Letter Ruling  Letter Ruling 93-12: Classification of a Mutual Fund Structure Known as a "Hub and Spoke"

Date:	08/03/1993
Organization:	Massachusetts Department of Revenue
Referenced Sources:	Massachusetts General Laws

Corporate Excise/Personal Income Tax

August 3, 1993

You have requested two letter rulings, one on behalf of *************** ("Organization I"), and one on behalf of *************** ("Organization II," and, collectively with Organization I, the "Organizations"). We treat these ruling requests jointly because the questions are identical and the Organizations are affiliated.

Your primary question is whether the Organizations will be treated as partnerships for Massachusetts tax purposes. In addition, you pose a related question as to the tax consequences of the interest income ("Obligations Income") received by the Organizations on certain debt obligations issued by (1) the United States, (2) the Governments of Puerto Rico, Guam or the United States Virgin Islands, or (3) the Commonwealth of Massachusetts or its political subdivisions (including agencies or instrumentalities thereof). The Organizations intend to pay the Obligations Income to their interest holders, which include regulated investment companies ("RICs"). Your question is whether the Obligations Income is tax-exempt when paid as dividends to the RIC shareholders.

I. FACTS

A. Organization I

1. Structure

Organization I is a trust formed under the common law of the state of [X] , with a principal office located in Massachusetts. It has been established to serve as the "hub" in a "hub & spoke" or "master fund/feeder fund" structure. Under this structure, various funds that each separately qualify as a RIC under Internal Revenue Code ("Code") § 851 (the "Funds") will hold an interest in the Organization, with each Fund contributing more than 90% of its gross assets to the Organization.

At some future date, Organization I may have other investors as holders (collectively, with the Funds, "Holders"). However, the Holders will be limited to RICs, foreign investment companies, bank common trust funds, collective trusts for the investment of retirement plan assets and any accredited investor as defined in Regulation D promulgated by the Securities and Exchange Commission under the Securities Act of 1933. No individual, S corporation, partnership, or grantor trust that is beneficially owned by an individual, S corporation, or partnership will be permitted to become an investor in the Organization.

The hub & spoke or master fund/feeder fund structure will enable institutional investors to enjoy economies of scale through the reduction of expenses that is eventually possible in the management and operation of a single, large investment portfolio. At the same time, each of the Holders can provide different services and distribution schedules to its investors.

There is no statute that controls the formation and operation of the Organization. The Organization has been formed and will be operated in accordance with the terms of the declaration of trust ("Declaration") and [state X] common law. The Declaration provides that a group of trustees ("Fiduciaries") will administer the affairs of the Organization. In accordance with the Declaration, the Organization has established procedures for allocations and distributions (the "Procedures"). Each prospective investor in the Organization must complete and execute a standard form application (the "Application" and, together with the Declaration and the Procedures, the "Agreement").

Meetings of the Holders must be called when requested by Holders holding not less than 10% of the aggregate interests of the Organization. At these meetings, a majority in interest of the Holders may elect new Fiduciaries or amend the Declaration. Moreover, two-thirds in interest of the Holders may remove a Fiduciary, with or without cause, or terminate the Organization.

The Agreement provides that the interests in the Organization are not transferable by any Holder. Increases and decreases in a Holder's interest in the Organization, which could occur on a daily basis, will be effected solely by adjustments to such Holder's capital account balance, not by a transfer of interests in the Organization or of capital accounts between Holders. Such increases or decreases will occur with respect to a Holder whenever there is a contribution to the Organization by such Holder or distribution from the Organization to such Holder. Increases or decreases in the value of a Holder's interest due to appreciation or depreciation in the value of the Organization's assets will also be reflected in capital account adjustments made on a daily basis. The income and deductions of the Organization are allocated under the Agreement consistent with the regulations promulgated under Code §§ 704(b) and 704(c).

