGMENT 6 City Vs. Royal Western India Turf Club Ltd. . It quoted with approval three conditions stipulated in The English & Scottish Joint Co-operative Wholesale Society Ltd. (supra), which were propounded after referring to various passages from the speeches of the different Law Lords in Styles case (supra). Lord Normand, 6 AIR 1954 SC 85 14 Page 14 who delivered the judgment of the Board summarized the grounds of the decision in Styles case (supra) as follows:

12. We will consider each of these conditions in detail before proceeding to the facts of the case. The first condition requires that there must be a complete identity between the contributors and participators. This was first JUDGMENT laid down by Lord Macmillan in Municipal Mutual 7 Insurance Ltd. Vs. Hills wherein he observed: “The cardinal requirement is that all the contributors to the common fund must be entitled to participate in the surplus and that all the participators in the surplus must be 7 (1932) 16 TC 430, 448 (HL); CIT v. Firozepur Ice Manufacturers’ Association 84 ITR 607 15 Page 15 contributors to the common fund; in other words, there must be complete identity between the contributors and the participators.”

Edition, Reissue, Vol. 23, paras 161 and 162 (pp. 130 and 132) states:

JUDGMENT rd 14. Simon’s Taxes , Vol. B, 3 Edn., paras B1.218 and B1. 222 (pp. 159 and 167) formulate the law on the point, thus: “..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. Any surplus resulting from 16 Page 16

15. In short, there has to be a complete identity between the class of participators and class of contributors; the 17 Page 17 particular label or form by which the mutual association is known is of no consequence. Kanga & Palkhivala explain th this concept in “The Law and Practice of Income Tax” (8 Edn. Vol. I, 1990) at p. 113 as follows:

16. British Tax Encyclopedia (I ), 1962 Edn. (edited by G.S.A. Wheatcroft) at pp. 1201, dealing with “mutual trading operations”, the law is stated as under:

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though not precisely in the proportions in which they have JUDGMENT contributed to them and the association does not in any true sense make any profit out of their contributions. 18. Therefore, in the case of Royal Western India Turf Club Ltd. (supra) , since the club realized money from both members and non- members, in lieu of the same 8 1927 AC 827 19 Page 19 services rendered in the course of the same business, the exemption of mutuality could not be granted. This Court held thus:

JUDGMENT 19. The second feature demands that the actions of the participators and contributors must be in furtherance of the mandate of the association. In the case of a club, it would be necessary to show that steps are taken in furtherance of activities that benefit the club, and in turn its members. Therefore, in Chelmsford Club (supra) , since the appellant provided recreational facilities 20 Page 20 exclusively to its members and their guests on “no-profit- no-loss” basis and surplus, if any, was used solely for maintenance and development of the club, the Court

20. The mandate of the club is a question of fact and can be determined from the memorandum or articles of association, rules of membership, rules of the organization, etc. However, the mandate must not be construed myopically. While in some situations, the benefits may be evident directly in the short-run, in others, they may be accruable to an organization indirectly, in the long-run. Space must be made for both such forms of JUDGMENT interactions between the organization and its members. Therefore, as Finlay J. observed in National Association 9 of Local Government Officers Vs. Watkins , where member of a club orders dinner and consumes it, there is no sale to him. At the same time, as in case of Commissioner of Income Tax, Bihar Vs. Bankipur 9 (1934) 18 TC 499; 503, 506 21 Page 21 10 Club Ltd. , where a club makes ‘surplus receipts’ from the subscriptions and charges for the various conveniences paid by members, even though there is no

services of the club must be considered as a furtherance of the mandate of the club. 21. Thirdly , there must be no scope of profiteering by the contributors from a fund made by them which could only be expended or returned to themselves. The locus classicus pronouncement comes from Rowlatt, J’s 11 observations in Thomas Vs. Richard Evans & Co. Ltd. JUDGMENT wherein, while interpreting Styles case (supra) , he held that if profits are distributed to shareholders as shareholders, the principle of mutuality is not satisfied. He observed thus: "But a company can make a profit out of its members as customers, although its range of customers is limited to its shareholders. If a 10 (1997) 5 SCC 394 11 (1927) 11 TC 790 22 Page 22

