Ruling 99-5, Corporation Business Tax
FACTS:
A trust that is established under the laws of the Commonwealth of Massachusetts ("the Trust") is registered as an open-end investment management 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 include 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 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)
ISSUE:
Whether an Investor that is a regulated investment company and that is subject to the corporation business tax may deduct from its gross income the sum of (1) distributions to its shareholders of exempt-interest dividends that are derived from interest income properly allocable to State or Local Bonds held by a Portfolio and (2) expenses, bond premium, and interest that are related thereto and that are disallowed as deductions for federal income tax purposes.
DISCUSSION:
Conn. Gen. Stat. §12-214(a)(1) imposes a tax on the franchise of every company carrying on, or having the right to carry on, business in this state, for the privilege of carrying on or doing business within the state in a corporate capacity, "such tax to be measured by the entire net income as herein defined received by such corporation ... from business transacted within the state during the income year ..."
"‘Net income’ means net earnings received during the income year and available for contributors of capital, whether they are creditors or stockholders, computed by subtracting from gross income the deductions allowed by the terms of section 12-217 ..." Conn. Gen. Stat. §12-213(a)(10).
"[U]nlike the federal government, the state of Connecticut, pursuant to General Statutes §12-213, does not exclude from gross income the interest earned on municipal bonds for purposes of the corporation business tax. See Connecticut Bank & Trust Co. v. Tax Commissioner, 178 Conn. 243, 423 A.2d 883 (1979)." D.A. Pincus & Co. v. Meehan, 235 Conn. 865, 869-870, 670 A.2d 1278 (1996). "‘Gross income’ means gross income, as defined in the Internal Revenue Code, and, in addition, means any interest or exempt interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, received by the taxpayer ... and in addition, notwithstanding any other provision of law, means interest or exempt interest dividends, as defined in said Section 852(b)(5) of the Internal Revenue Code, accrued on or after the application date, as defined in section 12-242ff, with respect to any obligation issued by or on behalf of the state, its agencies, authorities, commissions and other instrumentalities, or by or on behalf of its political subdivisions and their agencies, authorities, commissions and other instrumentalities ..." Conn. Gen. Stat. §12-213(a)(9)(A).
"In arriving at net income as defined in section 12-213 ...there shall be deducted from gross income, (A) all items deductible under the Internal Revenue Code effective and in force on the last day of the income year ..." Conn. Gen. Stat. §12-217(a)(1)(A). "[A]s a general rule, title 26 of the United States Code, §265(a)(2) expressly provides that no deduction shall be allowed for interest on indebtedness incurred and paid in connection with carrying federally tax-exempt municipal obligations." D.A. Pincus & Co., supra, at 871. As a general rule, "there is no specific deduction provided in Connecticut’s corporation business tax law for interest expenses incurred in carrying a portfolio of municipal obligations." D.A. Pincus & Co., supra, at 872.
To that general rule, Conn. Gen. Stat. §12-217(a)(1)(B) is an exception, applicable to companies that are regulated investment companies. "In arriving at net income as defined in section 12-213 ...there shall be deducted from gross income, ... (B) additionally, in the case of a regulated investment company, the sum of (i) the exempt-interest dividends, as defined in the Internal Revenue Code, and (ii) expenses, bond premium, and interest related to tax-exempt income that are disallowed as deductions under the Internal Revenue Code ..." Conn. Gen. Stat. §12-217(a)(1)(B).
The Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520, changed the treatment of distributions by a regulated investment company to its shareholders, where the distributions were attributable to interest income received or accrued by the regulated investment company in respect of State or Local Bonds. This change prompted the General Assembly to enact Conn. Gen. Stat. §12-217(a)(1)(B). "[B]efore 1976 there was no flow-through treatment for tax-exempt interest, and consequently, distributions of the tax exempt interest by a regulated investment company were taxable income to the shareholders. 4 U.S. Code Cong. & Ad. News (1976), p. 4240. The Tax Reform Act of 1976, P.L. 94-455 §2137, afford[ed] flow-through treatment to tax exempt interest if certain conditions [were] met." Woodruff v. Tax Commissioner, 185 Conn. 186, 192, 440 A.2d 854 (1981). As the legislative history (endnote 5) reflects, the General Assembly was cognizant of the changes made by the Tax Reform Act of 1976 and intended to encourage the creation in Connecticut of regulated investment companies that would invest in State or Local Bonds. "[U]nder the present Connecticut corporate business tax, a mutual fund which invests only in Federal tax exempt bonds and distributes all of its income to shareholders would now pay a 10% tax on its gross receipts." 20 S.R. Proc., Pt. 1, 1977 Sess., p 378 (Remarks of Sen. Beck). Remarking on the legislation that allowed the deduction by a regulated investment company of the exempt-interest dividends that would be distributed by it to its shareholders, Sen. Beck said that it "would in effect permit a pass through of that income to the investors in the mutual fund ..." Id. Hence, distributions by a regulated investment company to its shareholders of exempt-interest dividends are deductible by the regulated investment company from its gross income under Conn. Gen. Stat. §12-217(a)(1)(B).
RULING:
An Investor that is a regulated investment company and that is subject to the corporation business tax may deduct from its gross income the sum of (1) distributions to its shareholders of exempt-interest dividends that are derived from interest income properly allocable to State or Local Bonds held by a Portfolio and (2) expenses, bond premium, and interest that are related thereto and that are disallowed as deductions for federal income tax purposes.
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 "[i]nterest 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.Senate Bill No. 367 was enacted as 1977 Conn. Pub. Acts 16, which was codified as Conn. Gen. Stat. §12-217(a)(1)(B).
LEGAL DIVISION
Issued October 27, 1999