Michael Kreimer asked whether five zero-coupon Treasury-derivative products - CATS (Certificate of Accrual on Treasury Securities), TBR (Treasury Bond Receipts), CTR (Coupon Treasury Receipts), ETR (Easy Growth Treasury Receipts), and STRIPS (Separate Trading of Registered Interest and Principal of Securities) - count as 'obligations of the United States,' so that the interest they generate is exempt from New York personal income tax under Article 22 of the Tax Law.

Plain-English summary

Michael W. Kreimer asked the Department whether five popular zero-coupon Treasury-derivative products count as "obligations of the United States" for New York income-tax purposes: CATS (Certificate of Accrual on Treasury Securities), TBR (Treasury Bond Receipts), CTR (Coupon Treasury Receipts), ETR (Easy Growth Treasury Receipts), and STRIPS (Separate Trading of Registered Interest and Principal of Securities). Each of these products works the same basic way: a custodian holds actual US Treasury notes or bonds and issues certificates representing ownership of specific future interest or principal payments from those Treasury securities. The certificate holder is the real beneficial owner of the underlying Treasury securities and is entitled to the payment streams they generate - the derivative product is just a repackaging of a genuine US Treasury obligation into a zero-coupon instrument.

Tax Law § 612(c)(1), as amended by Chapter 535 of the Laws of 1986, lets a taxpayer subtract from federal adjusted gross income any interest earned on obligations of the United States and its possessions. Because of the 1986 amendment, that subtraction also reaches interest income received as dividends from a regulated investment company (RIC), so long as the RIC designates the dividend as US-obligation interest in a written notice to shareholders within 45 days after its fiscal year ends, and at least 50% of the RIC's assets (tested every quarter) consist of US or possessions obligations. The 1986 change was specifically meant to put investors who buy US government obligations indirectly through a RIC on equal footing with investors who buy the same obligations directly.

The harder question was whether these derivative products even qualify as "obligations of the United States" in the first place, since the certificate holder technically owns a claim against a custodian rather than a direct Treasury security. The Department resolved this by borrowing a federal test: under IRC § 851(b)(4), for purposes of deciding whether a RIC satisfies the federal 50%-government-obligations diversification test, the IRS treats the US government itself as the "issuer" of zero-coupon derivative products like CATS, TIGRs, and STRIPS-program interests, but only when the underlying Treasury securities are placed in permanent escrow for the exclusive benefit of the derivative-product investors. The IRS reasoning (from GCM 39699 and LTR 8806044) is a look-through test: find whoever actually bears the "true" liability for payment, or whose conduct determines whether the investment succeeds. Investors in these products can look only to the underlying Treasury income for payment, and any misuse of funds by the escrow agent is typically covered by a fidelity bond. Where such a bond exists, the escrow/custodian entity has effectively walked away from liability, leaving the US government as the real payor and issuer. Where no fidelity bond exists, the entity that created the derivative product retains liability and is itself treated as the issuer - meaning that product would not qualify as a US obligation.

Applying that framework, the Department found that CATS, TBR, CTR, ETR, and STRIPS have all met the requirements to be treated as US government securities for the RIC diversification test under IRC § 851. That meant they also counted as "obligations of the United States" under Tax Law § 612(c)(1), so the interest income they produce is exempt from New York tax - whether Kreimer holds them directly or through a RIC. If held through a RIC, the exemption is only available to the extent the RIC itself satisfies § 612(c)(1)'s 50%-of-assets and 45-day notice requirements.

What this means for you

Investors holding zero-coupon Treasury-derivative products

If you hold CATS, TBR, CTR, ETR, or STRIPS directly, the interest that accrues (or that you're deemed to receive as the discount unwinds) is treated the same as interest on a plain US Treasury bond for New York personal income tax purposes - it's exempt under Tax Law § 612(c)(1) and can be subtracted from federal adjusted gross income when you compute New York taxable income. This opinion is specific to these five named products; it doesn't automatically bless every zero-coupon derivative on the market, since the exemption depends on the underlying escrow structure and fidelity-bond arrangement actually being in place.

Investors holding these products through a mutual fund or other RIC

The exemption doesn't travel automatically just because a fund holds Treasury-backed zero-coupon products. Your fund must separately satisfy Tax Law § 612(c)(1)'s own requirements: at least 50% of its assets (tested quarterly) must be US or possessions obligations, and the fund must send shareholders written notice designating the exempt-interest portion of its dividend within 45 days after its fiscal year ends. Check your fund's year-end tax statement for that designation before claiming the subtraction - without it, the pass-through exemption isn't available even if the fund's underlying holdings would otherwise qualify.