Pursuant to the Declaration and applicable securities law, each Holder will be permitted to redeem its entire interest in the Organization at any time, provided that it gives the Organization adequate notice. A Holder that has redeemed its entire interest will not be permitted to purchase an interest in the Organization until the later of 60 calendar days after the date of such redemption or the first day of the Organization's fiscal year during which such redemption occurred.

The Agreement provides that the Holders will be jointly and severally liable for the liabilities and obligations of the Organization, with rights of contribution inter se in proportion to their pro rata interests in the Organization. To the extent there are assets available in the Organization, the Organization will also indemnify and hold each Holder harmless from and against any such liabilities and obligations to the extent they exceed the Holder's pro rata share of such liabilities and obligations.

The Organization will be dissolved upon the bankruptcy of a Holder or upon the redemption of a Holder's entire interest in the Organization. However, in such instances, the remaining Holders may unanimously agree to reconstitute the Organization.

2. Proposed Activity

You state that it is anticipated that the Organization will invest primarily in obligations ("Massachusetts Obligations") issued by the Commonwealth of Massachusetts or its political subdivisions (including agencies or instrumentalities thereof), the interest on which is exempt from federal income tax under Code § 103(a). The trust may also invest in obligations ("Possessions Obligations") issued by the Governments of Puerto Rico, Guam or the United States Virgin Islands, the interest on which is likewise exempt from federal income tax under Code § 103(a). Finally, the trust may invest in obligations ("United States Obligations") issued by the United States. You state that the interest on each of these three types of obligations would be exempt from Massachusetts personal income tax if received by an individual resident of Massachusetts.

You state that the shareholders of a Fund will be mailed tax information statements each year at such time or times as is necessary to satisfy the requirements of all applicable laws. These statements will set forth the percentage of the dividends received by the shareholder from the Fund that is exempt from Massachusetts personal income tax. To determine such percentage, a dividend declared by the Fund will be designated as tax-exempt for Massachusetts personal income tax in the same percentage as the actual interest earned by the Fund on Massachusetts Obligations, Possessions Obligations and United States Obligations, including the Fund's allocable share of such interest earned by the Organization, bears to the total income from which such dividend is paid.

B. Organization II

The facts for Organization II are the same as for Organization I.

II. DISCUSSION

A. Classification of the Entity for Massachusetts Tax Purposes

1. Analysis as to Foreign Corporation or Corporate Trust

We note as a preliminary matter that, under Massachusetts tax law, the Organizations are not foreign corporations or corporate trusts. Each of these two types of organizations is defined by statute. See G.L. c. 63, § 30.2; c. 62, § 1(j).

A foreign corporation is defined by c. 63, § 30.2 as "every ... association ... established, organized or chartered under laws other than those of the commonwealth ... which has privileges, powers, rights or immunities not possessed by individuals or partnerships." This language has been interpreted to mean that an organization established in a foreign jurisdiction is a foreign corporation if it is organized under another state statute and is "so far clothed with the functions and attributes of a corporation as to come within the just application of principles relating to corporations ..." Opinion of Justices, 196 Mass. 603, 626 (1908) (quoting Oliver v. Liverpool of London Ins. Co., 100 Mass. 531, 538 (1868)). An organization is not "clothed with the functions and attributes of a corporation" unless it possesses corporate powers and privileges conferred by a legislature. See id., LR 91-2. Because the Organizations are not governed by [state X] statutory law they are not foreign corporations for purposes of G.L. c. 63, § 30.2.

The Organizations are likewise not corporate trusts under Massachusetts law. A corporate trust is defined as "any partnership, association or trust, the beneficial interest of which is represented by transferable shares." G.L c. 62, § 1(j). The Organizations do not meet with this definition since the interests in the Organizations are not transferable.

2. Analysis as to Partnership or Common Law Trust

The ruling you seek is that the Organizations are partnerships under Massachusetts tax law. However, the Organizations have been formally established as [state X] common law trusts. Therefore, the issue arises as to whether the Organizations are trusts under Massachusetts tax law, rather than partnerships.

