If a New York municipal bond mutual fund invests its short-term cash in a money-market mutual fund that also pays exempt-interest dividends, do those dividends stay exempt from New York State and City income tax as they pass from the money-market fund up to the bond fund and then out to the bond fund's own shareholders?

Plain-English summary

Petitioners are Fidelity New York Municipal Trust and its portfolio series, Spartan New York Municipal Income Fund (the "Fund"), which qualifies as a regulated investment company ("RIC") under Subchapter M of the Internal Revenue Code. The Fund invests predominately in obligations of New York municipal issuers and US territories and possessions, and pays "exempt-interest dividends" under IRC § 852(b)(5) that are excluded from federal adjusted gross income and, correspondingly, largely or entirely exempt from New York State and City income tax.

Because the Fund is open-end (shareholders can redeem shares at any time), it must keep enough short-term, liquid investments on hand to meet redemptions. But short-term tax-exempt municipal paper is often in short supply, and the Fund's investment policy bars it from buying short-term instruments (like repurchase agreements or commercial paper) whose interest is taxable. To solve this, Fidelity proposed letting the Fund invest its short-term cash in one or more money-market mutual funds it manages - the "New York Retail Funds" (Spartan New York Municipal Money Market Fund and Fidelity New York Municipal Money Market Fund) - instead of, or in addition to, buying short-term securities directly. Each of these "lower-tier funds" is itself a RIC that has qualified and expects to continue to qualify to pay exempt-interest dividends, with roughly 95-96% of its net assets in New York-exempt obligations as of the facts described.

The question was whether exempt-interest dividends paid by the lower-tier money-market funds up to the Fund (the "upper-tier fund"), and then repaid by the Fund to its own shareholders, remain excluded from New York adjusted gross income all the way through to the ultimate individual shareholders. The Department concluded yes: so long as each RIC in the chain independently satisfies all the requirements of IRC § 852 to pay exempt-interest dividends, the dividends attributable to New York municipal obligations and obligations of US territories and possessions are excluded from federal adjusted gross income at every tier and, because Tax Law § 612(b)(1) and NYC Admin Code § 11-1712(b)(1) only require an add-back for interest on obligations of other states, remain excluded from New York adjusted gross income for shareholders subject to New York State or City personal income tax.

What this means for you

Investors in NY municipal bond funds

If you hold shares of a New York municipal bond fund that in turn invests part of its portfolio in a related money-market fund for liquidity purposes, the tax-exempt character of the underlying New York (and US territory/possession) interest is not lost just because it passes through an extra layer of fund ownership. As long as both funds independently qualify to pay exempt-interest dividends under IRC § 852(b)(5), the dividends you receive keep their New York State and City tax-exempt status to the same extent as if you had invested directly in the underlying municipal obligations.

Fund sponsors/administrators structuring tiered fund-of-funds arrangements

A fund can address its liquidity needs by parking short-term cash in an affiliated money-market fund rather than buying short-term taxable instruments directly, without jeopardizing the exempt status of dividends passed up to its own shareholders - provided each fund in the chain (both the lower-tier money-market fund and the upper-tier fund) independently meets all the IRC § 852 requirements to pay exempt-interest dividends, including the requirement that at least 50 percent of the RIC's total assets consist of IRC § 103(a) obligations at the close of each quarter and that the dividend be properly designated in a written notice to shareholders within 60 days after the close of the taxable year.

Common questions

Q: Why did the Fund need to invest in money-market funds instead of just buying short-term municipal bonds directly?
A: Short-term New York municipal obligations are often in short supply, and the Fund's investment policy prohibits it from buying short-term taxable instruments (such as repurchase agreements, overnight commercial paper, or overnight bank time-deposits) because its objective is to seek income exempt from federal and New York State and City income tax.

Q: Does it matter that the money is passing through two separate mutual funds before reaching the individual investor?
A: No, provided each fund independently qualifies under IRC § 852 to pay exempt-interest dividends. The opinion holds that exempt-interest dividends retain their character as the shareholder moves up the chain: first when the lower-tier money-market fund pays the upper-tier Fund, and again when the upper-tier Fund pays its own shareholders.

Q: What New York tax provision would otherwise require adding back this dividend income?
A: Tax Law § 612(b)(1) (and its NYC Admin Code § 11-1712(b)(1) counterpart) requires adding back interest income on obligations of states other than New York, to the extent not includible in federal adjusted gross income. Because the dividends here are attributable to New York obligations (and US territory/possession obligations), no add-back applies.

Q: Do exempt-interest dividends count as "interest" for New York tax purposes even though they are technically dividends?
A: Yes. The Department cited its own prior opinion, TSB-H-(245)I (Municipal Fund for Temporary Investment, Inc.), for the proposition that exempt-interest dividends issued by a RIC constitute interest for purposes of Tax Law § 612.

