Ruling 93-24, Corporation Business Tax / Dividends - Received Deduction

FACTS:

A corporation (hereinafter "the Company") owns shares of a company (hereinafter "the Regulated Investment Company") that is a regulated investment company, as defined in 26 U.S.C. § 851(a), and is "considered a regulated investment company", under 26 U.S.C. § 851(b). The Regulated Investment Company's income consists solely of interest income from U.S. Government obligations and capital gain, if any, on sales of such obligations. The Regulated Investment Company pays dividends, as defined generally in 26 U.S.C. § 316(a), to its shareholders, including the Company.

ISSUE:

Whether distributions paid by the Regulated Investment Company to the Company may be deducted under § 12-217(a)(D).

DISCUSSION:

Federal income tax provisions for regulated investment companies form the foundation for a discussion of whether distributions paid by a regulated investment company to a corporate shareholder may be deducted under Conn. Gen. Stat. § 12-217(a)(D). Therefore, this discussion begins with an overview of those federal provisions.

Certain investment companies, including mutual funds, may elect to be taxed under Subchapter M, 26 U.S.C. § § 851-855 and 860, as regulated investment companies. Subchapter M sets out

Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders 1.06 (5th ed. 1987). A company that elects to be treated as a regulated investment company also must meet distributional requirements. 26 U.S.C. § 852(a).

A qualified regulated investment company is taxed only on its undistributed income and is treated as a partial conduit for the income it earns. "The fundamental premise of conduit treatment is that the RIC's [regulated investment company's] income should be taxed only once[,] at the shareholder level, rather than to the RIC ... The basic mechanism for providing conduit treatment to a RIC is the allowance of a dividends-paid deduction by §852." Applying PFIC Rules to RICs Can Cause Double Taxation, 2 J. Int'l. Tax'n. 100 (1991). A distribution from a regulated investment company to its shareholders might include "exempt-interest dividends;" §852(b)(5)(A); and "capital gain dividends." §852(b)(3)(C).

An "exempt-interest dividend" is defined as "any dividend or part thereof (other than a capital gain dividend) paid by a regulated investment company and designated by it as an exempt-interest dividend in a written notice mailed to its shareholders not later than 60 days after the close of its taxable year..." 26 U.S.C. § 852(b)(5)(A). Further, "[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). Such purposes include but are not limited to (i) the determination of gross income and taxable income..." 26 U.S.C. § 852(b)(5)(B) (emphasis added). Under 26 U.S.C. § 103(a), interest on any State or local bond is excluded from gross income. 26 U.S.C. § 103(a).

A "capital gain dividend" is defined as "any dividend, or part thereof, which is designated by the company as a capital gain dividend in a written notice mailed to its shareholders not later that 60 days after the close of its taxable year." 26 U.S.C. § 852(b)(3)(C). A capital gain dividend is "treated by the shareholders as a gain from the sale or exchange of a capital asset held for more than 1 year." 26 U.S.C. § 852(b)(3)(B) (emphasis added).

Under certain conditions, Conn. Gen. Stat. § 12-217(a)(D), as amended by 1991 Conn. Pub. Acts 3, 100 (June Spec. Sess.), permits a company to deduct from its gross income dividends, or a portion of the dividends, that it receives from another company. It provides in pertinent part:

Conn. Gen. Stat. § 12-217(a)(D) (emphasis added).

Because of the special rules of 26 U.S.C. § 854(b), the Company does not, and could not, assert that the dividends in question are deductible under Conn. Gen. Stat. § 12-217(a)(A). 26 U.S.C. § 854(b) provides that the payee of a dividend is eligible for the dividends-received deduction only if the dividend payor would be so eligible. In this case, the Regulated Investment Company would not be eligible for the federal dividends-received deduction because the amounts it receives and distributes are derived not from dividends, but from interest on investments in federal obligations. See 26 U.S.C. § 854(b)(4). Therefore, 26 U.S.C. § 854(b)(4) prohibits the Company from deducting dividends received from the Regulated Investment Company under 26 U.S.C. § 243. Consequently, those dividends are not deductible under the plain language of Conn. Gen. Stat. § 12-217(a)(A). Circuits, Inc. v. Dubno, 213 Conn. 442, 568 A.2d 457 (1990); Skaarup Shipping Corp. v. Commissioner of Revenue Services, 199 Conn. 346, 507 A.2d 988 (1986).

