December 19, 2000

You request a letter ruling regarding the Massachusetts tax treatment of dividends received by shareholders of a certain regulated investment company (hereinafter "RIC"). In support of your request, you state the facts as follows.

I. FACTS

You ask for a letter ruling on behalf of *************** the ("Trust") and its portfolio series, *************** hereinafter referred to as the "Funds"). The Funds are qualified as Regulated Investment Companies under Internal Revenue Code ("IRC" or "Code") § 851. Each Fund has an investment management agreement with *************** the ("Management Company").

You state that the Management *************** Company plans to organize a RIC, *************** (hereinafter referred to as the "Lower-Tier Fund"), that will acquire United States obligations and other assets. The Funds will be shareholders in the Lower-Tier Fund.

II. RULING REQUESTED

You request a ruling regarding the Massachusetts personal income tax treatment of RIC dividends received by shareholders of the Funds. Specifically, you ask us to rule that:

The shareholders of the Funds will be allowed to deduct the portion of dividends the Funds distribute that are attributable to dividends the Funds have received from the Lower-Tier Fund, to the extent such Lower-Tier Fund dividends are attributable to interest on United States obligations ("U.S. obligations"), exempt under G.L. c. 62, § 2(a)(2)(A).

III. RULING

Dividends received by shareholders from the Funds are deducted from Massachusetts gross income to the extent that they are identified as attributable to the portion of RIC dividends received by the Funds from the Lower-Tier Fund, that are, in turn, attributable to interest on U.S. obligations. G.L. c. 62, § 2(a)(2)(A). Such portion of the dividends must be ". . . so identified in a written notice mailed to the shareholders . . . not later than sixty days after the close of [the Funds] taxable year." Id.

IV. DISCUSSION

Massachusetts gross income is federal gross income with certain modifications. G.L. c. 62, § 2(a). Federal gross income includes interest derived from U.S. obligations, however, Massachusetts modifies federal gross income by allowing a deduction for interest from U.S. obligations to the extent included in federal gross income. G.L. c. 62, § 2(a)(2)(A). Further, this deduction includes dividends received from a RIC "to the extent such dividends are attributable to interest on obligations of the United States exempt from state income taxation . . .." Id.

The issue raised by your ruling request is whether the RIC dividends received by shareholders of the Funds retain their characterization of being "attributable" to interest on U.S. obligations in light of their having flowed through the Lower-Tier RIC. In short, does the interest on U.S. obligations retain its exempt status as it flows through two levels of RICs? We hold that it does retain its exempt status, and our reasoning is twofold.

A. Definition of "Attributable"

In any issue of statutory interpretation, the first step is the analysis of statutory language. David D. v. Dartmouth School Committee, 775 F.2d 411 (1st Cir.) cert. denied 106 S.Ct. 1790 (1985). Where a statute does not define the words used, the natural import of the words according to the ordinary and approved usage of the language when applied to the subject matter of the act is to be considered as expressing the intention of the legislature. Franki Foundation Co. v. State Tax Commissioner, 361 Mass. 614 (1972).

There is nothing inherent in the definition of the term "attributable" or its derivatives, which would mandate a negative ruling under these facts. Under a layman's definition, the term appears flexible rather than static:

attribute. To regard or assign as belonging to or resulting from someone or something; ascribe. n. 1. A quality or characteristic belonging to a person or thing; a distinctive feature: " Travel has lost the attributes of privilege and fashion." (John Cheever).

The American Heritage Dictionary 85 (1973)

Further, Black's Law Dictionary provides a particularly instructive interpretation of the term "attribution" by way of an example of its use in tax law:

Under certain circumstances, the tax law applies attribution rules to assign to one taxpayer the ownership interest of another taxpayer. If, for example the stock of X Corporation is held 60% by M and 40% by S, M may be deemed to own 100% of X Corporation if M and S are mother and son. In such a case, the stock owned by S is attributed to M. Stated differently, M has a 60% "direct" and a 40% "indirect" interest in X Corporation. It can also be said that M is the "constructive" owner of S's interest.

Black's Law Dictionary 119 (5th ed. 1979)

As exemplified above, one does not need attribution unless a separation exists between two things. In this letter ruling request, the separation exists between the dividends received by the shareholders of the Funds and the interest on the U.S. obligations held by the Lower-Tier RIC. We conclude that closing that separation is a reasonable interpretation of the statutory authority granted by the Legislature's choice of the term "attributable."

B. RIC Flow -Through Characteristics & Legislative Intent

It is clear that a RIC has flow-through characteristics as codified in its authority to distribute capital gain dividends and exempt interest dividends. See IRC § 852(b)(3), (5). [1] One can argue that a RIC's reason for being is to provide a conduit through which the investing public can avail itself of the plethora of investment opportunities. However, it can also be stated that a RIC does not embody all of the flow-through characteristics of a partnership. For example, items of expense are not directly passed on to the shareholders. Neither does a RIC operate like a corporation, which transforms its various items of income and expense into one corporate dividend that is then distributed to shareholders.

In the latter case, the Department's efforts to determine the flow-through characteristics, or lack thereof, of different RIC entities, arrived at an apex in a letter ruling request involving a RIC organized as a corporation. The Department held at that time, that without explicit statutory authorization from the Legislature, it could not adopt a characterization-of-income rule for distributions from RICs organized as corporations. [2] See Letter Ruling 92-1, Distributions of Interest Derived From Federal Obligations by Regulated Investment Company Organized as a Corporation. Within months of the issuance of this letter ruling the Legislature acted, adding the language at issue in this letter ruling that allows the exempt status of U.S. obligation interest to flow-through a RIC, any RIC, to a shareholder.

The rapidity of the Legislature's response coupled with its choice of the flexible term "attributable" demonstrates a legislative intent to preserve and enhance the deduction for U.S. obligation interest. In addition, we are not aware of any underlying tax avoidance purpose to the facts presented to us that would cause us to reject the assertion that the business purpose of economies of scale and efficient management are the motivating factors in adopting the investment structure presented to us.

Very truly yours,

/s/Frederick A. Laskey

Frederick A. Laskey
Commissioner of Revenue

FAL:DMS:jmw

LR 00-17



[1] See Letter Ruling 00-12, Tax-Exempt Status of Dividends from Two-Tier RICs, in which the Department ruled that Exempt-Interest and Capital Gain Dividends retain their exempt status for Massachusetts personal income tax purposes, as they flow through two levels of RICs. In that ruling, the relevant Massachusetts statutes specifically adopted the Code provisions that allowed the exempt status of the dividends to flow through two levels of RICs. Id. No such Code provision exists for U.S. Obligation interest given such interest is taxable for federal income purposes.

[2] A characterization-of-income rule did apply to RICs organized as corporate trusts. See Letter Ruling 92-1, Distributions of Interest Derived From Federal Obligations by Regulated Investment Company Organized as a Corporation.