If a Connecticut individual owns a mutual fund that invests in other funds holding Connecticut municipal bonds, are the exempt-interest dividends that flow through both funds still exempt from Connecticut income tax?

Plain-English summary

A family of mutual funds set up a two-tier ("fund-of-funds") structure. An upper-tier fund invests predominantly in Connecticut and U.S.-territory municipal bonds, but to hold enough short-term liquidity it also buys shares of two lower-tier "Connecticut Funds" — money-market funds that themselves invest predominantly in Connecticut municipal bonds. Every fund involved is a regulated investment company (RIC) that qualifies to pay exempt-interest dividends under federal tax law. The funds asked DRS a technical but important question: when those exempt-interest dividends pass through both tiers to an individual Connecticut investor, does Connecticut make the investor add them back into taxable income?

DRS answered no — the exemption survives the pass-through. Two specific holdings:

• Regular Connecticut income tax: An individual shareholder of the upper-tier fund is not required under Conn. Gen. Stat. § 12-701(a)(20)(A)(ii) to add back the portion of the dividends that traces (through the lower-tier funds) to interest on Connecticut-Exempt State or Local Bonds. Connecticut's income tax starts from federal adjusted gross income, which already excludes exempt-interest dividends under 26 U.S.C. §§ 103(a) and 852(b)(5); and Connecticut's add-back statute specifically carves out dividends derived from Connecticut obligations (and obligations that federal law bars states from taxing, such as Puerto Rico, Virgin Islands and Guam bonds). Because federal law treats an exempt-interest dividend "for all purposes" as interest excludable under § 103(a), that character carries from the lower-tier fund up through the upper-tier fund to the investor.
• Connecticut minimum tax (AMT): For the portion of the dividends traceable to specified private activity bonds (a federal AMT preference item), the investor should exclude that Connecticut/territory-bond portion when computing "adjusted federal alternative minimum taxable income" (§ 12-701(a)(30)) and "adjusted federal tentative minimum tax" (§ 12-701(a)(24)) — so it does not feed the net Connecticut minimum tax.

DRS noted that New York's tax department had reached the same result (citing TSB-A-91(11)I and TSB-A-00(1)I), that the IRS had not issued a Revenue Ruling on the point, and that DRS would follow any such IRS Revenue Ruling if one were later issued.

What this means for you

Individual investors in Connecticut municipal-bond funds

If you hold a Connecticut muni-bond mutual fund and it happens to invest through a second layer of funds, you generally keep the Connecticut income-tax benefit: the exempt-interest dividends attributable to Connecticut (and U.S.-territory) bonds aren't added back to your Connecticut income, and the private-activity-bond slice is kept out of the Connecticut minimum-tax math. You still rely on the fund's reporting to tell you what portion is Connecticut/territory-sourced.

Mutual-fund companies and investment advisers

A fund-of-funds structure does not, by itself, cost Connecticut investors the state exemption on Connecticut-bond income. Because the exempt-interest-dividend character passes through under 26 U.S.C. § 852(b)(5)(B), your shareholder reporting should identify the Connecticut/territory-sourced portion at each tier so investors can claim the correct exclusion (including the private-activity-bond portion for AMT purposes).

Accountants and tax professionals

The mechanics run: federal AGI already excludes exempt-interest dividends (§§ 103(a), 852(b)(5)); Connecticut AGI begins from federal AGI (§ 12-701(a)(19)–(20)); and the add-back in § 12-701(a)(20)(A)(ii) excepts Connecticut obligations and federally protected obligations. The pass-through works because § 852(b)(5)(B) says an exempt-interest dividend is treated as § 103(a) interest "for all purposes," so an upper-tier RIC that receives it can re-designate it as an exempt-interest dividend to its own shareholders. Mirror the analysis for the Connecticut minimum tax under §§ 12-700a, 12-701(a)(24) and (a)(30), watching the § 57(a)(5) private-activity-bond preference.

Common questions

Q: Are Connecticut municipal-bond fund dividends taxable by Connecticut?
A: Exempt-interest dividends attributable to Connecticut obligations (and to U.S.-territory obligations that federal law protects from state taxation) are not added back into Connecticut adjusted gross income under § 12-701(a)(20)(A)(ii).

