Can a mutual fund (regulated investment company) subject to Connecticut corporation business tax deduct the tax-exempt bond dividends it passes through to shareholders, plus the related expenses federal law disallows?

Plain-English summary

A master-feeder mutual fund structure asked DRS a corporation-business-tax question. A Massachusetts trust set up "Portfolios" — sub-trusts that are treated as partnerships for tax purposes — which hold State or Local Bonds whose interest is federally tax-exempt under 26 U.S.C. § 103(a). The Investors in these Portfolios include regulated investment companies (RICs) — i.e., mutual funds — that in turn distribute the income to their own shareholders as exempt-interest dividends. The question: can an Investor that is a RIC and is subject to Connecticut's corporation business tax deduct from its gross income (1) the exempt-interest dividends it distributes to its shareholders and (2) the related expenses, bond premium and interest that federal law won't let it deduct?

DRS said yes. The reasoning walks through a quirk of Connecticut law:

• Connecticut's corporation business tax does NOT exempt municipal-bond interest. Unlike the federal income tax, Connecticut (§ 12-213(a)(9)(A)) includes interest and exempt-interest dividends from municipal bonds in a company's gross income for the corporation business tax. (The courts confirmed this: Connecticut Bank & Trust Co. v. Tax Commissioner; D.A. Pincus & Co. v. Meehan.) And generally there's no deduction for the interest expense of carrying municipal obligations (mirroring 26 U.S.C. § 265(a)(2)).
• But there's a specific exception for regulated investment companies. Conn. Gen. Stat. § 12-217(a)(1)(B) lets a RIC deduct from gross income the sum of (i) its exempt-interest dividends and (ii) the expenses, bond premium, and interest related to tax-exempt income that are disallowed as deductions under the Internal Revenue Code. The legislature added this provision (1977 Conn. Pub. Acts 16) in response to the federal Tax Reform Act of 1976, which created flow-through treatment for tax-exempt interest paid out by mutual funds — and Connecticut wanted to encourage the formation of Connecticut mutual funds investing in State or Local Bonds rather than tax away that income (as the courts noted in Woodruff v. Tax Commissioner).

The upshot: the RIC includes the municipal-bond income in gross income, then deducts the exempt-interest dividends it passes through (plus the federally disallowed related costs), so the tax-exempt character effectively flows through the fund to its investors instead of being taxed at the fund level.

What this means for you

Mutual funds (regulated investment companies) operating in Connecticut

Don't assume Connecticut mirrors the federal exclusion of municipal-bond interest — for the corporation business tax it doesn't; the interest lands in your gross income first. Your relief comes from the § 12-217(a)(1)(B) RIC deduction: subtract the exempt-interest dividends you distribute and the related expenses/bond premium/interest that federal law disallowed. Claim both prongs; the deduction is what delivers the pass-through result. This works even when the tax-exempt bonds are held indirectly through a partnership-classified Portfolio in a master-feeder structure.

Investment advisers and fund sponsors

Connecticut deliberately built this deduction to make the state hospitable to municipal-bond mutual funds. If you're choosing where to organize a tax-exempt bond fund, the § 12-217(a)(1)(B) deduction is the mechanism that prevents the corporation business tax from eroding the fund-level exempt income.

Corporate tax directors, accountants and tax professionals

The chain: § 12-214 imposes the tax on net income; § 12-213(a)(9)(A) pulls municipal interest/exempt-interest dividends into gross income (contra the federal rule — D.A. Pincus, Connecticut Bank & Trust); § 12-217(a)(1)(A) allows IRC-based deductions; and § 12-217(a)(1)(B) adds the RIC-specific deduction for exempt-interest dividends plus IRC-disallowed related expenses (§ 265(a)(2) items). This ruling arose from the same master-feeder facts as its companion, Ruling 99-4 (the individual/trust income-tax analysis).

Common questions

Q: Does Connecticut tax municipal-bond interest for the corporation business tax?
A: Yes — unusually, Connecticut includes municipal-bond interest and exempt-interest dividends in a company's gross income for the corporation business tax, unlike the federal income tax.

Q: How does a mutual fund avoid tax on that income at the fund level?
A: A regulated investment company deducts, under § 12-217(a)(1)(B), the exempt-interest dividends it distributes to shareholders plus the related expenses, bond premium and interest that federal law disallows — producing a pass-through to investors.

Q: Does it matter that the bonds are held through a partnership "Portfolio"?
A: No. The ruling applied the deduction even where the RIC Investor holds the State or Local Bonds indirectly through a partnership-classified Portfolio in a master-feeder structure.

