If a tax-exempt 'lower tier' mutual fund pays exempt-interest dividends up to other 'upper tier' mutual funds that hold its shares, and those upper tier funds then pay their own exempt-interest dividends down to individual shareholders, does the New York and U.S. territory tax-exempt character of the underlying municipal bond interest survive that two-tier fund-of-funds structure, or does it become ordinary taxable dividend income by the time it reaches the shareholder?

Plain-English summary

Seven Franklin mutual funds - collectively the "Taxpayer Funds" - asked New York whether a two-layer "fund of funds" structure would strip the tax-exempt character out of their dividends before those dividends reached individual New York shareholders. The funds were: Franklin New York Tax-Exempt Money Fund, Franklin New York Insured Tax-Free Income Fund, Franklin New York Tax-Free Income Fund, Inc., Franklin Federal Tax-Free Income Fund, Franklin Insured Tax-Free Income Fund, Franklin High Yield Tax-Free Income Fund, and Franklin Puerto Rico Tax-Free Income Fund, all part of The Franklin Group of Funds.

Franklin had filed an amended application with the SEC in May 1991 seeking approval to let certain Franklin funds ("Funds") invest their short-term, end-of-day uninvested cash in other Franklin funds specifically built for that purpose ("Money Funds"). Under this arrangement, the Franklin New York Tax-Exempt Money Fund (the "lower tier fund") would sell its shares to the other six Petitioner funds (the "upper tier funds"), which would hold those shares as part of their own portfolios. All seven funds had elected, or intended to elect, to be treated as "regulated investment companies" (RICs) under the Internal Revenue Code and to qualify to pay "exempt-interest dividends" under IRC section 852(b)(5) - dividends excludable from federal gross income where at least 50% of a RIC's assets (tested quarterly) sit in tax-exempt obligations described in IRC section 103(a), and the dividend is properly designated as exempt in a written notice within 60 days of the fund's fiscal year end. As of its fiscal year ended December 31, 1990, the lower tier Tax-Exempt Money Fund had 94.2% of its assets in New York municipal obligations and 1.8% in U.S. territory and possession obligations, and 100% of its distributions that year were exempt-interest dividends for federal, New York State, and New York City purposes.

The core question: when the lower tier fund pays exempt-interest dividends up to the upper tier funds, and those upper tier funds - themselves qualifying RICs - then pay their own exempt-interest dividends down to individual shareholders subject to New York State or City personal income tax, does the exemption survive that two-tier hop, or is it "cleansed away" into ordinary taxable dividend income by the time it reaches the shareholder?

The Department held the exemption survives. New York adjusted gross income starts from federal adjusted gross income under Tax Law section 612(a), and IRC section 852(b)(5)(B) treats an exempt-interest dividend, for all federal tax purposes, as an item of interest excludable under IRC section 103(a) - a treatment that applies at every shareholder level, including where the "shareholder" receiving the dividend is itself another RIC. So if the lower tier RIC meets all of section 852's requirements and pays exempt-interest dividends to an upper tier RIC, and that upper tier RIC also meets section 852's requirements and pays its own exempt-interest dividends (derived from that same underlying interest) down to individual New York shareholders, the dividends stay excluded from federal gross income - and therefore from federal adjusted gross income, the section 612(a) starting point for New York tax - at each level along the way. The only New York-specific adjustment that could claw any of it back is Tax Law section 612(b)(1), which requires adding back the portion of an exempt-interest dividend attributable to obligations of a state OTHER than New York. That add-back does not reach the portion attributable to New York's own municipal bonds or to U.S. territory and possession obligations (such as Puerto Rico's), which get the same favorable treatment as New York's own obligations. Because New York City Administrative Code sections 11-1712(a) and (b)(1) are identical to Tax Law sections 612(a) and (b)(1), the same result applies for New York City personal income tax. Bottom line: to the extent an individual shareholder's exempt-interest dividend traces back to New York municipal bond interest or U.S. territory/possession bond interest, and was excluded from federal adjusted gross income at each RIC level along the way, it stays excluded from both New York State and New York City personal income tax - regardless of how many layers of RIC-to-RIC fund-of-funds distribution it passed through first.

