DRS: Declaratory Ruling No. 1990-1, Dividends, Interest and Capital Gains Tax

 
 
Declaratory Ruling No. 1990-1
 
Dividends, Interest and Capital Gains Tax
 

FACTS

The Trust for Government Cash Reserves (the "Trust") is a mutual fund which invests exclusively in short-term obligations of the United States, its agencies or instrumentalities. The Trust does not participate in repurchase agreements, which are two-part transactions in which an owner sells governmental securities and simultaneously agrees to buy them back in the future, with interest at an agreed rate.

The Trust qualifies as a regulated investment company for the special tax treatment under the Internal Revenue Code of 1986, 26 U.S.C. §§851 through 855, and so incurs no federal income tax liability on its undistributed income. In order to receive the special tax treatment provided by the Code, the Trust must, among other requirements, distribute at least 90% of its taxable income during the tax year. Distributions from the Trust are taxable to shareholders for federal tax purposes.

The Trust has requested a ruling to the effect that distributions from it to its investors which represent interest from federal obligations are not taxable under the Connecticut Dividends, Interest and Capital Gains Tax, Conn. Gen. Stat. §12-505 – 522.

 

BACKGROUND

Connecticut Gen. Stat. §12-505(a) defines "interest income" as "… any interest income from obligations issued by or on behalf of any state, political subdivision thereof, or public instrumentality, state or local authority, district, or similar public entity, exclusive of such income from obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality…"

Connecticut Agencies Regs. §12-518-9a(d) defines "interest income" to mean any interest income which, for federal tax purposes, is subject to tax; any interest income which is derived from obligations issued by or on behalf of any state, any political subdivision thereof, or any agency, instrumentality, authority or district thereof; and any exempt-interest dividends, as defined in §852(b)(5) of the Internal Revenue Code.

Connecticut Gen. Stat. §12-506 imposes a tax on all dividends and interest income earned, received in fact or constructively, accrued or credited to the taxpayer during his taxable year where the taxpayer’s adjusted gross income in such year equals or exceeds $54,000.

Connecticut Agencies Regs. §12-518-6a provides that a taxpayer may exclude from interest income any interest income the taxation of which by any state is prohibited by federal law; any interest income derived from obligations issued by or on behalf of the state of Connecticut, any Connecticut political subdivision, or any agency, instrumentality, authority or district of the state of Connecticut; plus any exempt interest dividends, as defined in §852(b)(5) of the Internal Revenue Code, to the extent that such dividends are derived from obligations issued by or on behalf of the state of Connecticut, any Connecticut political subdivision, or any agency, instrumentality, authority or district of the state of Connecticut.

Title 26, section 852(b)(5) of the United States Code provides that an exempt interest dividend shall be treated by the shareholders of a regulated investment company as an item of interest excludable from gross income under §103(a). Section 103(a) excludes from gross income interest on any "state or local bond", which means an obligation of a state or political subdivision thereof.

Title 31, section 3124 of the United States Code provides that obligations of the federal government are exempt from taxation by a state or political subdivision of a state. The exemption applies, with two exceptions, to each form of taxation which requires the obligation, the interest on the obligation, or both, to be considered in computing the tax.

Connecticut’s tax policy with respect to the distributions of interest income arising from federal obligations from regulated investment companies parallels that of the Internal Revenue Service. Therefore, such distributions are treated for Connecticut taxing purposes as dividends, not passed-through interest.

 

DISCUSSION

The Connecticut Dividends, Interest and Capital Gains Tax applies to dividend distributions arising from mutual funds whose portfolio of investment securities contains, in whole or in part, federal obligations.

The imposition of the Connecticut Dividends, Interest and Capital Gains Tax on dividend distributions from mutual funds derived from interest on federal obligations does not require the obligation, the interest on the obligation, or both, to be considered in computing the tax, and thus does not violate 31 U.S.C. §3124. The tax is imposed on the distributions from a mutual fund to its shareholders, not on the interest paid by the federal government on its transactions to the fund. It is the latter transaction to which 31 U.S.C §3124(a) pertains, not the distributions from fund assets in which interest payments and dividends from the fund’s various investments are mingled.

While interest received by a mutual fund retains its identity as interest when taxed at the corporate level, distributions from a mutual fund are not passed through as tax exempt interest. Instead, the interest received by a mutual fund is regarded as dividend income for federal income tax purposes upon distribution to the fund’s shareholders. The Connecticut Supreme Court in Alling Woodruff v. Comm’r, 185 Conn. 186 (1981) addressed the issue presented herein. The taxpayer in that case contended that a regulated investment company should properly be regarded as a conduit of nontaxable interest. (At that time, interest was not subject to Connecticut tax, while dividends were taxable.) The Court ruled that the legislature intended to adopt and incorporate the scheme of federal taxation with respect to dividends. Since these distributions were regarded as taxable dividends for federal purposes, they were likewise so characterized for state purposes.

In 1976 Congress amended 26 U.S.C. §852(b)(5) to provide flow-through tax exempt treatment for distributions from mutual funds. Congress therefore enacted the amendment to allow, for federal tax purposes, such flow-through treatment of interest income of a mutual fund as exempt interest dividends.

When Congress amended 26 U.S.C. §852 in 1976, it did not prohibit the states from taxing exempt interest dividends distributed by mutual funds, but only exempted such distributions from federal taxation. See the legislative history at 1976 U.S. Code. Cong. & Admin. News 4240. Furthermore, the exemption of §852 does not apply to distributions arising from obligations issued by the federal government, but only to interest arising from state and local obligations.

American Bank and Trust Co. v. Dallas County, 463 U.S. 855, reh’g denied, 463 U.S. 1250 (1983) does not bar Connecticut from taxing distributions from mutual funds. In that decision, the Texas assessors had used an equity capital formula, which "involved determining the amount of the bank’s capital assets, subtracting from that figure the bank’s liabilities and the assessed value of the bank’s real estate, and then dividing the result by the number of shares" 463 U.S. at 863), to calculate a property tax on bank shares. In essence, the tax was being imposed on income still held by the bank, not income distributed into the hands of the shareholders. The Court held that the use of such a formula violated Rev. Stat. §3701 (now 31 U.S.C. §3124(a)), because the formula considered federal obligations held by the bank in computing the tax on the shares.

Connecticut’s taxing policy, as illustrated by Woodruff, is different from that followed in American Bank. The Connecticut tax is imposed on income at the shareholder level. The shareholders never receive nor hold an interest in federal obligations. Such interest is held at the mutual fund level. A mutual fund, as a taxable entity, cannot pass on the tax exempt status of income it receives on federal obligations in its distributions of such income to its investors. Connecticut taxes a mutual fund’s shareholders on the distributions from the fund as dividend income; it does not impose tax on the undistributed interests held by the mutual fund. The tax in American Bank, on the other hand, was invalidated because it reached exempt federal obligations by including them in the calculations of the value of the undistributed income, in the form of shares, of the plaintiff bank, the holder of the federal obligations.

It is hereby ruled that dividend distributions of the Trust for Governmental Cash Reserves are subject to the Connecticut tax on dividend income pursuant to §§12-505-522 of the Connecticut General Statutes.

 

James F. Meehan
Commissioner
August 6, 1990