Not-for-profit entities – mutual or non-mutual income?

Basic principle of not-for-profit organisations

The basic premise of a non-profit organisation is that it is not operating for the profit or gain of its individual members. Any income made by the organisation goes back into the operation of the organisation solely to carry out its purposes and is not distributed to any of its members.

The Australian Taxation Office (ATO) accepts an organisation as non-profit where its constituent or governing documents prevent it from distributing income or assets to members, both while it is operating and when it winds up.

Basic principle of mutual income

The mutuality principle is a legal principle established by case law. It is based on the proposition that an organisation cannot derive income from itself.

The principle provides that where a number of persons contribute to a common fund created and controlled by them for a common purpose, any surplus arising from the use of that fund for the benefit of members is not income. An example would be a sports club established principally for the benefit of its members. Any income derived from the members, such as membership fees and bar sales, is mutual and therefore not taxable.

The principle does not extend to include income that is derived from sources other than the members of the common fund. For example, if the club was open to the public at large, then any income from non-members would not be mutual income and therefore taxable.

Circumstances of our advice

We were asked to advise on the income tax and capital gains tax consequences of the granting of 99 year leases over certain common property of a not-for -profit organisation, where the leases were granted to particular, but not all, members.

Income of the organisation was typically mutual income from members and not subject to income tax. However the question arose as to whether the income from the granting of long term leases to some of the members was mutual or non-mutual income. It was necessary to consider whether the grant of the leases went beyond a mutual arrangement and was therefore in the nature of trade, giving rise to taxable income. Clearly the grant had the characteristics of a trading transaction in that it was outside the scope of the organisation’s normal activities and it gave rise to a surplus of funds to the organisation.

We then considered whether a dealing with only some members could be considered as mutual income. The principles of mutuality require a complete identity between contributors and participants as a class, not individually, in the surplus of common funds. It was our opinion, having regard to the relevant tax authorities, that mutuality ceased to apply when the select members contributed differentially from other members by paying to secure a right over the use of a collectively owned asset. That right was not available to all members as a class and only the select members benefited from the use of the asset. Accordingly, the identity between contributors (the lessees in this case) and the members as a class in the common fund was broken.

Therefore it was our opinion that the income derived from the granting of the leases was not mutual income and therefore subject to income tax.

Nature of the income

The question then turned to whether the gain was in the form of revenue or capital for tax purposes. If revenue, it would be taxed at the marginal tax rates of the individual members. If capital in nature, the Capital Gains Tax (CGT) would apply.

We advised as follows:

1. Pursuant to section 104-115 of the Income Tax Assessment Act 1997, where a lease is granted for a period in excess of 50 years, the transaction is regarded as disposal the underlying interest in the land for CGT purposes.
2. Accordingly, each member of the organisation, being entitled to a share of the common property that has been disposed, would be assessed on their share of the gain.
3. The consideration payable to each member would be the net funds remaining after the remission of GST on the granting of the leases. The organisation was registered for GST and the supply of the leases represented a taxable transaction.
4. The CGT cost base of a member’s share of the disposed common property would be a proportion of their overall cost base of their property.
5. Depending on the circumstances of each member, certain CGT concessions may have been available. If the members were individuals, then if they had held their interest in the property for more than 12 months, would most likely be eligible to claim the general 50% CGT exemption. Under this exemption, only 50% of their individual share of the gain would be subject to taxation.

As illustrated by this case, it is most important to fully consider all of the facts and circumstances of any unusual transactions entered into by otherwise taxable not-for-profit organisations as the principle of mutuality will not always apply.

If you would like further information on the principle of mutuality, or to discuss your circumstances, please contact Bruce Sainsbury on 03 9851 9000 or bjs@baumgartners.com.au