Are a mutual fund's exempt-interest dividends derived from Puerto Rico obligations subject to Connecticut's dividend and interest income tax?

Note — obsolete guidance on a former tax. This Ruling interprets Connecticut's former dividend and interest income tax. DRS marks it "not current … provided for reference purposes only," and it has been obsoleted by Announcement 94(2), obsoleted in part by Public Act 94-4 § 13, and superseded in part by Special Notice 95(17). The summary below explains what the Ruling said in 1991; it does not state Connecticut's current income-tax law. Do not rely on it — confirm the current treatment with DRS.

Plain-English summary

Back when Connecticut had a separate dividend and interest income tax (before the state adopted its general personal income tax), a regulated investment company — a mutual fund under 26 U.S.C. § 851(a) — asked a focused question. The fund was qualified to pay "exempt-interest dividends," and some of its assets were bonds issued by or on behalf of the Commonwealth of Puerto Rico. Were the exempt-interest dividends traceable to those Puerto Rico bonds subject to Connecticut's dividend and interest income tax?

DRS ruled they were exempt. The reasoning stacks three layers:

1. Federal law protects Puerto Rico bond interest. Under 48 U.S.C. § 745, bonds issued by the Government of Puerto Rico are "exempt from taxation by the Government of the United States … or by any State, Territory, or possession."
2. A fund's exempt-interest dividend keeps that character. Under 26 U.S.C. § 852(b)(5), an exempt-interest dividend is treated by the shareholders "as an item of interest excludable from gross income under section 103(a)" — so the fund passes the federally protected interest through to its shareholders.
3. Connecticut's own rules honor the federal bar. Connecticut regulation § 12-518-9a(d)(3) treats exempt-interest dividends as "interest income" for this tax, but § 12-518-6a(a) lets a taxpayer exclude any interest income the taxation of which by any State is prohibited by federal law. Reading the statute (Conn. Gen. Stat. § 12-505) to reach these dividends would put it in conflict with federal law, and DRS applied the rule that a statute is construed to stay constitutional.

Put together: exempt-interest dividends derived from Puerto Rico obligations were exempt from Connecticut's dividend and interest income tax.

What this means for you

This is a snapshot of a repealed tax

The most important thing to know is the caveat in the note above. Connecticut's separate dividend and interest income tax is not how the state taxes this income today, and this ruling has been formally obsoleted and partly superseded. Use it to understand the historical reasoning, not to compute a current liability.

The durable idea: federal law can override a state tax on certain interest

The principle underneath — that federal law (here, 48 U.S.C. § 745) can bar a state from taxing particular interest income, and that a mutual fund passing that interest through as an exempt-interest dividend carries the protection to shareholders — is the kind of analysis that still matters when a state tries to tax federally protected obligations. But the specific mechanics here run through repealed Connecticut provisions.

Verify current Connecticut income-tax treatment

If you hold or distribute exempt-interest dividends tied to Puerto Rico (or other federally protected) obligations, confirm how Connecticut's current income tax treats them, rather than relying on this obsolete ruling.

Common questions

Q: Can I rely on Ruling 91-14 today?
A: No. It interprets Connecticut's former dividend and interest income tax and is marked "not current"; it was obsoleted by AN 94(2), obsoleted in part by PA 94-4 § 13, and superseded in part by SN 95(17). Confirm the current law.

Q: What did the ruling decide?
A: That a mutual fund's exempt-interest dividends derived from Puerto Rico government obligations were exempt from Connecticut's dividend and interest income tax.

Q: Why were they exempt?
A: Federal law (48 U.S.C. § 745) bars any State from taxing Puerto Rico bond interest; a fund's exempt-interest dividend is treated as section 103(a) interest for shareholders (26 U.S.C. § 852(b)(5)); and Connecticut's regulation excluded interest income that federal law bars a State from taxing.

Q: Does this tell me how Connecticut taxes these dividends now?
A: No. This concerns a former tax. Check Connecticut's current income-tax rules or ask a Connecticut tax professional.

Citations and references

Federal law:

• 48 U.S.C. § 745 — Puerto Rico government bonds are exempt from taxation by the United States or by any State, Territory, or possession
• 26 U.S.C. § 852(b)(5) (with §§ 851(a), 103(a)) — a regulated investment company's exempt-interest dividend is treated by shareholders as section 103(a) interest excludable from gross income

Connecticut law:

• Conn. Gen. Stat. § 12-505 — definition of "interest income" for the dividend and interest income tax
• Conn. Agencies Regs. § 12-518-9a(d)(3) and § 12-518-6a(a) — exempt-interest dividends treated as interest income, but interest income whose taxation by any State is barred by federal law is excludable

Case law (as cited by the ruling):

• Woodruff v. Tax Commissioner, 185 Conn. 186, 440 A.2d 854 (1981)

Status:

• Obsoleted by Announcement 94(2); obsoleted in part by Public Act 94-4 § 13; superseded in part by Special Notice 95(17); DRS marks it "not current."