What this means for you

Mutual fund sponsors building fund-of-funds or cash-sweep structures

If you're designing a structure where a tax-exempt money market fund sells shares to other tax-exempt funds as a short-term cash management tool (as Franklin did here under SEC sections 6(c) and 17(b) exemptive relief), this opinion confirms New York will not treat that structure as breaking the chain of tax-exempt income - as long as every fund in the chain independently satisfies all of IRC section 852's requirements to be a qualifying RIC that pays properly designated exempt-interest dividends. The exemption is tested and preserved at each level, not just at the top or bottom of the chain.

Individual shareholders of tax-exempt bond funds

If you hold shares of a New York or U.S. territory tax-exempt bond fund, and that fund itself invests in another affiliated tax-exempt fund for liquidity purposes, you don't need to worry that this "fund of funds" plumbing will convert your exempt-interest dividends into taxable income. As long as the fund paying you and any fund it invested through were each properly qualified RICs paying exempt-interest dividends, your dividend keeps its New York State and City tax-exempt status to the extent it's traceable to New York or territorial bond interest.

Accountants and tax preparers reviewing multi-tier RIC structures

When a client holds a bond fund that itself invests in an affiliated money market fund, check whether both the "upstream" and "downstream" funds independently meet IRC section 852(b)(5)'s 50%-asset test and dividend-designation requirements. If they do, the New York treatment mirrors the federal treatment: only the portion of the exempt-interest dividend traceable to another state's obligations gets added back under Tax Law section 612(b)(1). New York's own bonds and U.S. territory/possession bonds pass through tax-free at every tier.

Common questions

Q: Why did Franklin need this opinion at all - why not just assume the exemption carries through?
A: Because the dividend passes through two separate RIC entities before reaching the individual shareholder, Franklin wanted certainty that New York wouldn't treat the "upper tier fund" as receiving fully taxable dividend income from the "lower tier fund" that then converts to taxable income when redistributed - effectively taxing what started as tax-exempt municipal bond interest. The Department confirmed each RIC-to-RIC leg preserves the section 103(a)/852(b)(5) federal exclusion, so the New York exclusion follows automatically through section 612(a).

Q: Does this exemption cover interest on bonds from states other than New York?
A: No. Tax Law section 612(b)(1) specifically requires adding back to New York adjusted gross income the portion of an exempt-interest dividend attributable to obligations of any state OTHER than New York (or that other state's political subdivisions), to the extent not already included in federal adjusted gross income. There is no comparable add-back for New York's own obligations or for U.S. territory and possession obligations (like Puerto Rico's), which is why the Franklin Puerto Rico Tax-Free Income Fund's distributions get the same favorable treatment as the New York funds' distributions.

Q: What has to be true for a fund to pay a valid "exempt-interest dividend" under federal law?
A: Under IRC section 852(b)(5), a regulated investment company that meets all of section 852's other requirements may pay exempt-interest dividends if, at the close of each quarter of its taxable year, at least 50% of the value of its total assets consists of obligations described in IRC section 103(a) (state and local bonds). The dividend must also be designated as an exempt-interest dividend in a written notice mailed to shareholders within 60 days after the close of the fund's taxable year.

Q: Does the New York City personal income tax reach a different result than the New York State tax?
A: No. New York City Administrative Code sections 11-1712(a) and (b)(1) are identical to Tax Law sections 612(a) and (b)(1), so the Department applied the same analysis and reached the same conclusion for both New York State and New York City personal income tax purposes.

Q: Is this the first time New York addressed whether exempt-interest dividends count as "interest" under section 612?
A: No. The Department had already established in Municipal Fund for Temporary Investment, Inc., TSB-H-80(245)I (July 18, 1980), that exempt-interest dividends constitute "interest" for purposes of Tax Law section 612. This 1991 opinion builds on that precedent to resolve the additional wrinkle of a two-tier RIC-to-RIC distribution chain.

