Was interest on Puerto Rico bonds taxable to South Carolina residents, whether held directly or received as exempt-interest dividends from a mutual fund?

Plain-English summary

South Carolina Revenue Ruling 87-3 addressed whether interest on bonds issued by Puerto Rico was taxable to South Carolina residents.

South Carolina income conforms to the Internal Revenue Code but, under Section 12-7-430(b)(1), modifies the IRC Section 103 exclusion so that only interest on obligations of South Carolina, its political subdivisions, and the United States is exempt. Standing alone, that modification would make ordinary out-of-state bond interest taxable. Puerto Rico bonds, however, carry a separate federal exemption: Title 48 U.S.C. Section 745 provides that bonds issued by the government of Puerto Rico are exempt from taxation by any state.

The Commission concluded that this federal exemption controls. Interest on Puerto Rico bonds held directly by a South Carolina resident is exempt from South Carolina tax. When the interest instead reaches a resident as exempt-interest dividends from a regulated investment company (a mutual fund) whose assets include Puerto Rico obligations, it is exempt to the extent it qualifies as an exempt-interest dividend under IRC Section 852(b)(5), which treats such dividends as interest excludable under Section 103(a).

Common questions

Q: Is out-of-state municipal bond interest generally taxable in South Carolina? Yes. The state modifies the IRC Section 103 exclusion to exempt only South Carolina, its subdivisions, and U.S. obligations.

Q: Why is Puerto Rico treated differently? A separate federal statute, 48 U.S.C. § 745, exempts Puerto Rico bonds from taxation by any state, which South Carolina must honor.

Q: Are directly held Puerto Rico bonds exempt? Yes, their interest is exempt from South Carolina income tax.

Q: What about Puerto Rico interest received through a mutual fund? It is exempt to the extent it qualifies as an exempt-interest dividend under IRC § 852(b)(5).

Citations and references

• S.C. Code § 12-7-430(b)(1) (modified IRC § 103 interest exclusion)
• 48 U.S.C. § 745 (Puerto Rico bonds exempt from state taxation)
• IRC § 852(b)(5) (regulated investment company exempt-interest dividends)

Subject

Interest on Bonds Isued By Puerto Rico

Source

• Landing page: https://dor.sc.gov/advisory-opinion-search
• Original PDF: https://dor.sc.gov/sites/dor/files/policies/RR87-3.pdf

Original ruling text

SC REVENUE RULING #87-3

SUBJECT:

Interest on Bonds Isued By Puerto Rico

SUPERSEDES:

All previous documents and any oral directives in conflict herewith.

REFERENCE:

S.C. Code Sections 12-7-410, 12-7-430

AUTHORITY:

S.C. Code Section 12-3-170

SCOPE:

A Revenue Ruling is the Commission's official interpretation of how tax
law is to be applied to a specific set of facts. A Revenue Ruling is
public information and remains a permanent document until superseded
by a Regulation or is rescinded by a subsequent Revenue Ruling.

Question:
Is interest earned on bonds issued by Puerto Rico taxable to South Carolina residents (1) if the
bonds are purchased and held directly by South Carolina residents, (2) if the bonds are purchased
and held by a regulated investment company and the interest is paid to the resident-shareholder
as exempt-interest dividends under IRC Section 852(b)(5)?
Law:
Section 12-7-410 provides:
"The South Carolina gross income, adjusted gross income, and taxable income of an
individual is the individual's gross income, adjusted gross income, and taxable income as
determined under the Internal Revenue Code with the modifications specified in
Sections12-7-430 and 12-7-435."
Section 12-7-430(b) provides:
(b) The determination of gross income as provided in the following Internal Revenue
Code Sections is made with the following modifications:
(1) The exclusion from gross income authorized by Internal Revenue Code
Section 103 is modified to exempt only interest upon obligations of this state, any
of its political subdivisions, and to exempt interest upon obligations of the United
States.
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(2) In any and all Internal Revenue Code sections that make reference to Internal
Revenue Code Section 103, the modification provided in subitem (b) of this
section similarly applies.
Internal Revenue Code Section 852(b)(5) provides:
Exempt-interest dividends. - 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), such company
shall be qualified to pay exempt-interest dividends, as defined herein, to its shareholders.
(A) Definition. - An exempt-interest dividend means 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 45 days after the close of its taxable year. If the aggregate
amount so designated with respect to a taxable year of the company (including
exempt-interest dividends paid after the close of the taxable year as described in
Section 855) is greater than the excess of(i) the amount of interest excludable from gross income under Section 103(a),
over
(ii) the amounts disallowed as deductions under Sections 265 and 171(a)(2), the
portion of such distribution which shall be only that proportion of the amount so
designated as the amount of such excess for such taxable year bears to the amount
so designated.
(B) Treatment of exempt-interest dividends by shareholders. – 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 taxabl income.
(ii) the determination of distributable net income under Subchapter J,
(iii) the allowance of, or calculation of the amount of any credit or deduction, and
(iv) the determination of the basis in the hands of any shareholder of any share of
stock of the company.
The United States Code, Title 48, Section 745 provides:
All bonds issued by the government of Puerto Rico or by its authority, shall be exempt
from taxation by the government of the United States, or by the government of Puerto
Rico or of any political or municipal subdivision thereof, or by any state, territory, or
possession, or by any county, municipality, or other municipal subdivision of any state,
territory, or possession of the United States or by the District of Columbia.
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Discussion:
South Carolina would treat as exempt-interest dividends to the extent provided under IRC
Section 852(b)(5), dividends of regulated investment companies whose assets consists of
obligations of this state or any of its political subdivisions, obligations of the United States and
obligations specifically exempt from taxation by any state by the United States Code. The United
States Code exempts bonds issued by Puerto Rico from taxation by any state.
Conclusion:
Interest earned on bonds issued by Puerto Rico, when the bonds are purchased and held directly
by South Carolina residents, is exempt from taxation by South Carolina as provided by the
United States Code, Title 48, Section 745.
Exempt-interest dividends paid to a South Carolina resident-shareholder by a regulated
investment company whose fund assets are comprised of Puerto Rico bonds are exempt from
taxation by South Carolina to the extent excluded from taxation by Section 852(b)(5) of the
Internal Revenue Code. (April 22, 1987)
SOUTH CAROLINA TAX COMMISSION
s/S. Hunter Howard
S. Hunter Howard, Chairman
s/John M. Rucker
John M. Rucker, Commissioner
s/Howard E. Duvall
Howard E. Duvall, Commissioner
Columbia, South Carolina
April 22

, 1987

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