Ruling 91-14

Dividend and Interest Income Tax

This Ruling has been obsoleted by AN 94(2); obsoleted in part by PA 94-4, §13 (May) superseded in part by SN 95(17)

ISSUE:

Where exempt-interest dividends are derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico, are those exempt-interest dividends subject to the dividend and interest income tax?

FACTS:

1. A corporation [hereinafter, "the Company"] is a "regulated investment company", as defined in 26 U.S.C. §851(a).
2. The Company is qualified, in accordance with 26 U.S.C. §852(b)(5), to pay exempt-interest dividends.
3. The assets of the Company include obligations issued by or on behalf of the Commonwealth of Puerto Rico.
4. Those obligations issued by or on behalf of the Commonwealth of Puerto Rico are obligations described in 26 U.S.C. §103(a).

DISCUSSION:

"All bonds issued by the Government of Puerto Rico [are] exempt from taxation by the Government of the United States ... or by any State, Territory, or possession ...." 48 U.S.C. §745.

Prior to the passage of the Tax Reform Act of 1976, Pub. L. No. 94-455, § 2137(c), if such bonds were owned by a regulated investment company, as defined in 26 U.S.C. §851(a), then the dividend income paid by the regulated investment company, to the extent it was attributable to such bonds, was taxable to its shareholders as dividend income; Woodruff v. Tax Commissioner, 185 Conn. 186, 440 A. 2d 854 (1981). If such bonds were owned by a resident individual, then the interest income paid by the Commonwealth of Puerto Rico to the bondholder was interest income that 48 U.S.C. §745 proscribed the States from taxing.

Since the passage of the Tax Reform Act of 1976, a regulated investment company that has total assets, at least fifty percent of the value of which, at the close of each quarter of its taxable year, consists of obligations described in 26 U.S.C. §103(a) is qualified to pay exempt-interest dividends to its shareholders. 26 U.S.C. §852(b)(5).

"An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under section 103(a)." 26 U.S.C. §852(b)(5)(B).

Pursuant to 26 U.S.C. §§103(c)(2) and 7701(d), obligations described in 26 U.S.C. §103(a) may include obligations of the Commonwealth of Puerto Rico. To the extent that the obligations issued by or on behalf of the Commonwealth of Puerto Rico are obligations described in 26 U.S.C. §103(a), a regulated investment company that owns such obligations and that is qualified to pay exempt-interest dividends to its shareholders will, with respect to such obligations, pay exempt-interest dividends.

Consistent with 26 U.S.C. §852(b)(5), Conn. Agencies Regs. §12-518-9a(d)(3) treats exempt-interest dividends as "interest income", for purposes of the dividend and interest income tax. Conn. Agencies Regs. §12-518-6a(a) provides that "[a] taxpayer is allowed to exclude from interest income (1) any interest income, the taxation of which by any State is prohibited by federal law ...."

"[I]n the absence of any evidence to the contrary, we may assume that this regulation's submission to the legislative regulation review committee and its subsequent ratification '[support] the position that the regulation is consistent with the general statutory scheme that the regulation was designed to implement.' Texaco Refining & Marketing Co. v. Commissioner of Revenue Services, 202 Conn. 583, 600, 522 A.2d 771 (1987)." Connecticut Water Co. v.Barbato, 206 Conn. 337, 344 (1988).

"Interest income", as defined in Conn. Gen. Stat. §12-505, could be construed as not allowing the exclusion of interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico. (The exclusion from "interest income" of "any such income with respect to which taxation by any state is prohibited by federal law"; Conn. Gen. Stat. §12-505; applies, arguably, only if the income is otherwise "any interest income taxable for federal income tax purposes"; id. Interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico is not taxable for federal income tax purposes; 48 U.S.C. §745.) Whether or not the General Assembly enacts legislation expressly excluding from taxation "income with respect to which taxation by any state is prohibited by federal law"; Conn. Gen. Stat. §12-505; interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico is not taxable by any State; 48 U.S.C. §745.

The Connecticut Supreme Court has stated that "[the ordinary rules of statutory construction do not apply when 'a literal reading places a statute in constitutional jeopardy. We are bound to assume that the legislature intended, in enacting a particular law, to achieve its purpose in a manner which is both effective and constitutional. [Citations omitted]' Moscone v. Manson, 185 Conn. 124, 128, 440 A.2d 848 (1981)." French v. Amalgamated Local Union 376, 203 Conn. 624, 636-637, 526 A.2d 861 (1987). (A similar interpretation must also be given to Conn. Agencies Regs. §§12-518-6a and 12-518-9a, which could also be interpreted as including within "interest income" exempt-interest dividends derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico.)

RULING:

Where exempt-interest dividends are derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico, those exempt-interest dividends are exempt from the dividend and interest income tax.

LEGAL DIVISION

May 17, 1991