Citations and references

• Tax Law § 612(a) - New York adjusted gross income starts from the taxpayer's federal adjusted gross income, with New York-specific modifications
• Tax Law § 612(b)(1) - requires adding back interest income on obligations of any state other than New York (or its political subdivisions), to the extent not already in federal adjusted gross income; no comparable add-back applies to New York's own obligations or to U.S. territory/possession obligations
• 20 NYCRR § 116.2(a) - the regulation implementing section 612(b)(1)'s add-back, expressly including the portion of an exempt-interest dividend derived from other states' obligations
• New York City Administrative Code § 11-1712(a) and (b)(1) - identical to Tax Law § 612(a) and (b)(1), extending the same analysis to New York City personal income tax
• IRC § 103(a) - excludes interest on state and local bonds from federal gross income
• Treas. Reg. § 1.103-1(a) - extends that exclusion to obligations of a state, territory, U.S. possession, the District of Columbia, or a political subdivision
• IRC § 852(b)(5) - allows a regulated investment company meeting all other section 852 requirements to pay exempt-interest dividends if at least 50% of its assets (tested quarterly) are in section 103(a) obligations, designated in a timely written shareholder notice
• IRC § 852(b)(5)(B) - treats an exempt-interest dividend, in the hands of shareholders, as an item of interest excludable under section 103(a) for all federal tax purposes, including gross/taxable income determinations, distributable net income, credits/deductions, and stock basis
• Municipal Fund for Temporary Investment, Inc., TSB-H-80(245)I (July 18, 1980) - established that exempt-interest dividends constitute "interest" for purposes of Tax Law § 612

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1991.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a91_11i.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-91 (11) I
Income Tax
December 30, 1991

Taxpayer Services Division
Technical Services Bureau
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I910822B

On August 22, 1991, a Petition for Advisory Opinion was received from
Franklin New York Tax-Exempt Money Fund1, Franklin New York Insured Tax-Free
Income Fund2, Franklin New York Tax-Free Income Fund, Inc.3, Franklin Federal TaxFree Income Fund4, Franklin Insured Tax-Free Income Fund5, Franklin High Yield TaxFree Income Fund6, and Franklin Puerto Rico Tax-Free Income Fund7 (collectively
referred to as the "Taxpayer Funds") 777 Mariners Island Boulevard, San Mateo,
California 94404.
The issue raised by Petitioners, the Taxpayer Funds, is whether for
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 a mutual fund ("lower tier fund") to other
mutual funds ("upper tier funds") that are similarly qualified to pay exempt­
interest dividends, may be excluded from adjusted gross income when paid by the
upper tier funds to shareholders who are subject to the New York State or City
Personal Income Tax.

1

A series of the Franklin New York Tax-Free Trust, an open-end management
investment company organized as a Massachusetts business trust in 1986.
2

Also a series of the Franklin New York Tax-Free Trust (see note 1). The
fund began operations on May 1, 1991.
3

An open-end management
corporation in 1982.

investment

company

organized

as

a

New

York

4

An open-end management investment Company organized as a California
corporation in 1982.
5

A series of the Franklin Tax-Free Trust, an open-end management investment
company organized as a Massachusetts business trust in 1984.
6

Ibid.

7

Ibid.

TP-9 (9/88)

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TSB-A-91 (11) I
Income Tax
December 30, 1991