Q: Why does this deduction exist?
A: The legislature enacted it (1977 Conn. Pub. Acts 16) after the federal Tax Reform Act of 1976 created flow-through treatment for tax-exempt interest, aiming to encourage Connecticut mutual funds that invest in State or Local Bonds.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-214(a)(1) (corporation business tax, measured by net income); § 12-213(a)(9)(A) & (a)(10) (gross income includes municipal interest/exempt-interest dividends; net income)
• Conn. Gen. Stat. § 12-217(a)(1)(A) (IRC deductions) and § 12-217(a)(1)(B) (RIC deduction for exempt-interest dividends and IRC-disallowed related expenses), from 1977 Conn. Pub. Acts 16
• 26 U.S.C. § 852(b)(5) (exempt-interest dividends); § 265(a)(2) (disallowed expenses of carrying tax-exempt obligations); § 851 (RIC)

Cases:

• Connecticut Bank & Trust Co. v. Tax Commissioner, 178 Conn. 243 (1979); D.A. Pincus & Co. v. Meehan, 235 Conn. 865 (1996); Woodruff v. Tax Commissioner, 185 Conn. 186 (1981)
• Companion ruling: Ruling 99-4 (income-tax treatment of the same master-feeder structure)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 99-5

Original ruling text

Ruling 99-5, Corporation Business Tax

FACTS:

A trust that is established under the laws of the Commonwealth of Massachusetts ("the Trust") is registered as an open-end investment management company under the Investment Company Act of 1940, as amended  (endnote 1) . The Trust itself is not open to investment. Rather, it establishes sub-trusts ("Portfolios") in which investments may be made.

Investors in Portfolios ("Investors") will include regulated investment companies, as defined in 26 U.S.C. §851, bank common trust funds, endowments and other institutional investors but will not include individuals, S corporations, partnerships, limited liability companies or grantor trusts. Each Portfolio is, for federal income tax purposes, a separate taxable entity which will hold for the benefit of its Investors marketable securities and cash, and the assets of each Portfolio will be separate and distinct from those of each other Portfolio.

Each Portfolio, although nominally a trust under state law, is an association for purposes of 26 U.S.C. §7701(a)(2) and the regulations thereunder, and will be classified for federal income tax purposes as a partnership. Each Portfolio will maintain capital accounts and allocate items of income and expense in accordance with subchapter K of the Internal Revenue Code  (endnote 2) . A Portfolio may not make a distribution prohibited under Rev. Rul. 89-81, 1989-1 C.B. 226, and will not be treated as a publicly traded partnership under 26 U.S.C. §7704.

Certain of the Portfolios will invest in State or local bonds ("the State or Local Bonds"), as defined in 26 U.S.C. §103(c)(1)  (endnote 3) , the interest income from which is excluded from gross income under 26 U.S.C. §103(a). A Portfolio’s distribution to an Investor, to the extent properly allocable to interest income received or accrued by the Trust in respect of State or Local Bonds, will be excludible from the Investor’s income under 26 U.S.C. §103(a). Payment by an Investor that is a regulated investment company of a dividend to a regulated investment company shareholder will, to the extent properly allocable to interest income received or accrued by the Investor in respect of the State or Local Bonds, be an exempt-interest dividend, as defined in 26 U.S.C. §852(b)(5).  (endnote 4)

ISSUE:

Whether an Investor that is a regulated investment company and that is subject to the corporation business tax may deduct from its gross income the sum of (1) distributions to its shareholders of exempt-interest dividends that are derived from interest income properly allocable to State or Local Bonds held by a Portfolio and (2) expenses, bond premium, and interest that are related thereto and that are disallowed as deductions for federal income tax purposes.

DISCUSSION:

Conn. Gen. Stat. §12-214(a)(1) imposes a tax on the franchise of every company carrying on, or having the right to carry on, business in this state, for the privilege of carrying on or doing business within the state in a corporate capacity, "such tax to be measured by the entire net income as herein defined received by such corporation ... from business transacted within the state during the income year ..."

"‘Net income’ means net earnings received during the income year and available for contributors of capital, whether they are creditors or stockholders, computed by subtracting from gross income the deductions allowed by the terms of section 12-217 ..." Conn. Gen. Stat. §12-213(a)(10).