Q: Has the Department reached a similar conclusion before for a single-tier fund?
A: Yes. In TSB-A-91(11)I (Franklin New York Tax-Exempt Money Fund), the Department concluded that a shareholder receiving exempt-interest dividends derived from New York municipal obligations and US territory/possession obligations, excluded from federal adjusted gross income, likewise excludes them from New York adjusted gross income. This opinion extends that same principle to a two-tier fund-of-funds structure.

Q: What has to be true at each tier for the exemption to hold?
A: Under IRC § 852(b)(5), each RIC must meet all of the requirements of IRC § 852, including that at least 50 percent of the value of its total assets consist of IRC § 103(a) obligations as of the close of each quarter, and it must designate the exempt-interest dividend in a written notice to shareholders no later than 60 days after the close of its taxable year.

Citations and references

• Tax Law § 612(a) - New York adjusted gross income starts from federal adjusted gross income, with specified modifications
• Tax Law § 612(b)(1) - requires adding back interest on obligations of other states (not New York or US territories/possessions) to the extent not includible in federal adjusted gross income
• NYC Admin Code § 11-1712(a)/(b)(1) - City personal income tax provisions identical to Tax Law § 612(a)/(b)(1)
• 20 NYCRR § 112.2(a) - regulation excluding from New York adjusted gross income the portion of an exempt-interest dividend derived from non-New York obligations, mirroring § 612(b)(1)
• IRC § 103(a) - gross income does not include interest on state or local bonds
• Treas. Reg. § 1.103-1(a) - interest on obligations of a state, territory, possession, or the District of Columbia is not includible in gross income
• IRC § 852(b)(5) - conditions (including the 50%-of-assets test and the written notice requirement) under which a RIC may pay exempt-interest dividends
• IRC § 852(b)(5)(B) - an exempt-interest dividend is treated as interest excludable under IRC § 103(a) for all purposes, including determination of gross and taxable income
• TSB-H-(245)I - Municipal Fund for Temporary Investment, Inc. (July 18, 1980): exempt-interest dividends paid by a RIC constitute "interest" for purposes of Tax Law § 612
• TSB-A-91(11)I - Franklin New York Tax-Exempt Money Fund (December 30, 1991): exempt-interest dividends derived from New York obligations excluded from federal adjusted gross income are also excluded from New York adjusted gross income

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_2000.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a00_1i.pdf

Original ruling text

New York State Department of Taxation and Finance

Office of Tax Policy Analysis
Technical Services Division

TSB-A-00(1)I
Income Tax
February 29, 2000

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I991123A

On November 23, 1999, a Petition for Advisory Opinion was received from Fidelity New
York Municipal Trust and its portfolio series Spartan New York Municipal Income Fund, 82
Devonshire Street, Boston, Massachusetts 02109.
The issue raised by Petitioners, Fidelity New York Municipal Trust (the “Trust”) and its
portfolio series Spartan New York Municipal Income Fund (the “Fund”), is whether for New York
State and City personal income tax purposes, exempt-interest dividends attributable to interest on
New York municipal obligations and obligations of United States territories and possessions that are
paid by mutual funds (the “lower-tier funds”) to another mutual fund (the “upper-tier fund”) that is
similarly qualified to pay exempt-interest dividends, which are excluded from federal adjusted gross
income, are also excluded from adjusted gross income for New York State and City personal income
tax purposes when paid by the upper-tier fund to shareholders of the upper-tier fund who are subject
to the New York State or City personal income tax.
Petitioners submit the following facts as the basis for this Advisory Opinion.
Background
The Fund is a portfolio series of the Trust1. The Fund qualified as a regulated investment
company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (“IRC”),
in its most recent taxable year ended January 31, 1999, and intends to continue to qualify as such in
all subsequent years. The Fund is treated as a separate corporation for federal income tax purposes
pursuant to section 851(g) of the IRC. The Fund invests predominately in obligations of New York
municipal issuers and United States territories and possessions, which obligations pay interest that
is exempt from federal and New York State and City income tax (“New York Exempt Obligations”).
The Fund has qualified and expects to continue to qualify to pay exempt-interest dividends
excludable from federal adjusted gross income under section 852(b)(5) of the IRC (“Federal ExemptInterest Dividends”), which dividends will be largely or entirely exempt from New York State and
City income tax under section 612 of the Tax Law and section 11-1712 of the New York City
Administrative Code, respectively.

