Effect of the mutuality principle on taxable income of not-for-profits
When writing an article about a common law principle concerning income tax, you risk losing half of your audience after they have read the heading; however the principle of mutuality is an important concept for those in the third sector to understand, and one that is not as widely understood as it should be. Certain types of non-profit organisations are exempt from income tax. Such organisations include charities, health organisations, educational organisations and others that have been endorsed by the Australian Taxation Office as income tax exempt. If you are a non-profit organisation that has not been so endorsed, it is likely that you rely upon the principle of mutuality to some degree.
What is the principle of mutuality?
The principle of mutuality is based on the proposition that an organisation cannot derive income from itself, meaning that an organisation’s income consists only of funds derived from external sources. Therefore, where a number of persons (for example, members of a club, association or organisation) contribute to a common fund which is created and controlled by those persons for a common purpose, any surplus arising from the use of that fund, for the common purpose, will not be deemed to be income.
What characteristics must an organisation have?
Typically, organisations with the following characteristics will be organisations that can apply the principle of mutuality: They are carried on for the benefit of their members collectively. They have members that share a common purpose. Those members are all entitled to participate in that common purpose.
The main purpose for which the organisation was established, and is operated, is the common purpose of the members. All the members contribute to a common fund that gives effect
to the common purpose and all contributions are applied for the collective benefit of the members.
The members have ownership and control of the common fund. Different classes of memberships may exist within the organisation. Those different classes may have varying subscription rates, rights and entitlements to facilities.
What impact does the principle of mutuality have on organisations?
The practical effect of the principle is that: receipts derived from mutual dealings with an organisation’s members
(mutual receipts) are excluded from the assessable income of the organisation; expenses incurred to get
mutual receipts are not deductible; receipts derived from trading with non-members and income from sources outside of the organisation are treated as assessable income; and the expenses directly related to that assessable income can be claimed as deductible expenses.
A brief history
The principle of mutuality was established by case law and the Australian Taxation Office had guidelines in place for the benefit of registered clubs and other organisations that applied the principle. The application of the principle was threatened by the Full Federal Court decision of Coleambally Irrigation Mutual Co‑operative Limited v FCT  FCAFC 250 which ruled that the principle of mutuality did not apply because the organisation’s constitution prohibited the distribution of surplus funds to members. The potential implications of this case were far-reaching as the law dictates that for an organisation to be a non-profit organisation, its constituent document must prohibit any distribution to its members. Pressure from the third sector led to the passing of the Tax Laws Amendment (2005 Measures No. 6) Bill 2005 which amended the Income Tax Assessment Act 1997 by confirming that the members of an organisation will not be precluded from applying the mutuality principle solely because they are prevented from making distributions to members on winding up. The Bill therefore restored the longstanding benefits of the mutuality principle to those non-profit organisations affected by the Coleambally decision.
Calculating your taxable income
Taxable income is calculated as the difference between an organisation’s assessable income and allowable eductions.
Taxable Income = Assessable Income – Allowable Deductions
As a result of the mutuality principle, income and expenses fall within one of three categories shown in the table below. Income tax law also classifies certain revenue and expenses as either assessable/non-assessable or deductible/non-deductible. For example, donations are deemed to be non-assessable (whether received from members or non-members) and therefore fall into the first category. Once revenue and expenses have been correctly classified and all apportionable items have been separated, the taxable income of an organisation will be able to be calculated.The following are examples of mutual receipts, assessable receipts and apportionable income:
Revenue that comprises both assessable and non-assessable income:
The mutuality principle hinges on the premise that an organisation must transact with the members collectively, as opposed to individually. The principle of mutuality is ingrained in the common law and is the practice of the Australian Taxation Office and, since 2005, is also reflected in Commonwealth legislation. Many non-profit organisations reap the benefits of the principle and it is therefore a concept that should be understood. This article looks at the principle in a broad sense, giving a brief summary of what the principle is and how it affects non-profits.
An example of mutuality and taxable income
A non-profit club owns two factory units. One unit is used for club activities and the other is rented to a club member. The member uses the unit to carry on business. The club’s activity involving the leasing of a factory unit to one club member is considered to be of a business nature rather than a mutual arrangement. Income from this activity is assessable to the club.