Pursuant to an amended and restated application filed with the Securities
and Exchange Commission ("SEC") on May 17, 1991, certain mutual funds included
among The Franklin Group of Funds ("Franklin") are seeking SEC approval under
sections 6(c) and 17(b) of the Investment Company Act of 1940 and Rules ltd-1
thereunder for an exemptive order that would permit certain Franklin funds to
invest their short-term cash balances in other Franklin funds that are
specifically designed to provide the liquidity necessary for short-term
investments. It is intended that the transactions proposed in the amended and
restated application ("SEC Application") will be carried out immediately upon
receipt of SEC approval and amendment of the funds' policies, as appropriate.
As set forth in the SEC Application, several of Franklin's money funds
("Money Funds") will sell shares to Franklin funds which are not Money Funds
("Funds") as a means for the Funds to invest their otherwise uninvested cash
balances at the end of a trading day. Included among the Funds and the Money
Funds are funds which invest predominantly in tax-exempt obligations and which
pay exempt-interest dividends excludable from adjusted gross income under section
852(b)(5) of the Internal Revenue Code of 1986, as amended (the "IRC"), section
612 of the Tax Law and section 11-1712 of the New York City Administrative Code.
Petitioner, Franklin New York Tax-Exempt Money Fund ("Tax-Exempt Money
Fund") is a New York tax-exempt Money Fund which will sell its shares to the
other six Petitioners that are tax-exempt Funds.
All Petitioners, except for the Franklin New York Insured Tax-Free Income
Fund, have elected to be treated as regulated investment companies ("RICs") under
the IRC and qualified as such for their preceding fiscal years and have each
qualified to pay and have paid exempt-interest dividends excludable from adjusted
gross income under section 852(b)(5) of the IRC and section 612 of the Tax Law
and section 11-1712 of the New York City Administrative Code in their prior
fiscal years. The Franklin New York Insured Tax-Free Income Fund intends to
elect to be treated as a RIC for its first fiscal year ending December 31, 1991.
Each Petitioner intends to qualify as a RIC during the current and future years.
Each Petitioner intends to qualify to pay and to pay such exempt-interest
dividends under the applicable federal and New York provisions in the current and
future years.
The Tax-Exempt Money Fund had invested 94.2% and 1.8%, respectively, of its
invested assets in tax-exempt obligations of New York municipal issuers and
United States territories and possessions as of its fiscal year ended December
31, 1990, and during such fiscal year 100% of the fund's distributions were
exempt-interest dividends for federal, New York State and New York City personal
income tax purposes. A small portion of the fund's assets were cash balances
maintained for liquidity purposes. The other Petitioners will satisfy the 50%
asset test of section 852(b)(5) of the IRC by direct holdings of obligations
described in section 103(a) of the IRC. In addition, each Petitioner distributes
all of its net investment income and net short-term and long-term capital gains
so as to not be liable for any federal income or excise taxes or state franchise
or income taxes.

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TSB-A-91 (11) I
Income Tax
December 30, 1991

Section 612(a) of the Tax Law provides:
"[t]he New York adjusted gross
income of a resident individual means his federal adjusted gross income as
defined in the laws of the United States for the taxable year, with the
modifications specified in this section."
Section 62 of the IRC provides that adjusted gross income means gross
income less certain deductions.
Section 103(a) of the IRC provides that gross income does not include
interest on any state or local bond.
Section 1.103-1(a) of the Treasury
Regulations, promulgated thereunder, provide 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 government unit") is not includable
in gross income .... "
Section 612(b)(1) of the New York State 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 required addition
of 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 constitute interest for the purposes of section 612 of the Tax
Law. Municipal Fund for Temporary Investment, Inc., St Tax Comm Adv Op, July 18,
1980, TSB-H-80-(245)-I.
Section 116.2(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
subparagraph [BI of paragraph [5] of subsection [bi of section 852
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.
Exempt-interest dividends are paid by a RIC pursuant to section 852(b)(5)
of the IRC. 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, at the close of each quarter of its taxable year, at least 50% 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.

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TSB-A-91 (11) I
Income Tax
December 30, 1991

Section 852(b)(5)(B) of the IRC states that:
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 taxable
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.
Therefore, the amount of exempt-interest dividends issued by a RIC that is
excluded from a shareholder's federal gross income pursuant to sections 10B(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 10B(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.
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.
Accordingly, if for federal income tax purposes, a shareholder 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.

-5­

TSB-A-91 (11) I
Income Tax
December 30, 1991

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 subject to the New York City Personal Income Tax, the principles
described herein and the conclusion reached for New York State Personal Income
Tax purposes will also apply to the application of the New York City Personal
Income Tax.

DATED: December 30, 1991

s/PAUL B. COBURN
Deputy Director
Taxpayer Services Division

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