How did Utah's 2001 legislation affect Utah income tax on interest from out-of-state government bonds held through mutual funds or investment trusts?

Plain-English summary

Utah Private Letter Ruling 02-001 initially used the purchase date of a mutual fund or investment trust to decide whether its out-of-state government-bond interest was grandfathered under House Bill 1006.

In the April 25, 2002 response, the Commission said a fund bought before January 1, 2003 would remain grandfathered even if the fund later traded its underlying bonds. A dividend reinvestment on or after January 1, 2003 was a new, separate fund purchase.

For a fund bought on or after January 1, 2003, Utah would presume the income taxable unless the taxpayer established that the income came from Utah government bonds or from out-of-state bonds covered by the statutory reciprocity exception.

That was not the final word. In a December 23, 2002 follow-up, the Commission said the interpretation had been challenged and that new information had emerged. It warned that it was reconsidering the policy and might use each underlying bond's purchase date instead of the mutual fund's purchase date.

What HB 1006 changed

The response described HB 1006 as applying Utah income tax to interest from certain bonds issued by nonfederal government entities outside Utah when acquired after January 1, 2003.

The ruling also described a reciprocity exception in Utah Code section 59-10-114(6). Interest would not be taxed in Utah when the issuing entity was in a state that did not impose an income-based tax on Utah-issued bonds.

Funds purchased before 2003

The April response addressed mutual funds and investment trusts containing bonds issued by multiple government entities.

It said interest from a fund purchased before January 1, 2003 would not be subject to Utah tax, even if the fund changed its holdings later.

This fund-level approach covered the requester's questions about actively managed tax-exempt mutual funds, closed-end funds, and unit investment trusts.

Dividend reinvestments

The Commission treated a dividend reinvestment occurring on or after January 1, 2003 as a new and separate purchase.

Interest attributable to that reinvested portion would therefore be taxable unless:

• It related to bonds issued by Utah government entities; or
• The taxpayer established that the underlying non-Utah bonds qualified for the reciprocity exception.

Funds purchased on or after 2003

For a government-bond mutual fund purchased on or after January 1, 2003, Utah would assume that the income was taxable unless the taxpayer proved otherwise.

A fund containing only Utah government bonds could avoid Utah tax upon proof that it held only those bonds.

For a mixed fund containing non-Utah government bonds, either the fund company or the taxpayer would need to research and document which underlying bonds were taxable and which qualified for an exception.

December 2002 reconsideration notice

The Commission later notified the requester that its April interpretation might change.

The follow-up said the policy had been challenged and that the Commission would undertake rulemaking with public comment. It specifically identified a possible bond-level method: using the purchase date of each bond held by a mutual fund rather than the date the investor bought the fund.

The official source does not provide the result of that later rulemaking. The April holding therefore should not be presented as a reliable statement of current Utah law.

Holding

The April 2002 response said:

• A pre-2003 mutual-fund purchase was grandfathered at the fund level, even after changes in the fund's holdings.
• A post-2002 dividend reinvestment was a new purchase.
• Income from a post-2002 fund purchase was presumed taxable unless Utah-bond status or reciprocity was documented.
• The Commission had not proposed clarifying legislation at that time.

The December 2002 notice then warned that the first point was under reconsideration and could be replaced with an underlying-bond purchase-date test.

What this means for you

Individual investors

Do not rely on the April 2002 grandfathering method without checking the later rulemaking and current Utah law. The source itself says that method might be revised.

Mutual-fund companies and financial advisers

The ruling contemplated tracing and documenting the governmental issuers inside a fund when an investor claimed Utah-bond or reciprocity treatment.

Accountants and tax preparers

Separate original fund purchases from later dividend reinvestments, but verify the current legal method before using the historical fund-level approach.

Common questions

Q: Did the April response grandfather a fund bought before January 1, 2003?

A: Yes. It initially said later trading inside the fund would not remove the grandfathering.

Q: Was a dividend reinvestment treated as part of the original purchase?

A: No. A reinvestment on or after January 1, 2003 was treated as a new purchase.

Q: Was all out-of-state government-bond interest taxable?

A: No. The response described an exception when the issuing state did not impose an income-based tax on Utah bonds.

Q: Who had to show that post-2002 fund income was exempt?

A: The taxpayer had to establish the nontaxable portion, potentially using research or evidence from the fund company.

Q: Did the Commission leave the April interpretation in place without qualification?

A: No. The December follow-up said it was reconsidering that policy and might switch to the acquisition date of each underlying bond.

Key source language

• Initial fund-level rule: “any interest earned by such a mutual fund will not be subject to Utah taxation if the fund is purchased prior to January 1, 2003, even if the fund changes its holdings after that date.”
• Dividend reinvestment: “a dividend reinvestment that occurs on or after January 1,2003, would be considered a new and separate purchase”
• Reconsideration: “the Commission will be reconsidering this policy and will be undertaking a rule-making process”
• Warning: “our current policy may be revised in the near future.”

Citations and references

• Utah Code Ann. § 59-10-114(1)(g)
• Utah Code Ann. § 59-10-114(6)
• Utah House Bill 1006, 2001 First Special Session

Source

• Landing page: Utah Private Letter Rulings
• Official ruling: Utah PLR 02-001
• Date note: the initial response is dated April 25, 2002; the same official source includes a reconsideration notice dated December 23, 2002.
• Fetch note: the exact official URL returned HTTP 404 to a direct request and was then retrieved through Sofya.