Q: Does a "fund-of-funds" structure break the exemption?
A: No. This ruling holds the exempt character passes through both tiers, so an individual investor in the upper-tier fund keeps the Connecticut exemption on the Connecticut/territory-bond portion.

Q: What about the Connecticut minimum tax on private activity bonds?
A: The portion of dividends traceable to Connecticut/territory specified private activity bonds should be excluded from adjusted federal AMTI and adjusted federal tentative minimum tax, so it doesn't drive the net Connecticut minimum tax.

Q: Does this cover out-of-state municipal bonds too?
A: No. The exclusion is specifically for Connecticut obligations and obligations federal law bars states from taxing (e.g., Puerto Rico, Virgin Islands, Guam). Dividends from other states' bonds are generally added back.

Citations and references

Connecticut statutes:

• Conn. Gen. Stat. § 12-701(a)(20)(A)(ii) (add-back of exempt-interest dividends, excepting Connecticut and federally protected obligations)
• Conn. Gen. Stat. § 12-701(a)(19) & (a)(20) (Connecticut adjusted gross income; federal AGI as starting point)
• Conn. Gen. Stat. § 12-700a(a); § 12-701(a)(23)–(26), (a)(29), (a)(30) (net Connecticut minimum tax and its components)

Federal law:

• 26 U.S.C. § 103(a) (interest on state or local bonds excluded from gross income)
• 26 U.S.C. § 852(b)(5) (exempt-interest dividends; treated as § 103(a) interest "for all purposes")
• 26 U.S.C. § 851 (regulated investment company; series-company funds treated as separate corporations)
• 26 U.S.C. § 55–58, § 57(a)(5) (alternative minimum tax; specified private activity bonds as a preference item)
• 26 C.F.R. § 1.103-1(a)

Regulations and related guidance:

• Conn. Agencies Regs. § 12-701(a)(20)-2(a)(2)
• New York TSB-A-91(11)I (Dec. 30, 1991) and TSB-A-00(1)I (Feb. 29, 2000) (cited by DRS as reaching the same result)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2001-1

Original ruling text

Ruling 2001-1, Income Tax

FACTS:

There are two business trusts ("the Massachusetts Trust" and "the Delaware Trust", hereinafter collectively referred to as "the Trusts"), each of which is registered as an open-end management investment company under the Investment Company Act of 1940, as amended ("the 1940 Act"). 15 U.S.C. §80a-1 to 15 U.S.C. §80b-2. As such, each of the Trusts is a regulated investment company, as defined in 26 U.S.C. §851(a)(1). Each of the Trusts is also a "series company" under Rule 18f-2 of the 1940 Act.

Each of the Trusts has more than one fund, as defined in 26 U.S.C. §851(g)(2). Pursuant to 26 U.S.C. §851(g)(1), each fund is treated as a separate corporation for federal income tax purposes. (Each fund is also treated as a separate corporation for corporation business tax purposes. See Ruling No. 91-26 , clarified by Ruling No. 92-10 and obsoleted in part by AN 94(1) , Rulings and Administrative Pronouncements Obsoleted by Legislative Changes Affecting the Corporation Business Tax Act .)

One of the funds of the Massachusetts Trust ("the Fund") is an "open-end" fund that invests predominantly in State or local bonds, as defined in 26 U.S.C. §103(c)(1), the interest income from which is excluded from gross income under 26 U.S.C. §103(a). Those State or local bonds were issued either by or on behalf of the state of Connecticut, one of its political subdivisions, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut, or by or on behalf of a territory or possession of the United States, such as Puerto Rico, the United States Virgin Islands or Guam, the taxation of which by any state is prohibited by federal law. ( See 48 U.S.C. §§745, 1403, 1423 and 1574(b)(ii), respectively.) Those bonds are hereinafter collectively and individually referred to as "Connecticut-Exempt State or Local Bonds".

In its most recent taxable year, the Fund has met the requirements of 26 U.S.C. §§851(b) and 852(a) for eligibility to be taxed as a regulated investment company, and has qualified to pay exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5). The Fund intends to continue to qualify as a regulated investment company and to pay exempt-interest dividends in all subsequent taxable years.

