Did tax-exempt interest and gain keep their exempt character when distributed through a municipal-bond mutual fund to Rhode Island shareholders?

Plain-English summary

Qualifying tax-exempt interest and gain kept their exempt character when the Fund distributed and designated them to shareholders. Those distributions were exempt from Rhode Island personal income tax and business corporation tax to the same extent the underlying interest or gain would have been exempt if the shareholder had earned it directly.

The Fund was a separate portfolio series of a Massachusetts business trust registered as an open-end investment company. It intended to qualify as a regulated investment company under IRC § 851 and distribute substantially all of its income under § 852.

Under normal conditions, the Fund planned to invest at least 65 percent of its assets in debt securities of Rhode Island and its political subdivisions, authorities, agencies, instrumentalities, corporations, and specified other issuers such as Puerto Rico. At least 80 percent would be invested in a combination of Rhode Island municipal securities and obligations of other states, territories, possessions, the District of Columbia, and their governmental bodies. The Fund could also hold U.S. obligations and other investments producing federally taxable interest.

The Division concluded that qualifying interest on Rhode Island obligations, qualifying interest on U.S. obligations, and qualifying gain on Rhode Island obligations retained their exempt character when passed through. Capital-gain distributions qualified only where Rhode Island law would have exempted the underlying gain.

The result was not a blanket exemption for every payment from the Fund. The distribution had to be both derived from and designated by the Fund as derived from interest or gain that would have been exempt in the shareholder's hands.

What this means for you

Municipal-bond fund investors

Use the Fund's tax reporting to identify the qualifying exempt portion. A fund name or general investment objective did not make every distribution Rhode Island-tax-free.

Fund administrators

Source tracing and designation were essential. The holding required the Fund to identify distributions derived from qualifying interest or gain.

Accountants and tax professionals

Analyze personal income tax and business corporation tax separately but apply the same pass-through principle stated in the order: the shareholder receives only the exemption the underlying item would have had if earned directly.

Common questions

Were all distributions from the Fund exempt? No. Only amounts derived from and designated as qualifying exempt interest or gain received the pass-through exemption.

Did Rhode Island municipal-bond interest retain its exemption? Yes, under the facts and designation described in the order.

What about U.S. Government obligations? Qualifying interest on U.S. obligations also retained its exempt character when passed through.

Could capital-gain dividends qualify? Yes, when the gain came from an obligation issued under Rhode Island law that exempted the gain from taxation.

Who could rely on the order? The Fund and its existing and future shareholders, subject to the representations, documentation, law, and facts stated in the ruling.

Citations and references

• R.I. Gen. Laws § 42-35-8 — authority for the declaratory-ruling request.
• R.I. Gen. Laws ch. 44-30 — personal income tax framework discussed in the order.
• R.I. Gen. Laws ch. 44-11 — business corporation tax framework discussed in the order.
• Internal Revenue Code § 851(h) — separate federal treatment for the Fund series.
• Internal Revenue Code § 851 — regulated investment company qualification.
• Internal Revenue Code § 852 — federal treatment of distributed RIC income.

Source

• Landing page: Rhode Island Declaratory Rulings
• Declaratory order: Declaratory Order 1995-04

Original ruling text

Ruling Request No. 95-04

Declaratory Rulings

Ruling Request No. 95-04

Re: Request for Ruling Regarding Tax Exempt Status of a Municipal Bond Fund

Request for Ruling

On behalf of your client, (the "Fund"), you request a declaratory ruling pursuant to R.I.G.L. 42-35-8 regarding the tax exempt status of distributions made by the Fund under the Rhode Island personal income tax law and the Rhode Island business corporation tax law.

Facts

The Fund is a separate series of the X Fund, a business trust organized under the laws of the Commonwealth of Massachusetts and registered as an open-end management company under the Investment Company Act of 1940, as amended (the "Trust"). The Fund consists of a separate and distinct portfolio of assets represented by a separate series of shares of beneficial interest in the Trust. For federal income tax purposes, the Fund is treated as a separate corporation pursuant to section 851(h) of the Internal Revenue Code of 1986, as amended (the "Code").

The Fund will be operated in a manner intended to qualify it as a regulated investment company (a "RIC") under section 851 of the Code and will distribute all or substantially all of its income to avoid being subject to tax on its income, to the extent distributed, under section 852 of the Code. In addition, the Fund will be operated in a manner intended to permit its shareholders to treat, for federal income tax purposes, distributions received with respect to their shares of the Fund as interest excludable from gross income or as gain from the sale of a capital asset held for more than one year, to the extent such distributions are attributable to income eligible for such treatment by the Fund.

The Fund seeks a level of current interest income exempt from federal income tax and, to the extent possible, Rhode Island personal income tax, that is as high as is consistent with relative stability of principal. Under normal market and economic conditions, the Fund will invest at least 65% of its assets in debt securities of the State of Rhode Island, its political subdivisions, authorities, agencies, instrumentalities and corporations and certain other governmental issuers, such as Puerto Rico. Under normal market and economic conditions, the Fund will invest at least 80% of its assets in a combination of Rhode Island Municipal Securities and obligations issued by other states, territories, and possessions of the Unites States, the District of Columbia and their respective authorities, agencies, instrumentalities and political subdivisions. The Fund may also invest in obligations of the United States, obligations of agencies or instrumentalities of the United States and other obligations the interest on which is subject to regular federal income taxation.

Rulings Requested

On behalf of the Fund, we respectfully request declaratory rulings that distributions made by the Fund will be exempt from Rhode Island personal income tax and the Rhode Island business corporation tax to the extent derived (and designated by the Fund as derived) from interest or gain that would be so exempt if realized directly by the Fund's shareholders.

Discussion

This ruling deals with the issue of the pass-through treatment of interest on Rhode Island obligations, interest on United States obligations, and the gain on Rhode Island obligations under the personal income tax law and the business corporation tax law.

Chapter 44-30 of the Rhode Island General Law imposes a personal income tax on a taxpayer's Rhode Island income which is calculated by reference to the taxpayer's federal income tax liability. The Rhode Island income tax of a taxpayer may be modified by certain additions and subtractions from the taxpayer's federal adjusted gross income.

Chapter 44-11 of the Rhode Island General Law imposes a business corporation tax against the taxpayer's net income which is calculated by reference to the taxpayer's federal taxable income with certain modifications which include the addition of interest not included in a taxpayer's federal taxable income and the subtraction of interest on obligations of the United States of its possessions and other interest exempt from taxation by Rhode Island.

The Fund will be operated in a manner which will qualify it as a regulated investment company under Section 851 of the Internal Revenue Code. Assets of the Fund will be invested in debt securities of the State of Rhode Island, its political subdivisions, authorities, agencies, instrumentalities and corporations and certain other governmental issuers, such as Puerto Rico. The Fund may also invest in obligations of the United States and obligations issued by other states, the District of Columbia and their respective authorities, agencies, instrumentalities and political subdivisions.

Under the facts set forth in its request, the items of interest will retain their exempt character when passed through to the Fund's shareholders and capital gain dividends paid by the Fund on an obligation authorized by a Rhode Island law exempting such gain from taxation shall likewise retain its exempt character.

Ruling

The distributions made by the Fund will be exempt from the Rhode Island personal income tax and the Rhode Island business corporation tax to the extent derived (and designated by the Fund as derived) from interest or gain that would be so exempt if realized directly by the Fund's shareholders.

This ruling is based upon the representations which have been indicated to be true, correct and complete and upon documentation submitted and represented to be true, accurate and complete.

This ruling may be relied upon by the Fund and its existing and future shareholders. It will be valid until expressly revoked or until the applicable statutory provisions of federal or Rhode Island law are amended in a manner that requires a different result or until the underlying situations described above change.

**R. Gary Clark

Tax Administrator

July 20, 1995**