Accountants and tax preparers advising clients on Treasury-derivative income

When a client reports income from zero-coupon Treasury-derivative products, confirm which specific product they hold. This opinion covers CATS, TBR, CTR, ETR, and STRIPS by name, based on the Department's finding (borrowed from federal RIC-qualification analysis) that these specific products' escrow/custodial structures include the fidelity-bond protection needed to treat the US government as the true issuer. For other, less common repackaged Treasury products, verify the escrow and bonding structure before assuming the same New York exemption applies.

Common questions

Q: Why does it matter whether the US government or the custodian is the "issuer" of these products?
A: Tax Law § 612(c)(1) only exempts interest on "obligations of the United States and its possessions." A zero-coupon certificate is, on its face, a claim against whatever entity issued it. If a private custodian or brokerage were considered the true issuer, the certificate wouldn't be a US obligation and the interest would be fully taxable in New York. The Department borrowed the federal look-through test from IRC § 851(b)(4) and IRS guidance (GCM 39699, LTR 8806044) to determine that, for these five products, the US government - not the custodian - bears the true payment liability, because the underlying Treasury securities sit in permanent escrow for the investors' exclusive benefit and any custodian misconduct is covered by a fidelity bond.

Q: What's the significance of the fidelity bond in this analysis?
A: The fidelity bond is what lets the custodian escape being treated as the "issuer." If a fidelity bond covers misuse of payments by the escrow agent, the custodian has effectively insulated itself from liability, so the true source of payment - and the true issuer - is the US government whose Treasury securities generate the cash flow. Without such a bond, the entity that created the derivative product retains real liability and would itself be treated as the issuer, in which case the product would not qualify as an "obligation of the United States" and its interest would be taxable.

Q: Does this ruling apply to every zero-coupon Treasury product, or just the five named here?
A: The holding is limited to the five products Kreimer asked about - CATS, TBR, CTR, ETR, and STRIPS - which the Department found had already met the federal RIC diversification-test requirements under IRC § 851. Other repackaged Treasury products aren't automatically covered; whether they qualify depends on whether their own escrow and fidelity-bond structure satisfies the same look-through test.

Q: If I hold these products through a mutual fund instead of directly, is the interest automatically exempt?
A: No. Tax Law § 612(c)(1) requires the RIC itself to meet two conditions: at least 50% of its total assets (valued under IRC § 851(c), tested at the close of each fiscal quarter) must consist of US or possessions obligations, and the fund must give shareholders written notice, within 45 days after the close of its taxable year, designating the portion of the dividend that represents such interest income. If the fund doesn't make that designation, the New York subtraction isn't available even though the fund's underlying holdings might otherwise qualify.

Q: What was the point of the 1986 amendment (Chapter 535) to § 612(c)(1)?
A: Before the 1986 amendment, taxpayers who invested in US government obligations directly could exclude the interest from New York income, but taxpayers who invested in the same obligations indirectly through a mutual fund arguably could not, because they technically received "dividends" from the fund rather than "interest." Chapter 535 fixed that gap so that investors going through a qualifying RIC get the same New York tax treatment as investors who buy US obligations directly.

Citations and references

• Tax Law § 612(c)(1) (as amended by L.1986, ch.535) - subtracts from federal adjusted gross income interest on US/possessions obligations, including qualifying RIC dividends designated as such within 45 days of fiscal year-end, provided at least 50% of the RIC's assets are US/possessions obligations each quarter
• IRC § 851(b)(4) - the federal RIC-qualification rule under which the US government is treated as the "issuer" of certain zero-coupon Treasury-derivative products
• IRC § 851(c) - defines "value of total assets" used in the RIC 50%-obligations diversification test
• IRS GCM 39699 (November 16, 1987) - sets out the look-through test for identifying the true "issuer" of a derivative zero-coupon obligation based on who bears true payment liability
• IRS LTR 8806044 (November 17, 1987) - applies the GCM 39699 look-through/fidelity-bond analysis to zero-coupon Treasury-derivative products
• NY Legis Ann, 1986, p. 246 - legislative history explaining that Chapter 535 of the Laws of 1986 was enacted to equalize New York tax treatment of direct and RIC-indirect investment in US government obligations

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1990.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a90_9i.pdf

Original ruling text

New York State Department of Taxation -1and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-90 (9) I
Income Tax
June 29, 1990