Due to its need to maintain an adequate position in short-term securities to maintain sufficient liquidity, the Fund will also purchase shares of two of the funds of the Delaware Trust (both of which are hereinafter collectively referred to as "the Connecticut Funds"). (Thus, the Fund is an "upper-tier fund", and each of the Connecticut Funds is a "lower-tier fund.") Each of the Connecticut Funds is an "open-end" fund that invests predominantly in Connecticut-Exempt State or Local Bonds. Each of the Connecticut Funds is also a money market fund that is governed by the rules set forth in 17 C.F.R. §260.2a-7 under the 1940 Act.

Each of the Connecticut Funds, in its most recent taxable year, has met the requirements of 26 U.S.C. §§851(b) and 852(a) for eligibility to be taxed as a regulated investment company, and has qualified to pay exempt-interest dividends. Each of the Connecticut Funds intends to continue to qualify as a regulated investment company and to pay exempt-interest dividends in all subsequent taxable years. Of the exempt-interest dividends that each of the Connecticut Funds pays, a portion is derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the Connecticut Funds and that are specified private activity bonds, as defined in 26 U.S.C. §57(a)(5)(C), the interest income on which is an item of tax preference described in 26 U.S.C. §57.

ISSUES:

Whether an individual who is a shareholder of an upper-tier fund and who receives exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), from the upper-tier fund is required under Conn. Gen. Stat. §12-701(a)(20)(A)(ii) to include in his or her Connecticut adjusted gross income the portion of those exempt-interest dividends that is derived from exempt-interest dividends which are paid by lower-tier funds to the upper-tier fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the lower-tier funds.

Whether an individual who is a shareholder of an upper-tier fund and who receives exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), from the upper-tier fund is required to include the portion of those exempt-interest dividends, to the extent includable in his or her federal alternative minimum taxable income, in calculating his or her adjusted federal alternative minimum taxable income, as defined in Conn. Gen. Stat. §12-701(a)(30), and in calculating his or her adjusted federal tentative minimum tax, as defined in Conn. Gen. Stat. §12-701(a)(24), that is derived from exempt-interest dividends which are paid by the lower-tier funds to the upper-tier fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the lower-tier funds and that are specified private activity bonds, as defined in 26 U.S.C. §57(a)(5)(C).

RULING:

An individual who is a shareholder of an upper-tier fund and who receives exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), from the upper-tier fund is not required under Conn. Gen. Stat. §12-701(a)(20)(A)(ii) to include in his or her Connecticut adjusted gross income the portion of those exempt-interest dividends that is derived from exempt-interest dividends which are paid by lower-tier funds to the upper-tier fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the lower-tier funds.

An individual who is a shareholder of an upper-tier fund and who receives exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), from the upper-tier fund is not required to include (and should exclude) the portion of those exempt-interest dividends, to the extent includable in his or her federal alternative minimum taxable income, in calculating his or her adjusted federal alternative minimum taxable income, as defined in Conn. Gen. Stat. §12-701(a)(30), and in calculating his or her adjusted federal tentative minimum tax, as defined in Conn. Gen. Stat. §12-701(a)(24), that is derived from exempt-interest dividends which are paid by the lower-tier funds to the upper-tier fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the lower-tier funds and that are specified private activity bonds, as defined in 26 U.S.C. §57(a)(5)(C).

DISCUSSION:

26 U.S.C. §62 provides that, for federal income tax purposes, adjusted gross income means gross income less certain deductions specified therein. 26 U.S.C. §103(a) provides that, with certain exceptions, gross income does not include interest on any State or local bond. 26 C.F.R. §1.103-1(a) provides that interest upon obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof is not includable in gross income.

Exempt-interest dividends are paid by a qualified regulated investment company pursuant to 26 U.S.C. §852(b)(5). A regulated investment company is qualified to pay exempt-interest dividends to its shareholders "if, at the close of each quarter of its taxable year, at least 50 percent of the value (as defined in section 851(c)(4)) of the total assets of the regulated investment company consists of obligations described in section 103(a)." 26 U.S.C. §852(b)(5). 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). "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).