In contrast to Conn. Gen. Stat. § 12-217(a)(A), subpart (D) of that section permits a company to deduct from its gross income "all dividends as defined in the federal income tax law ... not otherwise deducted from gross income..." Conn. Gen. Stat. § 12-217(a)(D). The phrase "dividends as defined in the federal income tax law" refers to any distribution that satisfies the general definition of "dividend" in 26 U.S.C. § 316(a), except where federal income tax law expressly changes the dividend character of all or part of such distribution. "Exempt-interest dividends" and "capital gain dividends" are instances in which federal income tax law expressly changes the dividend character of such distributions. Because "exempt-interest dividends" and "capital gain dividends" are not "dividends as defined in the federal income tax law" they may not be deducted under Conn. Gen. Stat. § 12-217(a)(D).

In order to ensure that the income of a regulated investment company is taxed only once, at the shareholder level, federal income tax law prescribes that some components of dividends not be treated as dividends for purposes of computing the federal dividends-received deduction. 26 U.S.C. § 854(b). Contrary to the position advanced in Ruling No. 93-2, the Department now holds that prescriptive provisions, such as those in 26 U.S.C. § 854(b), do not transform the dividend character of a distribution into some other type of income. Therefore, dividends paid by the Regulated Investment Company to the Company that are not "exempt-interest dividends" or "capital gain dividends" may be deducted under Conn. Gen. Stat. § 12-217(a)(D), as long as their dividend character is not changed by some express provision of federal income tax law.

After the passage of 1991 Conn. Pub. Acts 3, 100, the application of Conn. Gen. Stat. § 12-217(a)(A) and (D) is as follows. Where the distribution may be deducted under federal law:

• and the corporate shareholder owns 100% of the total voting power and value of the stock of a domestic payor corporation, the corporate shareholder may deduct 100% of the dividends that it receives from such payor under 26 U.S.C. § 243(a) and Conn. Gen. Stat. § 12-217(a)(A);
• and the corporate shareholder owns at least 20% but less than 100% of the total voting power and value of the stock of a domestic payor corporation, the corporate shareholder may deduct 80% of the dividends that it receives from such payor under 26 U.S.C. § 243(c) and Conn. Gen. Stat. § 12-217(a)(A), and the remaining 20% under Conn. Gen. Stat. § 12-217(a)(D);
• and the corporate shareholder owns less than 20% of the total voting power and value of the stock of a domestic payor corporation, the corporate shareholder may deduct 70% of the dividends that it receives from such payor under 26 U.S.C. § 243(a) and Conn. Gen. Stat. § 12-217(a)(A). The remaining 30% may not be deducted under Conn. Gen. Stat. § 12-217(a)(D), as amended by 1991 Conn. Pub. Acts 3, §100.

Where the distribution may not be deducted under federal law, and where such distribution is a "dividend" as defined in 26 U.S.C. § 316 and its character as a dividend is not transformed by another provision of federal income tax law:

• the corporate shareholder may deduct 70% of such distribution received from a domestic payor under Conn. Gen. Stat. § 12-217(a)(D), as amended by 1991 Conn. Pub. Acts 3, if the corporate shareholder owns less than 20% of the total voting power and value of the stock of such payor corporation;
• the corporate shareholder may deduct 100% of such distribution received from a domestic payor under Conn. Gen. Stat. § 12-217(a)(D), as amended by 1991 Conn. Pub. Acts 3, §100, if the corporate shareholder owns more than 20% of the total voting power and value of the stock of payor corporation.

RULING:

Distributions paid by the Regulated Investment Company to the Company that are "exempt-interest dividends," as defined in 26 U.S.C. § 852(b)(5), and "capital gain dividends," as defined in 26 U.S.C. § 852(b)(3)(C), are not "dividends as defined in the federal income tax law" because federal law transforms their character from dividend income to exempt-interest income and capital gain income, respectively. Therefore, "exempt-interest dividends" and "capital gain dividends" may not be deducted under Conn. Gen. Stat. § 12-217(a)(D). Distributions paid by the Regulated Investment Company to the Company that are not "exempt-interest dividends" or "capital gain dividends" may be deducted under Conn. Gen. Stat. § 12-217(a)(D), provided that such distributions are "dividends" as defined in 26 U.S.C. § 316 and no provision of federal income tax law expressly transforms their dividend character, and provided that the Regulated Investment Company is a domestic corporation.

Ruling No. 93-2 is hereby revoked.

LEGAL DIVISION

December 6, 1993