22. In Commissioner of Income Tax, Madras Vs. 12 Kumbakonam Mutual Benefit Fund Ltd. , this Court 12 AIR 1965 SC 96 23 Page 23 differentiated the facts of the case before it from those of Styles case (supra) and denied the exemption of mutuality because of the taint of commerciality. It was observed thus:

23. However, at what point mutuality ends and JUDGMENT commerciality begins is a difficult question of fact. It is best summarized in Bankipur Club (supra) wherein this Court echoed the following views:

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always the case that a legal entity cannot make profits out of its members. It held as follows :

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supplied) 26 Page 26 25. This brings us to the facts of the present case. As aforesaid, the assessee is an AOP. The concerned banks are 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, we are 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, enumerated above. 26. 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 JUDGMENT 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 27 Page 27 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

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. 27. As aforesaid, the second condition demands that to JUDGMENT 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. 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 28 Page 28 placed the same at the disposal of third parties, thus, initiating an independent contract between the bank and the clients of the bank, a third party, not privy to the

and indirect way benefit the club, nonetheless, it cannot be categorized as an activity of the club in pursuit of its objectives. It needs little emphasis that the second condition postulates a direct step with direct benefits to the functioning of the club. For the sake of argument, 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 stands violated. JUDGMENT 28. 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. This principle requires that the 29 Page 29 funds must be returned to the contributors as well as expended solely on the contributors. True, that in the present case, the funds do return to the club. However,

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, in our opinion, snaps the link of mutuality and thus, breaches the third condition. 29. There is nothing on record which shows that the banks JUDGMENT 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 as elucidated in Styles and Kumbakonam Mutual Benefit 30 Page 30 Fund Ltd. cases (supra). Rowlatt J., in our opinion, correctly points out that if profits are distributed to shareholders as shareholders, the principle of mutuality is

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Rs.1/- each. It carried on banking business restricted to its JUDGMENT shareholders, i.e., the shareholders were entitled to participate in its various recurring deposit schemes or obtain loans on security. Recurring deposits were obtained from members for fixed amounts to be contributed monthly by them for a fixed number of months as stipulated at the end of which a fixed amount was 32 Page 32 returned to them according to published tables. The amount so returned, covered the compound interest of the period. These recurring deposits constituted the main

to offer substantial security therefor, by way of either the paid up value of their recurring deposits, if any, or immovable properties within a particular district. Out of the interest realised by the assessee on the loans which constituted its main income, interest on the recurring deposits aforesaid was paid as also all the other outgoings and expenses of management and the balance amount was divided among the members pro rata according to their share-holdings after making provision for reserves, JUDGMENT etc., as required by the Memorandum or Articles aforesaid. It was not necessary for the shareholders, who were entitled to participate in the profits to either take loans or make recurring deposits. 33 Page 33 31. On these facts, as already noted, the Court distinguished Styles case (supra) and opined that the position of the assessee was no different from an ordinary

any less income from business. In our opinion, the ratio of the said decision is on all fours to the facts at hand. The interest earned by the assessee even from the member banks on the surplus funds deposited with them had the taint of commerciality, fatal to the principle of mutuality. 32. We may add that the assessee is already availing the benefit of the doctrine of mutuality in respect of the JUDGMENT surplus amount received as contributions or price for some of the facilities availed by its members, before it is deposited with the bank. This surplus amount was not treated as income; since it was the 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 34 Page 34 claim double benefit of mutuality. We feel that the present case is a clear instance of what this Court had cautioned against in Bankipur Club (supra), when it said:

35 Page 35 33. In our opinion, unlike the aforesaid surplus amount itself, which is exempt from tax under the doctrine of

JUDGMENT ……..…………………………………. (D.K. JAIN, J.) ……..…………………………………. (JAGDISH SINGH KHEHAR, J.) NEW DELHI, JANUARY 14, 2013. 36 Page 36 RS JUDGMENT 37 Page 37