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Colonial Trust v. Director

February 21, 1997


The opinion of the court was delivered by: Dougherty

N.J.S.A. 54A:6-14.1 is interpreted by the Division of Taxation to require shareholders of "non-qualified" investment funds to characterize the annual cash distributions they receive from their funds as "dividend" distributions. N.J.S.A. 54A:5-1f provides that dividend distributions are included in a taxpayer's gross income if they are paid out of current or accumulated earnings and profits of the payor corporation. In this declaratory judgment action, Plaintiffs contend that the Gross Income Tax Act, N.J.S.A. 54A:1-1 to -10 (GIT), does not provide immunity for that portion of a "non-qualified" investment fund's distribution to its shareholders which consists of interest earned on Federal debt obligations, and thereby violates the immunity of that interest mandated by 31 U.S.C.A. § 3124(a), as well as each of the Supremacy and Borrowing Clauses of the United States Constitution. The matter has been presented on stipulated facts.

The Facts

Plaintiff Investment Company Institute is a national association of investment companies. Plaintiff Colonial Trust III is a member of the Institute.

Colonial Trust III is an open-end investment company (Colonial), established as a Massachusetts business trust in 1986. A Massachusetts business trust (an MBT) is formed as a trust under state law but classified for Federal income tax purposes as an unincorporated association. That classification results in an MBT being taxed not as a trust, but as a corporation. Morrissey v. C.I.R., 296 U.S. 344, 56 S. Ct. 289, 80 L. Ed. 263 (1935); Treas. Reg. § 301.7701-4(b); Mertens, Law of Federal Income Taxation § 38A.30 (Main Vol. 1995). An MBT is also taxed as a corporation under the Corporate Business Tax Act, N.J.S.A. 54:10A-1 to -40 (CBT), rather than as a trust under the GIT. See N.J.S.A. 54A:2-1.

Colonial maintains its trust funds in several separate investment portfolios. Each portfolio is represented by a series of shares. Each series of shares represents beneficial ownership interests in the segregated assets of the particular portfolio. One of Colonial's investment portfolios is the Colonial Federal Securities Fund (Fund). This matter requires analysis of New Jersey's taxation of the holders of beneficial interests in the Fund (the Shareholders).

The Fund is an entity commonly known as a "mutual fund" in the investment and tax communities. The Fund sells participation shares to the general public and invests the proceeds of those sales primarily in (i) United States obligations and securities (Federal Obligations) and (ii) other securities. The Fund's Shareholders enjoy diversification in investment because they effectively own a pro rata (proportionate) share of all assets owned by the Fund. Shareholders buy into the Fund at a relatively modest cost. They could not reproduce the array of securities owned by the Fund in individual portfolios at that cost. The Fund's Shareholders bear the risk of profit or loss on the Fund's investments because the market value of their shares is directly related to the market value of the Fund's portfolio of investments.

The Federal Obligations owned by the Fund are among those "obligations which are statutorily free from state or local taxation under any other act of ... [New Jersey] or under the laws of the United States." N.J.S.A. 54A:6-14. The Federal Obligations pay interest to the Fund. If that interest were paid directly to the Shareholders it would be exempt from taxation under the GIT. N.J.S.A. 54A:6-14.

Historically, the Fund has made annual cash distributions in amounts equal to substantially all of its gross income from all of its investments reduced by the total of its expenses, including portfolio management fees.

The Fund has at all times invested less than eighty percent (80%) of its assets in government obligations and has failed to constitute a "qualified investment fund." N.J.S.A. 54A:6-14.1. New Jersey taxpayers owning shares in the Fund have been required to report distributions to them as taxable income. N.J.S.A. 54A:5-1.

During the Fund's fiscal year ending October 31, 1993 (Fiscal 1993) approximately two-thirds of its assets consisted of Federal Obligations. Accordingly, a portion of the Fund's income for Fiscal 1993 was attributable to interest paid by the United States Government. The amount of cash distributed by the Fund in Fiscal 1993 exceeded the net income derived from the Fund's "other securities", so that, a portion of the Fund's Fiscal 1993 distributions necessarily consisted of interest paid by the United States Government on the Federal Obligations.

The Fund is qualified as a Regulated Investment Company (RIC) under Subchapter M of the Internal Revenue Code of 1986, as amended (I.R.C. §§ 851-855) and is established under the Investment Company Act of 1940, as amended (15 U.S.C.A. §§ 80a-1 to 80b-2).

The Issue

Plaintiffs seek a declaratory judgment that taxation, under N.J.S.A. 54A:6-14.1 and N.J.S.A. 54A:5-1, of income received by shareholders of mutual funds attributable to interest paid to the fund on Federal Obligations is barred by: (i) the plain language of 31 U.S.C.A. § 3124(a); (ii) the Doctrine of Intergovernmental Tax Immunity; and (iii) the Supremacy and Borrowing Clauses of the United States Constitution.

The statutes, as pertinent, are:

N.J.S.A. 54A:6-14.1:

Gross income shall not include distributions paid by a qualified investment fund, to the extent that the distributions are attributable to interest or gain from obligations described in N.J.S. 54A:6-14. (emphasis added)

N.J.S.A. 54A:6-14:

Gross income shall not include interest on obligations (1) issued by or on behalf of this State or any county, municipality, school or other district, agency...body corporate and politic or political subdivision of this State, or (2) those obligations which are statutorily free from State ... taxation ... under the laws of the United States.

31 U.S.C.A. § 3124(a):

(a) Stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State. The exemption applies to each for of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax, except -

(1) a nondiscriminatory franchise tax or another nonproperty tax instead of a franchise tax, imposed on a corporation; and

(2) an estate or inheritance tax.

(b) The tax status of interest on obligations and dividends, earnings, or other income from evidences of ownership issued by the [United States] Government or an agency and the tax treatment of gain and loss from Disposition of those obligations and evidences of ownership is decided under the Internal Revenue Code of 1954 (26 U.S.C. 1 et seq.) (emphasis added)

The Supremacy Clause, U. S. Const. art. VI, cl. 2, provides "this Constitution, and the Laws of the United States which shall be made in Pursuance thereof ..., shall be the supreme Law of the land...." The Borrowing Clause, U.S. Const. art. I, § 8, cl. 2, establishes that Congress has the power "to borrow Money on the credit of the United States."

Plaintiffs contend the GIT's taxation of Fund Shareholders requires interest on Federal Obligations to "be taken into account, [and] ... included in computing the tax..." on "dividend" income, contrary to the plain language of the statute.

As to the Borrowing Clause, Plaintiffs argue that interest on Federal Obligations is generally exempt from State (and local) income tax so that the Obligations are issued at a lower interest rate than private, corporate obligations with which they compete in the markets. Because of the anticipated exemption, the Federal government (like the state and municipal governments) pays less than "market" interest to borrow money. Similarly, in anticipation of the exemption, purchasers of Federal Obligations accept a lower interest rate than might otherwise be available. N.J.S.A. 54A:6-14.1 and N.J.S.A. 54A:5-1, together imposing a tax upon non-qualified investment fund shareholders, it is asserted, tarnish the attractiveness of investing in Federal Obligations through mutual funds, disturbing investors' net returns, and thereby negatively affecting the exercise of the Federal Borrowing Power.

Defendant, Director, Division of Taxation (Director), contends that New Jersey may limit the immunity of Federal Obligation interest paid to the Fund's Shareholders just as the Federal government has limited the exemption of State and local obligation interest under I.R.C. § 852(b)(5), to entities meeting prescribed criteria. He contends that the "non-qualified" fund classification under N.J.S.A. 54A:6-14.1 applies equally to the interest from Municipal, State and Federal Obligations - that the tax is nondiscriminatory.

Relying on South Carolina v. Baker, 485 U.S. 505, 524, 108 S. Ct. 1355, 1367, 99 L. Ed. 2d. 592, 611 (1988), Plaintiffs assert that New Jersey has no power to limit the immunity of Federal Obligations as it does in N.J.S.A. 54A:6-14.1. They assert that Federal tax provisions for Exempt Interest Dividends (I.R.C. § 852(b)(5)) are not constitutionally mandated, but exist purely as a matter of legislative grace. It is clear, they conclude, that while Congress may limit and define the exemption from Federal income tax for State and local obligations, the States may not define limits of Federal Obligation immunity because that immunity is constitutionally grounded.

Director contends that 31 U.S.C.A. § 3124 requires immunity of interest paid to the Fund - the owner of record of the Obligations; and that the statute does not require immunity at the Shareholder level. Director contends that the Fund is a separate taxpayer from its Shareholders; that as a corporation the Fund is a "non-conductor", cutting off the pass through of immune interest character. (relying solely on Miller v. Milwaukee, 272 U.S. 713, 714, 47 S. Ct. 280, 71 L. Ed. 487, 489 (1927).) What is received by the Shareholders, Director contends, is no longer "interest" but merely fungible earnings and profits of the corporate entity.

Director concludes that the tax imposed on "dividend" distributions to Fund Shareholders is not measured in any manner by the amount of the Federal Obligation interest received by the Fund. It is, he argues, a tax on the income of the individual Shareholder, that is, upon the amount of dividends a Shareholder receives, and is neither computed by "considering" the Federal Obligation interest received by the Fund, nor otherwise "measured" by such Federal Obligation interest.

Director is aware that States other than New Jersey have already interpreted 31 U.S.C.A. § 3124 to require the pass-through of the Federal Obligation interest exemption to mutual fund shareholders. See Brown v. Franchise Tax Board, 242 Cal. Rptr. 810 (Cal. Ct. App. 1987); Comptroller of the Treasury v. First United Bank & Trust, 578 A.2d 192 (Md. 1990); Andras v. Ill. Dep't. of Revenue, 506 N.E. 2d 439 (Ill. App. Ct. 1987), cert. denied 485 U.S. 960 (1988); Matz v. Dep't of Treasury, 401 N.W.2d 62 (Mich. Ct. App. 1986); Borg v. Dep't of Revenue, 774 P.2d 1099 (Or. 1989); In re Thomas C. Sawyer Estate, 546 A.2d 784 (Vt. 1987); Commissioner of Revenue v. Plymouth Home National Bank, 473 N.E.2d 1139 (Mass. 1985); and Capital Preservation Fund, Inc. V. Wis. Dep't of Revenue, 429 N.W.2d 551 (Wis. Ct. App. 1988). In each case he argues, the Court relied, unjustifiably, upon the definition of a mutual fund utilized by the United States Supreme Court in Burks v. Lasker, 441 U.S. 471, 480, 99 S. Ct. 1831, 1838, 60 L. Ed. 2d 404, 414 (1979). In Burks, Justice Brennan describes a mutual fund as a "pool of assets, consisting primarily of portfolio securities, and belonging to the individual investors holding shares in the fund." Id. Because Burks is not a tax case, but a shareholders' derivative action, Director argues that its analysis and the Conclusion of "conduit" character which other Courts have drawn from that analysis, have no relevance here.

Director asserts that adopting Plaintiffs position would have broad ramifications - would necessarily exempt any dividends paid by "regular" corporations that were attributable to interest on Federal Obligations owned by those ...

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