Therefore, the amount of exempt-interest dividends that is paid by a regulated investment company and that is excluded from a shareholder’s federal gross income pursuant to 26 U.S.C. §§103(a) and 852(b) is excluded from the shareholder’s federal adjusted gross income, the starting point in computing the Connecticut adjusted gross income, as defined in Conn. Gen. Stat. §12-701(a)(20), of an individual. Conn. Gen. Stat. §12-701(a)(19).

In the matter at hand, a lower-tier fund, such as either of the Connecticut Funds, meets the requirements of 26 U.S.C. §§851(b) and 852(a) for eligibility to be taxed as a regulated investment company, and qualifies to pay, and does pay, exempt-interest dividends to a shareholder that is an upper-tier fund, such as the Fund. 26 U.S.C. §852(b)(5)(B) provides that an exempt-interest dividend is to be treated by shareholders (including an upper-tier fund) "for all purposes of this subtitle as an item of interest excludable from gross income under section 103(a). Such purposes include ... (i) the determination of gross income and taxable income ..."

An upper-tier fund is required to determine the portion of any dividend that it will pay to its own shareholders which shall constitute an exempt-interest dividend. This involves determining whether "(i) the amount of interest excludable from gross income under section 103(a)" exceeds "(ii) the amounts disallowed as deductions under sections 265 and 171(a)(2)." 26 U.S.C. §852(b)(5)(A). An exempt-interest dividend that is received by an upper-tier regulated investment company and that is treated "as an item of interest excludable from gross income under section 103(a)"; 26 U.S.C. §852(b)(5)(B); must also be treated, to the extent provided by 26 U.S.C. §852(b)(5)(A), as an "amount of interest excludable from gross income under section 103(a)"; 26 U.S.C. §852(b)(5)(A)(i); when it is paid by the upper-tier fund to its shareholders.

Accordingly, where a lower-tier fund meets the requirements of 26 U.S.C. §§851(b) and 852(a) for eligibility to be taxed as a regulated investment company, and qualifies to pay, and does pay, exempt-interest dividends to an upper-tier fund, and the upper-tier fund also meets the requirements of 26 U.S.C. §§851(b) and 852(a) for eligibility to be taxed as a regulated investment company, and qualifies to pay, and does pay, exempt-interest dividends to a shareholder who is an individual, the amount of such exempt-interest dividends received by the shareholder who is an individual is excluded from the individual’s federal adjusted gross income.

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

(ii) any exempt-interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, exclusive of such exempt-interest dividends derived from obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut and exclusive of such exempt-interest dividends derived from obligations, the income with respect to which taxation by any state is prohibited by federal law ...

(This modification is described in greater detail in Conn. Agencies Regs. §12-701(a)(20)-2(a)(2).)

The Connecticut-Exempt State or Local Bonds are either "obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut" or "obligations, the income with respect to which taxation by any state is prohibited by federal law."

Therefore, an individual who is a shareholder of the Fund receiving exempt-interest dividends from the Fund is not required under Conn. Gen. Stat. §12-701(a)(20)(A)(ii) to include in his or her Connecticut adjusted gross income the portion of those exempt-interest dividends that is derived from exempt-interest dividends which are paid by the Connecticut Funds to the Fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the Connecticut Funds.

The New York Department of Taxation and Finance has taken the same approach. See TSB-A-91(11)I (December 30, 1991) and TSB-A-00(1)I (February 29, 2000). Notably, the Internal Revenue Service has not issued a Revenue Ruling on this subject. Were the Internal Revenue Service to issue a Revenue Ruling on this subject, the Department of Revenue Services would follow the approach taken in such a Revenue Ruling.

Conn. Gen. Stat. §12-700a(a) requires every resident individual who is "subject to and required to pay the federal alternative minimum tax under Section 55 of the Internal Revenue Code" to "pay, in addition to the tax imposed under section 12-700, the net Connecticut minimum tax." "‘Net Connecticut minimum tax’ means the amount by which the Connecticut minimum tax exceeds the income tax imposed under section 12-700." Conn. Gen. Stat. §12-701(a)(25). The Connecticut minimum tax of an individual is "the lesser of (i) nineteen per cent of the adjusted federal tentative minimum tax, as defined in subdivision (24) of subsection (a) of this section, or (ii) five per cent of the adjusted federal alternative minimum tax, as defined in subdivision (30) of this subsection." Conn. Gen. Stat. §12-701(a)(26)(A).

