New York Advisory Opinion TSB-H-80(245)I: Are exempt-interest dividends from a proposed regulated-investment-company share class investing exclusively in New York State and local bonds subject to New York Personal Income Tax or the Unincorporated Business Income Tax?

Plain-English summary

Municipal Fund for Temporary Investment, Inc. was a no-load, diversified, open-end investment company aiming to give institutional investors current interest income exempt from federal tax while preserving principal. The Fund intended to qualify as a "regulated investment company" under Internal Revenue Code section 851 and to invest substantially all its assets in federally tax-exempt bonds. Its Board was considering creating special share classes tied to specific bond issuers - including a proposed "New York Series" that would participate exclusively in income from bonds issued by New York State or its political subdivisions. The Fund asked whether exempt-interest dividends paid on that New York Series would be subject to New York Personal Income Tax or the Unincorporated Business Income Tax.

Under federal law, exempt-interest dividends paid by a regulated investment company are excluded from federal gross income (26 U.S.C. sections 103(a)(1) and 852(b)(5)(b)). Since federal adjusted gross income is the starting point for New York's Personal Income Tax, that exclusion carries through unless New York requires an addback. Tax Law section 612(b)(1) does require adding back interest income from bonds issued by states other than New York (or their political subdivisions, unless created by an interstate compact New York is party to) - but there's no such addback requirement for interest from New York's own state or local bonds. The Department confirmed that exempt-interest dividends count as "interest" for purposes of this addback rule, so the same distinction applies to them: dividends tied to non-New York bonds get added back, but dividends tied to New York bonds don't.

The same logic applied to the Unincorporated Business Income Tax, which also starts from items includible in federal gross income and excludes exempt-interest dividends on the same basis, with the same addback exception for non-New York state bonds (not New York's own). Because the proposed New York Series would participate exclusively in New York State and local bond income, its exempt-interest dividends would escape both taxes - though the Department was careful to note it expressed no opinion on dividends from any other proposed share class investing in other jurisdictions' bonds.

What this means for you

Investors in a municipal bond fund with state-specific share classes

Whether your exempt-interest dividends escape New York tax depends on which bonds actually back your specific share class - dividends tied exclusively to New York State or local obligations avoid both the addback for the Personal Income Tax and inclusion under the Unincorporated Business Tax, but dividends tied to other states' bonds generally don't.

Fund sponsors structuring state-specific municipal bond share classes

Structuring a share class to hold only a single state's exempt bonds (like this proposed "New York Series") can let that class's dividends achieve favorable New York tax treatment that a mixed-state fund's dividends wouldn't get - New York's addback exception applies bond-issuer-by-bond-issuer, not fund-by-fund.

Unincorporated businesses holding municipal fund investments

The same New York-source exclusion that applies to individuals under the Personal Income Tax carries over identically to the Unincorporated Business Income Tax, since both taxes start from the same federally-includible gross income base.

Common questions

Q: Do all tax-exempt municipal bond fund dividends escape New York tax?
A: No - only dividends attributable to New York State or local bond interest escape New York's addback requirement; dividends from other states' municipal bonds must generally be added back to compute New York adjusted gross income.

Q: Does this ruling cover dividends from the Fund's other proposed share classes investing in other states' bonds?
A: No - the Department explicitly limited its opinion to exempt-interest dividends derived exclusively from the proposed New York Series and expressed no view on any other share class.

Q: Does the same rule apply to unincorporated businesses, or only individual taxpayers?
A: Both - the ruling applies the identical reasoning to the Unincorporated Business Income Tax, since it also computes gross income starting from federally includible items and shares the same New York-bond addback exception.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1980.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/h80_245i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-80 (245)I
Income Tax
August 26, 1980

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

Petition #I800428A

On April 28, 1980, a Petition for Advisory Opinion was received from Municipal Fund for
Temporary Investment, Inc., Suite 20#, Webster Building, 3411 Silverside Road, Wilmington,
Delaware 19810.
The issue raised is the taxability under the Personal Income Tax and the Unincorporated
Business Income Tax of exempt interest dividends received from a regulated investment company
by holders of shares of common stock belonging to a series participating exclusively in the net
income produced by investments in obligations issued by the State of New York or its political
subdivision.
The Fund is a no-load, diversified, open-end investment company whose purpose is stated
to be to provide institutional investors with as high a level of current interest income exempt from
Federal income taxation as is consistent with relative stability of principal. It is intended that the
Fund will conduct its operations in such a manner as to qualify as a regulated investment company
under section 851 of the Internal Revenue Code, and that it will invest substantially all of its assets
in Federally tax exempt obligations. At the present time the Board of Directors of the Fund is
contemplating the establishment of special classes or series of Common Stock, one or more of which
would be related exclusively to portfolios consisting solely of Federally tax-exempt obligations
issued by a particular jurisdiction. Thus, the Fund is considering the issuance of a special class or
series of Common Stock (the "New York Series") which will be entitled to participate exclusively
in the net income produced by investments in obligations issued by the State of New York or its
political subdivisions.
Exempt interest dividends issued by a regulated investment company are excluded from
Federal gross income pursuant to sections 103(a)(l) and 852(b)(5)(b) of the Internal Revenue Code.
Such income is therefore not included in Federal adjusted gross income, which is the starting point
in computing taxable income under New York's Personal Income Tax. Section 612(b)(1) of the Tax
Law requires an addition to Federal adjusted gross income, in computing New York adjusted gross
income, of interest income from obligations of any state other than New York or of any political
subdivisions of any such other state unless created by compact or agreement to which New York is
a party. There is no such required addition of interest income from obligations of the State of New
York or its political subdivisions. It should be noted that exempt interest dividends constitute interest
for the purposes of the provision of the Tax Law here referred to.
Similar considerations apply with respect to the Unincorporated Business Income Tax.
Unincorporated business gross income includes only items of income and gain includible in gross
income for Federal purposes, and thus excludes exempt interest dividends. As in the case of the
Personal Income Tax there is a required addition to such items includible in Federal gross income
of interest income on obligations of any State other than New York or of certain political
subdivisions of any such other state, as described above, but not of interest income from obligations
of the State of New York or its political subdivisions.

TP-8 (4/80)

-2­
TSB-H-80 (245)I
Income Tax
August 26, 1980

Accordingly, exempt interest dividends derived exclusively from the proposed New York
Series of shares of common stock, as described above, would not be subject to either the Personal
Income Tax imposed, under Article 22 of the Tax Law, on the New York taxable income of
individuals, estates and trusts, or the Unincorporated Business Income Tax, imposed under Article
23 of the Tax Law. No opinion is expressed as to the applicability of the Tax Law to any dividends
except those exempt interest dividends which are derived exclusively from the proposed New York
Series.

Dated: July 18, 1980

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau