New York Advisory Opinion TSB-A-91(9)I: May Federal Trust Fund, a regulated investment company, and its shareholders treat the fund's 'Exempt Obligations' - federal government obligations whose interest is subject to federal tax but exempt from New York State tax - as 'obligations of the United States' for purposes of the Tax Law § 612(c)(1) subtraction, and, provided the asset and notice requirements are met, may shareholders subtract the portion of their dividends attributable to interest on those obligations from their New York taxable income?

Plain-English summary

Federal Trust Fund was one of seven separate portfolios of the Trust For Federal Securities, a Pennsylvania business trust, with each portfolio treated as its own "regulated investment company" (RIC) for both federal and New York tax purposes. The fund invested in what it called "Exempt Obligations" - a specific, technical category of bonds that (a) are described in the Department's TSB-M-86(8)I guidance, (b) are obligations of the federal government or its agencies, authorities, or instrumentalities, (c) have interest that IS subject to federal income tax, and (d) have interest that IS exempt from New York State income tax under Article 22 of the Tax Law. In other words, these are federal-agency or instrumentality bonds that Congress made federally taxable but that New York law separately exempts from state tax.

The fund asked the Department two related questions. First, could it and its shareholders treat these Exempt Obligations as "obligations of the United States" for purposes of Tax Law § 612(c)(1) - the provision that lets RIC shareholders subtract from their New York taxable income the portion of RIC dividends attributable to interest on federal obligations, provided at least 50% of the RIC's assets (tested quarterly) consist of such obligations and the RIC gives shareholders written notice within 45 days after its fiscal year ends? Second, if so, could shareholders actually claim that subtraction on their New York personal income tax returns?

The Department walked through the 1986 legislative history behind § 612(c)(1) at length. Before a 1986 amendment (Chapter 535, originating as Senate Bill 6647-B, passed without dissent), individuals who bought federal obligations directly could exclude the interest from New York taxable income, but individuals who invested indirectly through a RIC could not - even though RICs are treated as tax "conduits." The bill's sponsors, then-Commissioner Roderick Chu's letter to the Governor, a Budget Report, and a Department of Commerce memorandum all described the fix in broad terms, as reaching "Federal obligations" generally rather than some narrower subcategory. Although the term "obligations of the United States" is not itself defined in the statute, and Tax Law § 612(c)(2) separately covers interest on obligations of a "authority, commission or instrumentality of the United States" that is federally taxable but state-exempt, the Department reasoned that the existence of that separate clause didn't require reading § 612(c)(1)'s broader phrase narrowly - especially because the RIC pass-through rule in § 612(c)(1) was added later, by amendment, and wasn't adopted at the same time as § 612(c)(2). The Department also pointed to its own prior ruling, Bernstein Government Short Duration Portfolio of Sanford C. Bernstein Fund, Inc. (TSB-A-89(4)I, April 11, 1989), which held that RIC dividends attributable to interest on obligations of the United States and its possessions are treated as § 612(c)(1) interest income, with TSB-M-86(8)I as the reference for what counts as such an obligation.

Based on that legislative purpose and prior precedent, the Department answered both questions yes: Federal Trust Fund's Exempt Obligations qualify as "obligations of the United States" for purposes of the § 612(c)(1) RIC pass-through rule, and, provided the 50%-of-assets and 45-day notice requirements are satisfied, the fund's shareholders may treat the portion of their dividends attributable to interest on those Exempt Obligations as a subtraction item on their New York returns - exempting that income from New York State personal income tax, just as if they had bought the bonds directly.

What this means for you

Investors in bond funds holding federal agency or instrumentality obligations

If you own shares in a regulated investment company that invests in federal government, agency, or instrumentality obligations whose interest is subject to federal tax but exempt from New York tax under Article 22, you may be entitled to subtract your pro-rata share of that dividend income from your New York taxable income - but only if the fund itself satisfies two conditions: at least 50% of its total assets (measured at the end of each fiscal quarter) must consist of such obligations, and the fund must give you written notice, within 45 days after its fiscal year-end, designating the amount of your dividends attributable to that interest. Without both the asset test and the timely notice, the subtraction is unavailable even if the underlying bonds would otherwise qualify.

