Discussion:California's 50% bond interest rule
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Discussion Forum Index --> Tax Questions --> California's 50% bond interest rule
| 31 July 2008 | |
| A client received a notice explaining California's rule that if a bond fund has less than 50% invested in qualifying CA Municipal Bonds, then the entire interest income from the bond fund is subject to California tax. I have always known this rule, but I just wanted to confirm this against the R&TC or some regulation. However, all I can find is a reference to the issue of a bond fund having less than 50% invested in qualifying US Govt Bonds being subject to tax. The tax exempt status of bonds issued by the US Govt is a whole separate issue than the tax exempt status of bonds issued by state/local governments.
Do I have this confused? Does this 50% rule apply in both cases? Does anyone have a cite as it relates to muni bonds? | |
Michaelstar (talk|edits) said: | 31 July 2008 |
| This is directly from an article dated Oct. 1, 2006 from the CA Tax Letter written by Spidell :
"California law does not allow a taxpayer to exclude interest from out-of-state municipal bonds (R&TC §17143, 24272). In addition, California has its own quirky law pertaining to exempt interest flowing from mutual funds. Under R&TC §17145, interest can only be excluded if at least 50% of the assets held by a mutual fund consists of interest-bearing tax-free obligations. This includes U.S. and California obligations. Thus, if the fund holds less than 50%, all distributions are taxable. If the fund holds 50% or more in qualifying obligations, the flow-through character of the distributions is retained." | |
| 7 August 2008 | |
| I'm a little late to this discussion (I was on a plane from Vienna to Chicago on July 31), but wanted to add my two cents' worth.
I believe CRTC Sec. 17145 violates federal statutory law, to the extent it relates to interest income from federal obligations. And the restriction on California state obligations may violate the state constitution. Historically, the FTB's position was that interest on federal obligations could not be passed through tax exempt to stockholders of a mutual fund. In Sandra Brown et al. v. Franchise Tax Board, 197 CA3d 300, 242 CRptr 810 (1987), pet. for rev. den., Cal. Sup. Ct, March 28, 1988, the Court of Appeal held that the federal law (31 USC Sec. 3124(a)) prohibited state taxation of such interest. At the time the U.S. Supreme Court had just denied certiorari in a similar case arising in Illinois (Andras et al. v. Dept. of Revenue, 154 Ill.App.3d 37, 506 N.E.2d 439, cert. den. U.S.S.Ct., 1988), and the Brown case was not appealed further. CRTC Sec. 17145 was enacted effective in August, 1988. The FTB's attempt to apply its terms to dividends paid in 1987 was thwarted by the Court of Appeal in Ross Bewley et al. v. FTB, 20 CA4th 534 (1993). The validity of the 50% rule under 31 USC Sec. 3124(a) has not been challenged, but it should be. The issue did not arise in Brown or Andras because those cases both involved mutual funds that were 100% invested in federal securities. There's nothing in either of those decisions that suggests that a percentage of investment threshold would be upheld. As for interest income from California state and local government obligations, the California Constitution (Sec. 26(b)) provides simply that "Interest on bonds issued by the State or a local government in the State is exempt from taxes on income." Again, if the income keeps its character as it passes through from a mutual fund, it shouldn't matter how much of the fund is invested in California bonds. This issue was raised at the annual tax practitioners' meeting with the FTB a number of years ago, and Dr. O'Connell, who was State Controller at the time, expressed interest in seeking a legislative change to repeal the limitation. However, she was termed out, and as far as I know no one else has taken up that particular cudgel. Maybe we could get John Chiang interested, but probably not until after the budget is passed! | |