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I900202C

On February 2, 1990, a Petition for Advisory Opinion was received from Michael W.
Kreimer, c/o A.G. Edwards, P.O. Box 9036, Smithtown, N.Y. 11787.
The issue raised by Petitioner, Michael W. Kreimer, is whether the following zero coupon
obligations are considered "obligations of the United States" and therefore the interest payments on
such obligations are exempt from personal income tax under Article 22 of the Tax Law: Certificate
of Accrual Treasuries ("CATS"), Treasury Bond Receipts ("TBR"), Coupon Treasury Receipts
("CTR"), Easy Growth Treasury Receipts ("ETR"), and Separate Trading of Registered Interest and
Principal of Securities ("STRIPS").
Generally, CATS, TBRs, CTRs, ETRs and STRIPS evidence ownership of future interest and
principal payments on issue or issues of United States Treasury notes or bonds. Such interest and
principal payments are direct obligations of the United States of America. The Treasury securities
are held in custody by a custodian on behalf of the holders of the related instruments. Holders of the
related instruments are the beneficial owners of the underlying Treasury securities entitled to the
rights and privileges evidenced thereby.
Section 612(c) of the Tax Law, as amended by Chapter 535 of the Laws of 1986, provides,
in part:
There shall be subtracted from federal adjusted gross income:
(1) Interest income on obligations of the United States and its possessions to the
extent includible in gross income for federal income tax purposes; such interest
income shall include the amount received as dividends from a regulated investment
company, as defined in section eight hundred fifty-one of the internal revenue code,
which has been designated as the amount of such interest income in a written notice
to shareholders not later than forty-five days following the close of its taxable year;
provided that, at the close of each quarter of the taxable year of such regulated
investment company, at least fifty percent of the value of its total assets, as defined
in subsection (c) of section eight hundred fifty-one of the internal revenue code,
consists of obligations of the United States and its possessions ....
Chapter 535 of the Laws of 1986 was enacted to permit individuals who invest in United
States government obligations through regulated investment companies (hereinafter "RICs") to treat
the income they receive therefrom as if they had directly invested in such securities. Specifically,
section 612(c)(1) of the Tax Law was amended to provide that "interest income on obligations of the
United States and its possessions" includes income received from a RIC that is
TP-9 (9/88)

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TSB-A-90 (9) I
Income Tax
June 29, 1990
attributable to its investment in obligations of the United States and its possessions. (See NY Legis
Ann, 1986, p 246.)
For purposes of defining a RIC for federal income tax purposes, it has been determined under
section 851(b)(4) of the Internal Revenue Code, that the United States government is considered to
be the issuer of zero coupon obligations, including CATS, TIGRs (Treasury Investment Growth
Receipts), and interests purchased through the Treasury Department's STRIPS Program, when the
underlying Treasury securities are placed in permanent escrow for the exclusive benefit of investors
of those instruments. (See Internal Revenue Service GCM 39699 (November 16, 1987);
LTR8806044 (November 17, 1987)). Counsel held that in determining the issuers of CATS, TIGRS
and similar derivative zero coupon obligations, it is proper to look through to the person burdened
with "true" liability in respect of payments on such security or to the person whose activities will
determine the success of the investment in such security. In the case of CATS, TIGRS and similar
derivative zero coupon obligations, the investor can look only to the income from the underlying
Treasury securities for payment. Any misuse of payments from the government by the escrow agent
generally will be covered by fidelity bonds. In situations in which a fidelity or similar bond exists,
the entities generating such bonds have generally insulated themselves from, and generally have
minimal liability in respect of the zero coupon obligations. In those situations where the entity has
not generated such fidelity bonds, the entity has not insulated itself from liability in respect of the
zero coupon obligations and the entity that generated the obligations is the issuer of such obligations
rather than the United States government.
Herein, the zero coupon obligations in question; namely, CATS, TBR, CTR, ETR and
STRIPS have met the requirements to be considered government securities for purposes of the
diversification tests for RICs under section 851 of the Internal Revenue Code. Therefore, such
obligations are considered "obligations of the United States" for purposes of section 612(c)(1) of the
Tax Law. Accordingly, the interest income on such zero coupon obligations is exempt from tax
under section 612(c)(1) of the Tax Law. However, when the zero coupon obligations are acquired
through a RIC, the interest income from such obligations is exempt only if the RIC meets the
requirements of section 612(c)(1).

DATED: June 29, 1990

s/PAUL B. COBURN
Deputy Director
Taxpayer Services Division

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.