"[U]nlike the federal government, the state of Connecticut, pursuant to General Statutes §12-213, does not exclude from gross income the interest earned on municipal bonds for purposes of the corporation business tax. See Connecticut Bank & Trust Co. v. Tax Commissioner , 178 Conn. 243, 423 A.2d 883 (1979)." D.A. Pincus & Co. v. Meehan , 235 Conn. 865, 869-870, 670 A.2d 1278 (1996). "‘Gross income’ means gross income, as defined in the Internal Revenue Code, and, in addition, means any interest or exempt interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, received by the taxpayer ... and in addition, notwithstanding any other provision of law, means interest or exempt interest dividends, as defined in said Section 852(b)(5) of the Internal Revenue Code, accrued on or after the application date, as defined in section 12-242ff, with respect to any obligation issued by or on behalf of the state, its agencies, authorities, commissions and other instrumentalities, or by or on behalf of its political subdivisions and their agencies, authorities, commissions and other instrumentalities ..." Conn. Gen. Stat. §12-213(a)(9)(A).

"In arriving at net income as defined in section 12-213 ...there shall be deducted from gross income, (A) all items deductible under the Internal Revenue Code effective and in force on the last day of the income year ..." Conn. Gen. Stat. §12-217(a)(1)(A). "[A]s a general rule, title 26 of the United States Code, §265(a)(2) expressly provides that no deduction shall be allowed for interest on indebtedness incurred and paid in connection with carrying federally tax-exempt municipal obligations." D.A. Pincus & Co ., supra, at 871. As a general rule, "there is no specific deduction provided in Connecticut’s corporation business tax law for interest expenses incurred in carrying a portfolio of municipal obligations." D.A. Pincus & Co ., supra, at 872.

To that general rule, Conn. Gen. Stat. §12-217(a)(1)(B) is an exception, applicable to companies that are regulated investment companies. "In arriving at net income as defined in section 12-213 ...there shall be deducted from gross income, ... (B) additionally, in the case of a regulated investment company, the sum of (i) the exempt-interest dividends, as defined in the Internal Revenue Code, and (ii) expenses, bond premium, and interest related to tax-exempt income that are disallowed as deductions under the Internal Revenue Code ..." Conn. Gen. Stat. §12-217(a)(1)(B).

The Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520, changed the treatment of distributions by a regulated investment company to its shareholders, where the distributions were attributable to interest income received or accrued by the regulated investment company in respect of State or Local Bonds. This change prompted the General Assembly to enact Conn. Gen. Stat. §12-217(a)(1)(B). "[B]efore 1976 there was no flow-through treatment for tax-exempt interest, and consequently, distributions of the tax exempt interest by a regulated investment company were taxable income to the shareholders. 4 U.S. Code Cong. & Ad. News (1976), p. 4240. The Tax Reform Act of 1976, P.L. 94-455 §2137, afford[ed] flow-through treatment to tax exempt interest if certain conditions [were] met." Woodruff v. Tax Commissioner , 185 Conn. 186, 192, 440 A.2d 854 (1981). As the legislative history  (endnote 5)  reflects, the General Assembly was cognizant of the changes made by the Tax Reform Act of 1976 and intended to encourage the creation in Connecticut of regulated investment companies that would invest in State or Local Bonds. "[U]nder the present Connecticut corporate business tax, a mutual fund which invests only in Federal tax exempt bonds and distributes all of its income to shareholders would now pay a 10% tax on its gross receipts." 20 S.R. Proc., Pt. 1, 1977 Sess., p 378 (Remarks of Sen. Beck). Remarking on the legislation that allowed the deduction by a regulated investment company of the exempt-interest dividends that would be distributed by it to its shareholders, Sen. Beck said that it "would in effect permit a pass through of that income to the investors in the mutual fund ..." Id . Hence, distributions by a regulated investment company to its shareholders of exempt-interest dividends are deductible by the regulated investment company from its gross income under Conn. Gen. Stat. §12-217(a)(1)(B).

RULING:

An Investor that is a regulated investment company and that is subject to the corporation business tax may deduct from its gross income the sum of (1) distributions to its shareholders of exempt-interest dividends that are derived from interest income properly allocable to State or Local Bonds held by a Portfolio and (2) expenses, bond premium, and interest that are related thereto and that are disallowed as deductions for federal income tax purposes.

Endnotes

1. 15 U.S.C. §80a-1 to 15 U.S.C. §80-b-2.

2. 26 U.S.C. §701 to 26 U.S.C. §777.

3. Also see 26 C.F.R. §1.103-1(a) which provides generally that "[i]nterest upon obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (hereinafter collectively or individually referred to as "State or local governmental unit") is not includable in gross income.

4. "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).

5. Senate Bill No. 367 was enacted as 1977 Conn. Pub. Acts 16, which was codified as Conn. Gen. Stat. §12-217(a)(1)(B).

LEGAL DIVISION

Issued October 27, 1999