1

The Trust is organized as a Massachusetts business trust and is registered as an open­
end management investment company under the Investment Company Act of 1940, as amended,
15 USC 80a-1 et seq. (The “1940 Act”). The Trust is also a “series company” under Rule 18f-2
of the 1940 Act.

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The principal office of the Fund is located at 82 Devonshire Street, Boston, Massachusetts
02109. The Fund has an investment management agreement with Fidelity Management & Research
Company (“Fidelity”) and a sub-advisory agreement with an affiliated sub-advisor.
As a New York municipal income fund, the Fund seeks a high level of current income
exempt from federal income tax and New York State and City personal income tax. Specifically,
one of the Fund’s principal investment strategies is to invest so that normally at least 80 percent of
its income distributions are exempt from federal and New York State and City personal income tax.2
In selecting the Fund’s investments, Fidelity uses the Lehman Brothers New York 4 Plus Year
Municipal Bond Index (the “Index”) as a guide. Fidelity’s strategy for the Fund is to have an overall
interest-rate risk which is comparable to the Index and to maintain the Fund’s dollar-weighted
average maturity (“DWAM”) at a level that is reasonably close to the DWAM of the Index. As of
January 31, 1999, the DWAMs of the Fund and the Index were 13.7 years and 15.65 years,
respectively.
Need to Invest in Short-Term Securities
Although the DWAM of the fund frequently exceeds 10 years, the Fund must maintain an
adequate position in short-term securities for purposes of maintaining sufficient liquidity. Because
the Fund is “open-end”, investors have the right to purchase and redeem Fund shares at any time.
As a result, the fund may need cash in certain circumstances to fund unexpected shareholder
redemptions. Short-term investments, which mature frequently, provide a source of proceeds to
satisfy unexpected redemptions by shareholders. By staggering short-term investments so that a
certain portion matures every day, the Fund can ensure a ready supply of cash. Cash that is not used
to finance redemptions can be “rolled over” into new short-term investments. Such an approach
would not be feasible with long-term securities, which mature over a more extended period.
Although short-term investments are, therefore, extremely important to the Fund, there is a
limited supply of such investments that the Fund may purchase. There are numerous types of short­
term fixed-income investments. Many of the most popular of these investments, however, such as
repurchase agreements, overnight commercial paper and overnight bank time-deposits, pay interest
that is subject to both federal and state income tax. The Fund cannot purchase such instruments due
to (a) the Fund’s investment objective to seek a high level of current income exempt from federal
and New York State and City income tax and (b) the Fund’s policy not to invest in municipal

2

Under a proposal on which the Fund’s shareholders are scheduled to vote on February
16, 2000, this strategy would be modified so that the Fund would be required to invest at least 80
percent of its assets in municipal securities whose interest is exempt from federal and New York
State and City personal income taxes. This shift from an income-distribution-based strategy to
an asset-based strategy is intended to facilitate compliance monitoring, since asset-based limits
generally can be monitored more efficiently.

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securities whose interest is subject to federal income tax. As a result, the Fund’s preferred option
for short-term investments is to invest in obligations issued by New York municipalities.
Unfortunately, in many cases such obligations may be in short supply.
Alternative Investments
In order to alleviate these problems, Fidelity is planning to allow the Fund to invest in one
or more money market funds that it manages in lieu of, or in addition to, having the Fund invest
directly in short-term securities. Money market funds are governed by an extensive set of rules set
forth in Rule 2a-7 (17 CFR §270.2a-7) under the 1940 Act and differ from other types of mutual
funds in that they seek to maintain a stable net asset value, typically $1.00 per share.
Two of the specific money market funds in which the Funds may invest are the Spartan New
York Municipal Money Market Fund and Fidelity New York Municipal Money Market Fund
(collectively, the “New York Retail Funds”), which are available to the public. Each of the New
York Retail Funds is organized as a portfolio series of a Delaware business trust, is taxable as a
separate corporation for federal income tax purposes under section 851(g) of the IRC, and has
qualified and expects to continue to qualify as a RIC under Subchapter M of the IRC. Each of the
New York Retail Funds also has qualified and expects to continue to qualify to pay Federal ExemptInterest Dividends which dividends will be largely or entirely exempt from New York State and City
income tax pursuant to section 612 of the Tax Law and section 11-1712 of the New York City
Administrative Code. As of October 29, 1999, 95.7 percent of Fidelity New York Municipal Money
Market Fund’s net assets and 95.4 percent of Spartan New York Municipal Money Market Fund’s
net assets consisted of New York Exempt Obligations.
Discussion
Section 612(a) of the Tax Law provides that the New York adjusted gross income of a
resident individual means the individual’s federal adjusted gross income as defined in the laws of
the United States for the taxable year, with the modifications specified in section 612 of the Tax
Law.
Section 62 of the IRC provides that, for federal income tax purposes, adjusted gross income
means gross income less certain deductions.
Section 103(a) of the IRC, with certain exceptions, provides that gross income does not
include interest on any state or local bond. Section 1.103-1(a) of the Treasury Regulations provides
that interest upon obligations of a State, territory, a possession of the United States, the District of
Columbia, or any political subdivision thereof is not includible in gross income, except as provided
under section 103(c) and(d) of the IRC.