"‘Federal alternative minimum taxable income’ means alternative minimum taxable income, as defined in Section 55(b)(2) of the Internal Revenue Code." Conn. Gen. Stat. §12-701(a)(29). "The term ‘alternative minimum taxable income’ means the taxable income of the taxpayer for the taxable year (A) determined with the adjustments provided in section 56 and section 58, and (B) increased by the amount of the items of tax preference described in section 57." 26 U.S.C. §55(b)(2). Interest on specified private activity bonds is an item of tax preference. 26 U.S.C. §57(a)(5). "[A]ny exempt-interest dividend is treated as interest on a specified private activity bond to the extent of its proportionate share of the income of such bonds received by the company paying such dividend." 26 U.S.C. §57(a)(5)(B). Therefore, exempt-interest dividends that are derived from exempt-interest dividends which are paid by lower-tier funds to an upper-tier fund and which are derived from interest income properly allocable to specified private activity bonds that are owned by the lower-tier funds are items of tax preference described in 26 U.S.C. §57, to the extent provided by 26 U.S.C. §57(a)(5)(B).

Under Conn. Gen. Stat. §12-701(a)(30), an individual’s adjusted federal alternative minimum taxable income is calculated

by excluding, to the extent includable in federal alternative minimum taxable income, the amount of any interest income or exempt-interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, from obligations that are issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district, or similar public entity that is created under the laws of the state of Connecticut, or from obligations that are issued by or on behalf of any territory or possession of the United States, any political subdivision of such territory or possession, or public instrumentality, authority, district or similar public entity of such territory or possession, the income with respect to which taxation by any state is prohibited by federal law...

The Connecticut-Exempt State or Local Bonds are either "obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity that is created under the laws of the state of Connecticut" or "obligations that are issued by or on behalf of any territory or possession of the United States, any political subdivision of such territory or possession, or public instrumentality, authority, district or similar public entity of such territory or possession, the income with respect to which taxation by any state is prohibited by federal law."

Therefore, an individual who is a shareholder of the Fund receiving exempt-interest dividends from the Fund is not required to include (and should exclude) the portion of those exempt-interest dividends, to the extent includable in his or her federal alternative minimum taxable income, in calculating his or her adjusted federal alternative minimum taxable income under Conn. Gen. Stat. §12-701(a)(30), that is derived from exempt-interest dividends which are paid by the Connecticut Funds to the Fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the Connecticut Funds and that are specified private activity bonds, as defined in 26 U.S.C. §57(a)(5)(C).

"‘Federal tentative minimum tax’ means tentative minimum tax, as determined pursuant to Section 55 of the Internal Revenue Code, reduced by the alternative minimum tax foreign tax credit." Conn. Gen. Stat. §12-701(a)(23).

Under Conn. Gen. Stat. §12-701(a)(24), an individual’s adjusted federal tentative minimum tax is calculated

by excluding, to the extent includable in federal alternative minimum taxable income, the amount of any interest income or exempt-interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, from obligations that are issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district, or similar public entity that is created under the laws of the state of Connecticut, or from obligations that are issued by or on behalf of any territory or possession of the United States, any political subdivision of such territory or possession, or public instrumentality, authority, district or similar public entity of such territory or possession, the income with respect to which taxation by any state is prohibited by federal law...

Therefore, an individual who is a shareholder of the Fund receiving exempt-interest dividends from the Fund is not required to include (and should exclude) the portion of those exempt-interest dividends, to the extent includable in the individual’s federal alternative minimum taxable income, in calculating the individual’s adjusted federal alternative minimum tax under Conn. Gen. Stat. §12-701(a)(24) ), that is derived from exempt-interest dividends which are paid by the Connecticut Funds to the Fund and which are derived from interest income properly allocable to Connecticut-Exempt State or Local Bonds that are owned by the Connecticut Funds and that are specified private activity bonds, as defined in 26 U.S.C. §57(a)(5)(C).

LEGAL DIVISION

January 12, 2001