Massachusetts applies different tax treatment to a partnership on the one hand, and a trust on the other. See G.L. c. 62, §§ 10, 17. Notwithstanding this different treatment, neither the term "partnership" nor "trust" is defined for purposes of these provisions. To determine the proper tax treatment of the entities in question, we look generally to Massachusetts law.

The question as to whether an organization formed under a declaration of trust is a partnership or trust was addressed by the Supreme Judicial Court ("SJC") in the cases of Frost v. Thompson, 219 Mass. 360 (1914) and Williams v. Milton, 215 Mass. 1 (1913). Those cases stand for the proposition that the determination depends upon the manner in which the "trustees" conduct the affairs of the enterprise. "If [the trustees] act as principals and are free from the control of the certificate holders, a trust is created; but if they are subject to the control of the certificate holders, it is a partnership." Frost, 219 Mass. at 365. See Milton, 215 Mass. at 6-9. We note that this test is similar to that used under the Code to differentiate trusts from partnerships and other organizations. [1]

We conclude that, because the Fiduciaries of the Organizations are subject to the substantial control of the Holders, the Organizations are partnerships under Massachusetts tax law. In this regard, we note that, for example, the Agreement allows the Holders to call meetings, elect Fiduciaries, remove Fiduciaries (with or without cause), amend the Declaration, terminate the Organization, and, upon a prospective dissolution, reconstitute the Organization. Indeed, the organization is very similar to that classified as a partnership in Frost. [2] See Reg. § 301.7701-4. [3]

B. Taxation of Interest Income on Government Obligations

Your second question pertains to Obligations Income which is first distributed by the Organizations to the Funds, and then paid by the Funds as a dividend to their respective shareholders. To determine the tax consequences of the dividends to the shareholders, it is necessary to analyze both levels of the distribution.

As a threshold matter, we note that c. 62, § 17(c) provides that the character of any item of income included in a partner's distributive share shall be determined as if such item were realized directly by the partner from the source from which realized by the partnership. Therefore, the interest income realized by the Organizations from debt obligations is treated as if it were realized by the Funds from this same source.

1. Massachusetts Obligations

Massachusetts gross income is federal gross income, with certain modifications. See G.L. c. 62, § 2(a). Interest on bonds issued by a state or its political subdivisions is excluded from federal gross income under Code § 103. However, G.L. c. 62, § 2(a)(1)(A) adds back into Massachusetts gross income interest received from governmental obligations excluded under Code § 103, other than interest from such obligations issued by the Commonwealth of Massachusetts or its political subdivisions (or any agency or instrumentality thereof).

The effect of G.L. c. 62, §§ 2(a) and 2(a)(1)(A), is that the interest income from Massachusetts Obligations ("Massachusetts Interest") is excluded from Massachusetts gross income under chapter 62. Because the Organizations are partnerships under Massachusetts tax law, any Massachusetts Interest realized by the Organizations would be treated as if it were realized by the Holders, including the Funds. Therefore, any Massachusetts Interest received by the Funds would be excluded from Massachusetts gross income under chapter 62.

We repeat your assertion that the Funds are RICs which are qualified under Code § 851. G.L. c. 62, § 2(a)(2)(I), as added by St.1992, c. 133, § 391, deducts from Massachusetts gross income dividends received from such RICs which are "exempt interest dividends" under Code § 852, [4] but only to the extent of the portion of such dividends that is directly attributable to interest from Massachusetts Obligations that is exempt from taxation under any provision of law, and provided that such portion is identified in a written notice mailed to the shareholders of the RIC not later than sixty days after the close of the RIC's taxable year. [5]

You ask for a ruling that the shareholders of a Fund will not be required to include in their Massachusetts gross income that portion of their "exempt-interest dividends" which is directly attributable to Massachusetts Income (including the Fund's allocable share of Massachusetts Income earned by the Organization). You state that the Fund will clearly identify this portion in a statement to its shareholders which will be mailed at such time or times as is necessary to satisfy the requirements of all applicable laws. Based upon your statement of the facts, we grant this ruling - assuming the statements which the Funds mail to their shareholders meet with the timing requirement set forth in G.L. c. 62, § 2(a)(2)(I).