Fund sponsors and administrators of RICs holding federal obligations

This opinion confirms that "obligations of the United States" for purposes of the Tax Law § 612(c)(1) RIC pass-through rule is read broadly, consistent with the 1986 legislative intent to put indirect RIC investors on equal footing with direct bondholders - it isn't limited to Treasury obligations narrowly, and isn't cut down merely because a separate clause (§ 612(c)(2)) exists for authority/instrumentality obligations. If your fund holds obligations described in TSB-M-86(8)I, meets the 50% asset test each quarter, and sends the required shareholder notice within 45 days of fiscal year-end, you can designate the associated dividend income as § 612(c)(1) interest income so your shareholders can subtract it on their New York returns.

Accountants preparing returns for RIC shareholders

When a client reports dividends from a bond fund, check whether the fund issued a written notice under § 612(c)(1) identifying a portion of the distribution as attributable to interest on obligations of the United States (including obligations covered by TSB-M-86(8)I). If the fund met the 50%-of-assets test each quarter and gave timely notice, that designated portion is subtractable from federal adjusted gross income on the New York return, regardless of whether the underlying obligations are also subject to federal tax.

Common questions

Q: What exactly is an "Exempt Obligation" as used in this opinion?
A: It's Petitioner's own defined term for a specific category of bond: an obligation that (a) is described in the Department's TSB-M-86(8)I guidance, (b) is issued by the federal government or one of its agencies, authorities, or instrumentalities, (c) has interest that is subject to federal income tax, and (d) has interest that is exempt from New York State income tax under Article 22 of the Tax Law. It is not federal Treasury debt in the ordinary sense - it's a narrower category of federal-agency or instrumentality obligations that Congress made federally taxable but that New York law exempts from state tax.

Q: Why did the Department need to address this at all - doesn't § 612(c)(1) just say "obligations of the United States"?
A: Because the phrase "obligations of the United States" isn't defined anywhere in the Tax Law, and a separate provision, § 612(c)(2), specifically addresses interest or dividend income on obligations of a "authority, commission or instrumentality of the United States" that is federally taxable but state-exempt. That juxtaposition could suggest that § 612(c)(1)'s broader phrase should be read narrowly to exclude instrumentality obligations, leaving them to be covered (if at all) only by § 612(c)(2). The Department rejected that narrow reading, relying on the 1986 legislative history's broad description of "Federal obligations" and the fact that the § 612(c)(1) RIC pass-through rule was added later, by a separate amendment, rather than being adopted alongside § 612(c)(2).

Q: What are the "asset and notice requirements" the opinion keeps referencing?
A: Two conditions built into Tax Law § 612(c)(1) itself. First, at the close of each quarter of the RIC's taxable year, at least 50% of the value of its total assets (as defined by reference to Internal Revenue Code § 851(c)) must consist of obligations of the United States and its possessions. Second, the RIC must designate, in a written notice to shareholders no later than 45 days after the close of its taxable year, the amount of dividends attributable to that interest income. Both conditions must be met before a shareholder can subtract the designated amount from federal adjusted gross income.

Q: How does this opinion relate to the Bernstein Government Short Duration Portfolio ruling?
A: TSB-A-89(4)I (April 11, 1989) already established that dividends RIC shareholders receive that are attributable to interest on obligations of the United States and its possessions are treated as § 612(c)(1) interest income, and that TSB-M-86(8)I is the reference for what counts as such an obligation. This opinion extends that same reasoning to Federal Trust Fund's "Exempt Obligations" - a subcategory that is federally taxable but state-tax-exempt - confirming they too fall within the § 612(c)(1) pass-through rule rather than being excluded from it.

Q: Does this mean all income from federal agency bonds is New York tax-exempt when held through a fund?
A: No. Only the portion of dividends attributable to interest on obligations that meet the "Exempt Obligation" definition (or otherwise qualify as obligations of the United States and its possessions under TSB-M-86(8)I) and that the fund designates through a timely written notice, and only if the fund's assets meet the 50% quarterly threshold. Dividends attributable to other income sources, or paid by a fund that fails the asset or notice requirements, remain fully taxable.