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 91-14

Original ruling text

Ruling 91-14, Dividend and Interest Income Tax

This information is not current and is being provided for reference purposes only

Ruling 91-14

Dividend and Interest Income Tax

This Ruling has been obsoleted by   AN 94(2) ;  obsoleted in part by PA 94-4 , §13 (May)  superseded in part by   SN 95(17)

ISSUE:

Where exempt-interest dividends are derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico, are those exempt-interest dividends subject to the dividend and interest income tax?

FACTS:

A corporation [hereinafter, "the Company"] is a "regulated investment company", as defined in 26 U.S.C. §851(a).

The Company is qualified, in accordance with 26 U.S.C. §852(b)(5), to pay exempt-interest dividends.

The assets of the Company include obligations issued by or on behalf of the Commonwealth of Puerto Rico.

Those obligations issued by or on behalf of the Commonwealth of Puerto Rico are obligations described in 26 U.S.C. §103(a).

DISCUSSION:

"All bonds issued by the Government of Puerto Rico [are] exempt from taxation by the Government of the United States ... or by any State, Territory, or possession ...." 48 U.S.C. §745.

Prior to the passage of the Tax Reform Act of 1976, Pub. L. No. 94-455, § 2137(c), if such bonds were owned by a regulated investment company, as defined in 26 U.S.C. §851(a), then the dividend income paid by the regulated investment company, to the extent it was attributable to such bonds, was taxable to its shareholders as dividend income; Woodruff v. Tax Commissioner , 185 Conn. 186, 440 A. 2d 854 (1981). If such bonds were owned by a resident individual, then the interest income paid by the Commonwealth of Puerto Rico to the bondholder was interest income that 48 U.S.C. §745 proscribed the States from taxing.

Since the passage of the Tax Reform Act of 1976, a regulated investment company that has total assets, at least fifty percent of the value of which, at the close of each quarter of its taxable year, consists of obligations described in 26 U.S.C. §103(a) is qualified to pay exempt-interest dividends to its shareholders. 26 U.S.C. §852(b)(5).

"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)." 26 U.S.C. §852(b)(5)(B).

Pursuant to 26 U.S.C. §§103(c)(2) and 7701(d), obligations described in 26 U.S.C. §103(a) may include obligations of the Commonwealth of Puerto Rico. To the extent that the obligations issued by or on behalf of the Commonwealth of Puerto Rico are obligations described in 26 U.S.C. §103(a), a regulated investment company that owns such obligations and that is qualified to pay exempt-interest dividends to its shareholders will, with respect to such obligations, pay exempt-interest dividends.

Consistent with 26 U.S.C. §852(b)(5), Conn. Agencies Regs. §12-518-9a(d)(3) treats exempt-interest dividends as "interest income", for purposes of the dividend and interest income tax. Conn. Agencies Regs. §12-518-6a(a) provides that "[a] taxpayer is allowed to exclude from interest income (1) any interest income, the taxation of which by any State is prohibited by federal law ...."

"[I]n the absence of any evidence to the contrary, we may assume that this regulation's submission to the legislative regulation review committee and its subsequent ratification '[support] the position that the regulation is consistent with the general statutory scheme that the regulation was designed to implement.' Texaco Refining & Marketing Co. v. Commissioner of Revenue Services , 202 Conn. 583, 600, 522 A.2d 771 (1987)." Connecticut Water Co. v.Barbato , 206 Conn. 337, 344 (1988).

"Interest income", as defined in Conn. Gen. Stat. §12-505, could be construed as not allowing the exclusion of interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico. (The exclusion from "interest income" of "any such income with respect to which taxation by any state is prohibited by federal law"; Conn. Gen. Stat. §12-505; applies, arguably, only if the income is otherwise "any interest income taxable for federal income tax purposes"; id. Interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico is not taxable for federal income tax purposes; 48 U.S.C. §745.) Whether or not the General Assembly enacts legislation expressly excluding from taxation "income with respect to which taxation by any state is prohibited by federal law"; Conn. Gen. Stat. §12-505; interest income derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico is not taxable by any State; 48 U.S.C. §745.

The Connecticut Supreme Court has stated that "[the ordinary rules of statutory construction do not apply when 'a literal reading places a statute in constitutional jeopardy. We are bound to assume that the legislature intended, in enacting a particular law, to achieve its purpose in a manner which is both effective and constitutional. [Citations omitted]' Moscone v. Manson , 185 Conn. 124, 128, 440 A.2d 848 (1981)." French v. Amalgamated Local Union 376, 203 Conn. 624, 636-637, 526 A.2d 861 (1987). (A similar interpretation must also be given to Conn. Agencies Regs. §§12-518-6a and 12-518-9a, which could also be interpreted as including within "interest income" exempt-interest dividends derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico.)

RULING:

Where exempt-interest dividends are derived from obligations issued by or on behalf of the Commonwealth of Puerto Rico, those exempt-interest dividends are exempt from the dividend and interest income tax.

LEGAL DIVISION

May 17, 1991