Tax Type
Individual Income Tax
Description
Taxable Income
Topic
Partnerships
Date Issued
09-20-1994
September 20, ]994
Re: Ruling request: Individual income taxes
Dear*************
This will reply to your letter in which****************on behalf of a partnership to be formed named************************(the "Partnership") and***********************one of its prospective partners (the "Corporation"), applies for rulings regarding the tax consequences of organizing and investing in the Partnership and the Corporation. I apologize for the delay in responding.
The rulings requested are: (1) for any taxable year in which the Corporation qualifies as a regulated investment company ("RIC") under IRC §§851 et seq., distributions made by the Corporation to its shareholders with respect to its shares of stock will not be included in the Virginia taxable income of its shareholders to the extent the distributions are attributable to tax-exempt interest received by (or allocated to) the Corporation; and (2) a shareholder will be able to substantiate the exempt portion of distributions received from the Corporation if the Corporation provides the shareholder with a report on a monthly or less frequent basis (but at least annually) that segregates taxable and exempt interest on a percentage or average percentage basis for the period covered by the report.
FACTS
The Partnership is an open-end management investment company to be organized as a partnership and registered under the Investment Company Act of 1940. Interests in the Partnership will not be registered under the Securities Act of 1933 and will not be traded on an established securities market.
The Corporation will invest in the Partnership. The Corporation will be a closed-end management investment company registered under the Investment Company Act of 1940, or a series thereof. The Corporation will be treated as a separate corporation for federal income tax purposes, whether organized as a corporation or a series thereof, pursuant to IRC § 851(h), and the Corporation will elect and qualify as a RIC.
The Corporation intends to issue two classes of stock -- a preferred class and a common class. The Corporation will seek to provide its shareholders, regardless of which class they invest in, with current income that is exempt from federal income tax and from Virginia personal income tax. To that end, the Corporation's investment policies will require it under normal circumstances to invest at least 80% of its assets in tax-exempt obligations or in the Partnership.
It is intended that the Corporation invest more than 90% of its assets in the Partnership. Other corporations and some individuals also will invest in the Partnership. The Partnership will invest under normal circumstances at least 80% of its assets in tax-exempt obligations. It is intended that the Partnership will manage its investments so as to satisfy the income and diversification requirements of IRC §851(b)(2), (3) and (4) as if those requirements applied to the Partnership directly. In addition, the Partnership intends to invest in sufficient tax-exempt obligations so as to satisfy the asset requirement of IRS §852(b)(5) as if that requirement applied to the Partnership directly.
Cash contributed by each corporate partner to the Partnership will be invested in a separate portfolio of tax exempt state and local obligations (a "State Portfolio"). Each State Portfolio will invest in the tax-exempt obligations of a separate, single state except to the extent that the State Portfolio needs investments with a short maturity and such obligations are not readily available. In this situation, a State Portfolio will invest in the tax-exempt obligations of a different state, but such investments will normally not exceed 10% of the total assets of a State Portfolio. If necessary, each State Portfolio also may invest a limited amount of its assets in federal obligations, except in certain extraordinary circumstances in which the State Portfolio may invest all of its assets in federal obligations.
Each corporate partner in the Partnership will be entitled to all of the tax-exempt municipal bond interest income of a single State Portfolio, with one possible exception. A single corporate partner which issues only preferred shares (the "Preferred Stock Partner") may be organized to derive tax-exempt municipal bond interest income from tax-exempt obligations of more than one State Portfolio. The State Portfolios involved would be those State Portfolios whose tax-exempt municipal bond interest is otherwise allocable to a corporate partner that does not issue a preferred class of shares. Thus, each corporate partner in the Partnership that issues a preferred class of shares will be entitled to all of the tax-exempt municipal bond interest income of a single State Portfolio. The tax-exempt municipal bond interest income of each of the remaining State Portfolios of the Partnership will be allocated on a preferential basis to the Preferred Stock Partner. The remaining tax-exempt income of each such State Portfolio will be allocated exclusively to the corporate partner that invests in that State Portfolio.
Pursuant to the partnership agreement of the Partnership, the Corporation will derive all of its tax-exempt municipal bond interest income from a State Portfolio of the Partnership which will attempt to invest exclusively in Virginia tax-exempt obligations (the "Virginia Portfolio").
