Ruling 99-4, Income Tax

FACTS:

A trust that is established under the laws of the Commonwealth of Massachusetts ("the Trust") is registered as an open-end management investment company under the Investment Company Act of 1940, as amended (endnote 1). The Trust itself is not open to investment. Rather, it establishes sub-trusts ("Portfolios") in which investments may be made.

Investors in Portfolios ("Investors") will be regulated investment companies, as defined in 26 U.S.C. §851, bank common trust funds, endowments and other institutional investors but will not include individuals, S corporations, partnerships, limited liability companies or grantor trusts. Each Portfolio is, for federal income tax purposes, a separate taxable entity which will hold for the benefit of its Investors marketable securities and cash, and the assets of each Portfolio will be separate and distinct from those of each other Portfolio.

Each Portfolio, although nominally a trust under state law, is an association for purposes of 26 U.S.C. §7701(a)(2) and the regulations thereunder, and will be classified for federal income tax purposes as a partnership. Each Portfolio will maintain capital accounts and allocate items of income and expense in accordance with subchapter K of the Internal Revenue Code (endnote 2.  A Portfolio may not make a distribution prohibited under Rev. Rul. 89-81, 1989-1 C.B. 226, and will not be treated as a publicly traded partnership under 26 U.S.C. §7704.

Certain of the Portfolios will invest in State or local bonds ("the State or Local Bonds"), as defined in 26 U.S.C. §103(c)(1)(endnote 3), the interest income from which is excluded from gross income under 26 U.S.C. §103(a). A Portfolio’s distribution to an Investor, to the extent properly allocable to interest income received or accrued by the Trust in respect of the State or Local Bonds, will be excludible from the Investor’s income under 26 U.S.C. §103(a). Payment by an Investor that is a regulated investment company of a dividend to a regulated investment company shareholder will, to the extent properly allocable to interest income received or accrued by the Investor in respect of the State or Local Bonds, be an exempt-interest dividend, as defined in 26 U.S.C. §852(b)(5) (endnote 4).

One of the Portfolios (hereinafter, the "Connecticut Portfolio") will invest in State or Local Bonds that are issued by or on behalf of the state of Connecticut, its political subdivision, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut or in State or Local Bonds that are issued by or on behalf of a territory or possession of the United States (such as Puerto Rico, Guam or the Virgin Islands), the taxation of which by any state is prohibited by federal law (endnote 5). (The State or Local Bonds in which the Connecticut Portfolio will invest are hereinafter collectively and individually referred to as "the Connecticut State or Local Bonds.")

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ISSUES:

Whether the Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds retains in the hands of an Investor its character as interest income derived from the Connecticut State or Local Bonds.

Whether, in the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is required to be added to the shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income.

Whether, in the case of an investor that is a regulated investment company, a distribution by the investor, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is required to be taken into account in computing the Connecticut fiduciary adjustment.

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DISCUSSION:

Chapter 229 of the Connecticut General Statutes imposes an income tax on individuals, trusts and estates. Conn. Gen. Stat. §12-700. "A partnership as such is not subject to income tax. Individuals carrying on business as partners are liable for the income tax only in their individual capacities on their respective distributive shares of partnership income, whether or not such shares are actually distributed to them." Conn. Agencies Regs. §12-701(a)(20)-5(a). Any entity that is a partnership for federal income tax purposes (such as the Connecticut Portfolio) is a partnership for Connecticut income tax purposes. Conn. Gen. Stat. §12-701(a)(33); Conn. Agencies Regs. §12-701(b)-1(a)(3).

The starting point in computing the Connecticut adjusted gross income, as defined in Conn. Gen. Stat. §12-701(a)(20), of a resident individual is the individual’s federal adjusted gross income. Conn. Gen. Stat. §12-701(a)(19). The starting point in computing the Connecticut taxable income, as defined in Conn. Gen. Stat. §12-701(a)(10), of a resident trust or estate, is the trust or estate’s federal taxable income. To an individual’s federal adjusted gross income, there is added or subtracted the modifications enumerated in Conn. Gen. Stat. §12-701(a)(20) (endnote 6). To the trust or estate’s federal taxable income is added or subtracted the share of the trust or estate in the modifications enumerated in Conn. Gen. Stat. §12-701(a)(10) (the Connecticut fiduciary adjustment) (endnote 7).

Conn. Gen. Stat. §12-701(a)(20)(A)(ii) provides that there shall be added to an individual’s federal adjusted gross income,

A similar amount is required to be taken into account pursuant to Conn. Gen. Stat. §12-701(a)(10)(A)(ii) in computing the Connecticut fiduciary adjustment(endnote 9). The share of a trust or estate, as determined under Conn. Gen. Stat. §12-716(endnote 10), in the Connecticut fiduciary adjustment is added to or subtracted from, as the case may be, the federal taxable income of the fiduciary of such trust or estate (endnote 11).