Citations and references

• Tax Law § 612(c)(1), as amended by Chapter 535 of the Laws of 1986 - subtracts interest income on obligations of the United States and its possessions from federal adjusted gross income, extending the subtraction to RIC dividends designated as such interest income where at least 50% of the RIC's assets (tested quarterly) consist of such obligations and shareholders receive written notice within 45 days of fiscal year-end
• Tax Law § 612(c)(2) - separately subtracts interest or dividend income on obligations or securities of a US authority, commission, or instrumentality that is federally taxable but exempt from state income tax
• TSB-M-86(8)I - Department guidance describing what qualifies as "obligations of the United States and its possessions," referenced as the definitional touchstone for both this opinion and the underlying Exempt Obligation definition
• Bernstein Government Short Duration Portfolio of Sanford C. Bernstein Fund, Inc., TSB-A-89(4)I (April 11, 1989) - prior Department ruling holding that RIC dividends attributable to interest on obligations of the United States and its possessions are treated as § 612(c)(1) interest income
• Senate Bill 6647-B (1986) - the legislation (enacted as Chapter 535 of the Laws of 1986) that added the RIC pass-through rule to § 612(c)(1) to eliminate the disparity between direct and indirect (RIC) investors in federal obligations

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_9i.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-91 (9) I
Income Tax
December 5, 1991

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

PETITION NO. I910702A

On July 2, 1991, a Petition for Advisory Opinion was received from Federal
Trust Fund, Bellevue Park Corporate Center, 103 Bellevue Parkway, Suite 152,
Wilmington, Delaware 19809.
The issues raised by Petitioner, Federal Trust Fund, are whether Petitioner
and its shareholders are allowed to treat Petitioner's "Exempt Obligations" as
"obligations of the United States" for purposes of section 612(c)(1) of the Tax
Law and provided that the relevant asset and notice requirements are satisfied,
whether the shareholders are allowed to treat dividends paid by the Petitioner
that are attributable to interest paid on such "Exempt Obligations" as a
subtraction item for purposes of section 612(c)(1) of the Tax Law.
Petitioner is one of seven separate portfolios of the Trust For Federal
Securities which is a Pennsylvania business trust. Petitioner and each of the
other six portfolios are separate regulated investment companies (hereinafter
"RICs") for federal and New York State tax purposes.
For purposes of this
petition, an obligation is denominated by Petitioner as an "Exempt Obligation"
if (a) it is described in TSB-M-86(8)I, (b) it is an obligation of the federal
government or of the federal government's agencies, authorities and
instrumentalities, (c) interest on the obligation is subject to federal income
taxation, and (d) interest on the obligation is exempt from New York State income
taxation under Article 22 of the Tax Law.
Section 612(c) of the Tax Law, as amended by Chapter 535 of the Laws of
1986, provides, in part:
There shall be subtracted from federal adjusted gross income:
(1) Interest income on obligations of the United States and its
possessions to the extent includible in gross income for federal
income tax purposes; such interest income shall include the amount
received as dividends from a regulated investment company, as
defined in section eight hundred fifty-one of the internal revenue
code, which has been designated as the amount of such interest
income in a written notice to shareholders not later than forty-five
days following the close of its taxable year; provided that, at the
close of each quarter of the taxable year of such regulated
investment company, at least fifty percent of the value of its total
assets, as defined in subsection (c) of section eight hundred fifty­
one of the internal revenue code, consists of obligations of the
United States and its possessions.
(2) Interest or dividend income on obligation or securities of any
authority, commission or instrumentality of the United States to the
TP-9 (9/88)