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Exempt-interest dividends are paid by a RIC pursuant to section 852(b)(5) of the IRC.
Section 852(b)(5)(B) of the IRC states that “[a]n 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 taxable income ...” If all of the other requirements of section 852 of the IRC have been
met, section 852(b)(5) of the IRC provides that a RIC may pay exempt-interest dividends if, as the
close of each quarter of its taxable year, at least 50 percent of the value of the total assets of the RIC
consist of obligations described in section 103(a) of the IRC. An exempt-interest dividend paid must
be designated as such in a written notice mailed to its shareholders not later than 60 days after the
close of its taxable year.
Therefore, the amount of exempt-interest dividends issued by a RIC that is excluded from
a shareholder’s federal gross income pursuant to section 103(a) and 852(b)(5) of the IRC, is excluded
from federal adjusted gross income, the starting point in computing the shareholder’s New York
adjusted gross income.
Likewise, where a RIC meets all of the requirements of section 852 of the IRC and pays
exempt-interest dividends pursuant to section 852(b)(5) of the IRC to a shareholder that is another
RIC, and that other RIC also meets all the requirements of section 852 of the IRC, and also pays
exempt-interest dividends pursuant to section 852(b)(5) of the IRC to shareholders who are subject
to New York personal income tax, the amount of such exempt-interest dividends received by a
shareholder is excluded from the shareholder’s federal gross income pursuant to section 103(a) and
852(b)(5) of the IRC. Such exempt-interest dividends are also excluded from the shareholder’s
federal adjusted gross income, the starting point for computing the shareholder’s New York adjusted
gross income.
When computing New York adjusted gross income, the only modification contained in
section 612 of the Tax Law that affects the shareholders of a RIC that pays exempt-interest dividends
is section 612(a) which provides an add modification for the portion of such exempt-interest
dividends derived from obligations of any state, other than New York, or a political subdivision of
any such other state, to the extent not includible in federal adjusted gross income.
Section 612(b)(1) of the Tax Law provides that when computing New York adjusted gross
income a taxpayer shall add to federal adjusted gross income “interest income on obligations of any
state other than this state, or of a political subdivision of any such other state ... to the extent not
properly includible in federal adjusted gross income.” There is no such add modification required
for interest income from obligations of the State of New York, its political subdivisions or of
possessions or territories of the United States. Exempt-interest dividends issued by a RIC constitute
interest for the purposes of section 612 of the Tax Law. Municipal Fund for Temporary Investment,
Inc., Adv Op of Commn T&F, July 18, 1980, TSB-H-(245)I.

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Section 112.2(a) of the New York State Personal Income Tax Regulations provides:
Interest income on obligations of any state, other than New York State, or of
a political subdivision of any such other state (including that part of an exempt­
interest dividend, as described in section 852(b)(5)(B) of the Internal Revenue Code,
paid by a regulated investment company which is derived from any such obligations),
unless created by compact or agreement to which New York State is a party, to the
extent not properly includible in Federal adjusted gross income.
Accordingly, if for federal income tax purposes, a shareholder of a RIC receives exempt­
interest dividends derived from New York municipal obligations and obligations of United States
territories and possessions that are excluded from the shareholder’s federal adjusted gross income,
such exempt-interest dividends are excluded from New York adjusted gross income. (See, Franklin
New York Tax-Exempt Money Fund, Adv Op Comm T&F, December 30, 1991, TSB-A-91(11)I)
Section 11-1712(a) and (b)(1) of the New York City Administrative Code are identical to
section 612(a) and (b)(1) of the Tax Law. Therefore, for a shareholder of a RIC subject to the New
York State and City personal income tax, the principles described and the conclusion reached herein,
for New York State personal income tax purposes, will also apply to the application of the New York
City personal income tax.
Conclusion
For New York State and City personal income tax purposes, exempt-interest dividends
attributable to interest on New York municipal obligations and obligations of United States
territories and possessions that are paid by the lower-tier funds to an upper-tier fund that is similarly
qualified to pay exempt-interest dividends, which are excluded from federal adjusted gross income,
are also excluded from New York adjusted gross income when paid by the upper-tier fund to
shareholders of the upper-tier fund who are subject to New York State or City personal income tax.

DATED: February 29, 2000

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Division

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