Turning now to the issue of whether a partnership’s interest income derived from the Connecticut State or Local Bonds retains in the hands of its partner its character as interest income derived from the Connecticut State or Local Bonds, Conn. Agencies Regs. §12-715(b)-1(a) provides that partnership items of income, gain, loss or deduction "shall have the same character for a partner for Connecticut income tax purposes as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, the item shall have the same character for a partner as if realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership. If a partnership item is not required to be taken into account for federal income tax purposes (such as interest on bonds of another state), the character of the item for a partner for Connecticut income tax purposes is the same as if the partner, as an individual, had realized or incurred the item directly." Accordingly, because the Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds is not required to be taken into account for federal income tax purposes, such income retains in the hands of an Investor its character as interest income derived from Connecticut State or Local Bonds as if the Investor had realized the item directly.

Because the interest income derived from the Connecticut State or Local Bonds retains in the hands of an Investor in the Connecticut Portfolio its character as interest income derived from Connecticut State or Local Bonds as if realized directly by the Investor, and because payment by an Investor that is a regulated investment company of a dividend to a regulated investment company shareholder will, to the extent properly allocable to interest income received or accrued by the Investor in respect of the State or Local Bonds, be an exempt-interest dividend, as defined in 26 U.S.C. §852(b)(5), a distribution by an Investor that is a regulated investment company, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be added to the shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income. Conn. Gen. Stat. §12-701(a)(20)(A)(ii) (endnote 12). A comparable rule applies with respect to any shareholder which is a trust or estate: a distribution by an Investor that is a regulated investment company, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be taken into account in computing the Connecticut fiduciary adjustment. Conn. Gen. Stat. §12-701(a)(9)(A) and (10)(A)(ii).

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RULING:

The Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds will retain in the hands of an Investor its character as interest income that is derived from the Connecticut State or Local Bonds.

In the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be added to such shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income.

In the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be taken into account in computing the Connecticut fiduciary adjustment.

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Endnotes:

1. 15 U.S.C. §80a-1 to 15 U.S.C. §80-b-2.
2. 26 U.S.C. §701 to 26 U.S.C. §777.
3. Also see 26 C.F.R. §1.103-1(a) which provides generally that "[interest upon obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (hereinafter collectively or individually referred to as "State or local governmental unit") is not includable in gross income.
4. "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).
5. See 48 U.S.C. §§745, 1423a and 1574(b)(ii), respectively.
6. These modifications are described in greater detail in Conn. Agencies Regs. §§12-701(a)(20)-2 and 12-701(a)(20)-3.
7. These modifications are described in greater detail in Conn. Agencies Regs. §§12-701(a)(10)-2 and 12-701(a)(10)-3.
8. See also Conn. Agencies Regs. §12-701(a)(20)-2(a)(2).
9. See also Conn. Agencies Regs. §12-701(a)(10)-2(a)(2).
10. See also Conn. Agencies Regs. §§12-716(a)-1 and 12-716(b)-1.
11. Conn. Gen. Stat. §12-701(a)(9). Where the beneficiary of the trust or estate is an individual, the share of the beneficiary, as determined under Conn. Gen. Stat. §12-714, in the Connecticut fiduciary adjustment is added to or subtracted from, as the case may be, the beneficiary’s federal adjusted gross income in computing his or her Connecticut adjusted gross income. Conn. Gen. Stat. §12-701(a)(20). See also Conn. Agencies Regs. §§12-714(a)-1 and 12-714(a)-2.
12. The Massachusetts Department of Revenue has taken the same approach. Letter Ruling 93-12 (Aug. 3, 1993), [Mass.] St. Tax Rep. (CCH) ¶400-121. So has the South Carolina Department of Revenue and Taxation. Private Letter Ruling 93-8 (Dec. 13, 1993), [S.C.] St. Tax Rep. (CCH) ¶320-011. In an Advisory Opinion, the New York Department of Taxation and Finance has taken a similar approach with respect to exempt-interest dividends paid by a regulated investment company that was itself the shareholder of another regulated investment company that owned New York state and local bonds, the interest income from which was excluded from gross income under 26 U.S.C. §103(a). TSB-A-91(11)I (Dec. 30, 1991) [N.Y.] St. Tax Rep. (CCH) ¶400-309. No Revenue Ruling has been issued by the Internal Revenue Service.

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LEGAL DIVISION

Issued September 2, 1999