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TSB-A-91 (9) I
Income Tax
December 5, 1991

extent includible in gross income for federal income tax purposes
but exempt from state income taxes under the laws of the United
States . . .
Section 612(c)(1) of the Tax Law provides that dividends paid by qualifying
RICs that are attributable to interest on "obligations of the United States"
(hereinafter "tax-exempt dividends") are not subject to New York State income
taxation if the relevant asset and notice requirements are satisfied (i.e., a
shareholder of a RIC can treat his tax-exempt dividends as a subtraction item for
purposes of section 612(c)(1) of the Tax Law). Although the phrase "obligations
of the United States" is not defined in section 612(c)(1) of the Tax Law, the
legislative history of section 612(c)(1) of the Tax Law indicates that dividends
can qualify as tax-exempt dividends so long as the interest income allocated to
such tax-exempt dividends is derived from interest income on Exempt Obligations.
Senate Bill 6647-B was approved by the New York Legislature in 1986 without
dissent for the stated purpose of correcting the inequitable differentiation
under the Tax Law between taxpayers who invest directly in obligations which are
exempt from New York State tax and taxpayers who invest indirectly in such
obligations through a RIC.
This is clearly and broadly stated in the
justification included in the memorandum of the Sponsors in support of the bill:
Presently, individuals are permitted to exclude the interest they
receive on obligations of the United States from their income
subject to the State's personal income tax.
Although regulated
investment companies are treated as "conduits" for tax purposes,
there is the anomalous situation, in that individuals receiving such
interest directly can exclude it from income subject to State income
tax, but those receiving such interest as distributions from
regulated investment companies, cannot take such an exclusion.
This legislation would correct this inequity by permitting these
individuals to treat this income as the interest from obligations of
the United States.
As previously acknowledged by Congress,
investors who wish to obtain the advantages of expert management and
diversification available to them through a regulated investment
company, who might otherwise not be able to afford such services,
should be permitted to treat such income as if they had invested in
these obligations directly.
The July 14, 1986 letter of Commissioner of Taxation and Finance Roderick
Chu to the Governor in support of the bill, the July 22, 1986 Budget Report
recommending approval of the bill and the July 21, 1986 memorandum of the
Department of Commerce recommending approval uniformly state this legislative
purpose.
Furthermore, these materials broadly state the effect of Senate Bill 6647B. Commissioner Chu's letter speaks of its application to interest on "Federal
obligations." The Budget Report makes the intent of the legislature even more
clear:

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TSB-A-91 (9) I
Income Tax
December 5, 1991

The bill would amend paragraph (1) of section 612(c) of the Tax Law
to add a modification reducing Federal adjusted gross income. . .for
interest on obligations or securities of the United States or its
instrumentalities when such earnings are distributed, as dividends,
by a regulated investment company, 50% or more of the assets of
which are represented by such Federal obligations or securities.
(emphasis added).
As noted above, "obligations of the United States" is not defined in the
Tax Law. The juxtaposition of section 612(c)(2) of the Tax Law which by its terms
deals with "interest or dividend income on obligations or securities of any
authority, commission or instrumentality of the United States" should not be
construed to suggest a narrow construction of the phrase. The legislative history
of Senate Bill 6647-B discussed herein provide substantial reasons to construe
the phrase broadly in the context of the RIC pass-through provisions of section
612(c)(1) of the Tax Law. Furthermore, the argument for a narrow construction
based upon the juxtaposition of section 612(c)(2) of the Tax Law is. . . diluted
by the fact that adoption of the RIC pass-through rule of section 612(c)(1) of
the Tax Law was by amendment to the statute and was not contemporaneous with the
adoption of section 612(c)(2) of the Tax Law.
In Bernstein Government Short Duration Portfolio of Sanford C Bernstein
Fund, Inc., Adv 0p Comm T&F, April 11, 1989, TSB-A-89(4)I, it was held that the
dividends received by individuals from RIC's that invest in obligations of the
United States and its possessions is treated as interest income pursuant to
section 612(c)(1) of the Tax Law, and such individuals may look to TSB-M-86(8)I
for guidance in determining what is meant by "obligations of the United States
and its possessions."
Therefore, in accordance with the understanding of the meanings of the RIC
pass-through rule evidenced at the time of its enactment, it is concluded (a)
that the Petitioner's Exempt Obligations are "obligations of the United States"
for purposes of the RIC pass-through rule of section 612(c)(1) of the Tax Law and
(b) that the Petitioner's shareholders may treat tax-exempt dividends
attributable to interest on such Exempt Obligations as a subtraction item for
purposes of section 612(c)(1) of the Tax Law if the relevant asset and notice
requirements are satisfied.

DATED: December 5, 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.