Original ruling text

REQUEST LETTER

02-001

NAME

ADDRESS

Re: Tax Treatment of Tax Exempt Bonds in 2003

Gentlemen:

It is requested that you provide me with an advisory opinion on the treatment of tax exempt bond interest for Utah residents after the passage of new tax legislation during this past summers special session of the Utah Legislature. More specifically my questions relate to the grand fathering of bonds held by Utah residents prior to January 1, 2003 through the various investment products offered by financial institutions.

1. Will tax-exempt mutual funds be fully grand fathered even though they may actively trade their bond holdings? How will reinvested dividends be treated?

2. Will closed end tax exempt bond funds that typically hold fixed bond holdings be fully grandfathered?

3. Will unit investment trusts holding tax-exempt bonds and do not change their bond holdings throughout the life of the trust be fully grand fathered?

4. Is the tax commission requesting the Utah Legislature to address any new legislation in the upcoming session to clarify the grand fathering guidelines?

I realize this request may seem premature but I hope to fully understand how this new tax policy will be applied so that I can realign my investments as necessary this next year to meet the legislatures intent for this new tax law to be revenue neutral and the Tax Commission staffs opinion that the new law would be revenue neutral.

Thank you for your response to these questions.

Sincerely

NAME

RESPONSE LETTER

April 25, 2002

NAME

ADDRESS

RE: Advisory Opinion Effect of HB 1006 on Taxation of Mutual Fund Income

Dear NAME,

You have presented several questions concerning the implementation of House Bill 1006 (�HB 1006�), which was enacted by the 2001 First Special Session of the Utah Legislature. HB 1006 provides that interest from certain bonds, notes, and other evidences of indebtedness (hereinafter referred to as �bonds�) issued by non-federal governmental entities outside Utah will be subject to Utah�s income tax if acquired after January 1, 2003 (see Utah Code Ann.
�59-10-114(1)(g)). However, Section
59-10-114(6) of the bill also contains a reciprocity provision concerning such bonds. This provision provides that interest earned on the bonds will not be subject to taxation in Utah if the state where the entity (as well as its political subdivisions, agencies, and instrumentalities) issuing the bonds is located does not impose a tax based on income on bonds issued by Utah. Given this statutory framework, we address your questions as follows.

Your letter identifies several investment products, all of which specifically concern the interest earned by mutual funds and investment trusts (�mutual funds�) that are comprised of bonds issued by multiple governmental entities. To implement the statute, any interest earned by such a mutual fund will not be subject to Utah taxation if the fund is purchased prior to January 1, 2003, even if the fund changes its holdings after that date. However, a dividend reinvestment that occurs on or after January 1,2003, would be considered a new and separate purchase of the mutual fund subject to the provisions of HB 1006, even though the original mutual fund was purchased prior to January 1, 2003. Accordingly, any interest earned by the portion of the mutual fund related to such a dividend reinvestment would be subject to Utah taxation unless it qualified for the reciprocity exception provided in Section 59-10-114(6) and is evidenced as explained below, or was related to bonds issued by Utah governmental entities.

For a mutual fund comprised of governmental bonds that is purchased on or after January 1, 2003, Utah will assume that any income earned from such a fund is subject to Utah taxation unless the taxpayer shows that the income is nontaxable, either because the bonds comprising the mutual fund are issued by Utah governmental entities or because the bonds are issued by non-Utah governmental entities that qualify under the Section 59-10-114(6) reciprocity exception.

Page Two

For mutual funds comprised only of bonds issued by Utah governmental entities, there would be no Utah taxation upon showing that the funds contains only such bonds. For mutual funds that contain bonds issued by non-Utah governmental entities, the income earned by such mutual funds will be taxable in Utah, unless either the bond company or the taxpayer researches the bonds comprising the mutual fund and determines and evidences which are subject to taxation under HB 1006 and which are not.

The Tax Commission has not proposed any legislation to the Legislature that would amend or clarify HB 1006. If you have any other question, please contact us.

For the Commission,

Marc B. Johnson

Commissioner

MBJ/KC

02-001

December 23, 2002

NAME

ADDRESS

Dear NAME,

Earlier this year, you asked the Commission for a private letter ruling pertaining to the implementation of House Bill 1006 (�HB 1006�), which was enacted by the 2001 First Special Session of he Utah Legislature. We replied to your request on April 25, 2002 in Private Letter Ruling 02-001 (copy enclosed). In this ruling, we stated that any interest earned by a mutual fund that is purchased prior to January 1, 2003, would not be subject to Utah taxation, even if the fund changes its holdings after that date.

Recently, this interpretation has been challenged and new information has come to our attention. As a result, the Commission will be reconsidering this policy and will be undertaking a rule-making process, where we will be taking public comment. In particular, we will consider whether instead of using the purchase date of the mutual fund to determine taxability, we would use the purchase date of each bond in a mutual fund to determine whether the interest from that particular bond is subject to taxation under HB 1006.

Accordingly, we are notifying you that our current policy may be revised in the near future. We will welcome your comments concerning any proposed revision and will keep you informed of any developments concerning this issue.

For the Commission,

Marc B. Johnson