It is presently contemplated that the Corporation will issue preferred stock as well as common stock, so that all of the income from the Virginia Portfolio will go to the Corporation. However, if the Corporation is not sufficiently large to support a substantial issue of preferred stock, the Preferred Stock Partner may also invest in the Virginia Portfolio in lieu of the Corporation issuing preferred stock. In this case the Corporation will receive all of the tax-exempt income from the Virginia Portfolio in excess of the preferred distribution to the Preferred Stock Partner.
Because the yield on Virginia tax-exempt obligations will differ from the yield on obligations of other states, the amount of tax-exempt income allocated to the Corporation will differ from the amount of income allocated to other partners by the State Portfolio from which they derive tax-exempt income.
The Partnership will maintain capital accounts and allocate items of income and loss and other distributive items in accordance with the partnership agreement, and in accordance with IRC §704 and the regulations thereunder.
The net asset value of assets of a State Portfolio underlying the common stock issued by a corporate partner will vary due to fluctuations in value of the tax-exempt obligations of that State Portfolio. Because the objective of the proposed structure is to enable investors to share the risk of fluctuations in value, cash will be shifted among State Portfolios so that the net asset value of assets of any given State Portfolio bears the same relationship to the total net asset value of the Partnership that the capital account balance of the corporate partner investing in that State Portfolio bears to the total of all of the corporate partners' capital account balances. If insufficient cash is available, tax-exempt obligations will be sold to obtain cash. Any cash received by a State Portfolio will be invested solely in tax-exempt obligations which are authorized for that State Portfolio.
RULING
A regulated investment company is treated as a pass through entity for both federal and Virginia income tax purposes. Virginia Regulation (VR) 630-2-322(C)(3) provides that tax-exempt interest distributed by a regulated investment company will be treated as tax-exempt interest to its shareholders. This regulation further provides:
-
- When taxable income is commingled with exempt income all income is presumed taxable unless the portion of income which is exempt from Virginia income tax can be determined with reasonable certainty and substantiated.
In the instant case, the regulated investment company (the Corporation) will receive a large part of its income from the Partnership. Because a partnership is a pass through entity for federal income tax purposes, the character of the income received by the Partnership will be retained in the hands of the Corporation. Accordingly, the fact that a portion of the Corporation's income is received from the Partnership will not change the treatment of such income when ultimately distributed to the Corporation's shareholders.
The department has previously taken the position that if the distributions are computed or made monthly, then it is sufficient to make the determination of exempt interest monthly. The department has also ruled that our policy does not require a breakdown of dividends earned on a monthly basis, if such a breakdown cannot be furnished to the Taxpayer by the mutual fund. Nor is it the department's policy to deny a subtraction for exempt mutual fund interest if the fund's report to the taxpayer, whether on a monthly or less frequent basis, segregates taxable and exempt interest on a percentage or average percentage basis. See Public Document 89-78 (2/21/89), copy attached.
Accordingly, subject to the limitations described below, for any year that the Corporation qualifies as a regulated investment company, distributions made by the Corporation to its shareholders will retain their tax-exempt character in the hands of the shareholders, and will not be included in the Virginia taxable income of the shareholders to the extent that such distributions are attributable to income that is exempt from taxation in Virginia. Furthermore, the department will allow any shareholder of the Corporation to determine his share of income which is exempt from Virginia income taxes by using reports prepared by the Corporation and supplied to the shareholder on a monthly basis that segregates taxable and tax-exempt interest on a percentage or average percentage basis for the period covered by the report. Subject to the limitations described below, such reports may be made on a less frequent basis (but at least annually).
Limitations: The transactions contemplated by this ruling relate to a complex series of allocations and special distributions. It is not possible to anticipate all of the possible scenarios that may arise under changing fact patterns. Accordingly, this ruling must be limited to provide that: 1) In no event may the total amount of tax-exempt income deemed distributed to the shareholders of the corporation exceed the total amount of tax-exempt income actually received and distributed by the Corporation (including the Corporation's distributive share of the Partnership's tax-exempt income; 2) The Taxpayer must determine the percentage of tax-exempt income with sufficient mathematical accuracy to ensure that the total amount of tax-exempt income computed by the individual shareholders does not exceed the total amount of tax-exempt income actually received and distributed by the Corporation; and, 3) Neither the special allocations provisions of the Partnership's partnership agreement nor the manner in which the Corporation reports the percentage of tax-exempt income to its shareholders may operate in such a manner as to shift tax-exempt income among taxpayers solely for the purpose of reducing Virginia income taxes.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7081M
Rulings of the Tax Commissioner