2. United States and Possessions Obligations

G.L. c. 62, § 2(a)(2)(A) deducts from Massachusetts gross income dividends received from a RIC qualified under Code § 851 to the extent (1) such dividends are attributable to interest on obligations of the United States exempt from state income tax, and (2) the dividends are so identified in a written notice mailed to the RIC's shareholders not later than 60 days after the close of the RIC's taxable year. G.L. c. 62, § 2(a)(2)(A), as amended by St.1992, c. 133, § 390. [6]

For purposes of G.L. c. 62, § 2(a)(2)(A), an obligation of the United States exempt from state income tax is a financial instrument that (1) is issued by the United States or one of its instrumentalities or is otherwise backed by the full faith and credit of the United States, and (2) embodies a direct and binding promise by the United States to pay specified sums on specified dates. See TIR 89-8 (citing Smith v. Davis, 323 U.S. 111, 115 (1944)). This definition may include obligations issued by United States possessions. See id. You have stated that the interest on the United States Obligations and Possessions Obligations would be exempt from Massachusetts personal income tax if received by an individual resident of Massachusetts. We assume, therefore, that the United States Obligations and Possessions Obligations are "obligations of the United States exempt from state income taxation" within the meaning of G.L. c. 62, § 2(a)(2)(A) and TIR 89-8.

You ask for a ruling that the shareholders of a Fund will not be required to include in their Massachusetts gross income (1) that portion of their "exempt-interest dividends" which is directly attributable to interest on Possessions Obligations (including the Fund's allocable share of interest earned by the Organization on such obligations), and (2) that portion of their income from the Fund which is directly attributable to interest on United States Obligations (including the Fund's allocable share of interest earned by the Organization on such obligations). You state that the Funds will clearly identify each of these amounts in a statement to their shareholders which will be mailed at such time or times as is necessary to satisfy the requirements of all applicable laws. Based upon your statement of the facts, we grant this ruling - assuming the statements which the Funds mail to their shareholders meet with the timing requirement set forth in G.L. c. 62, § 2(a)(2)(A).

III. CONCLUSION

Both Organization I and Organization II will be classified as partnerships for Massachusetts tax purposes. Because this is the case, the Obligations Income received by the Organizations shall be treated as if realized directly by the Holders, including the Funds.

Because the Funds are RICs qualified under Code § 851, the portion of a dividend paid by these RICs which is directly attributable to interest on Massachusetts Obligations, Possessions Obligations, or United States Obligations (including the Fund's allocable share of interest earned by the Organization on such obligations) will be excluded from Massachusetts gross income, as long as (1) this portion is identified in a written notice mailed to the shareholders of the RIC consistent with the applicable G.L. c. 62 § 2(a)(2) timing requirement, and (2), in the instance of Massachusetts Obligations, the dividend qualifies as an "exempt interest dividend" under Code § 852.
 

Very truly yours,
 

/s/Mitchell Adams by JFL
 

Mitchell Adams
Commissioner of Revenue
 

MA:HMP:mtf
 

LR 93-12

[1] The regulations promulgated under Code § 7701, which pertain to the classification of organizations for tax purposes, state:

Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.

Reg. § 301.7701-4

[2] In Frost, the SJC stated:

[The trust documents] provide that the shareholders representing two thirds in value of outstanding shares have power to remove either or all of the trustees at any time, without assigning any cause, and to appoint others to fill the vacancy; to terminate the trust at any time earlier than that limited for its duration in the declaration of trust, and to terminate it by requiring conveyance of the property to other trustees upon new trusts, or to a corporation. A majority of shareholders at any time by vote may amend the declaration of trust. The by-laws may be "altered, amended or repealed" by vote of the majority of the shareholders "at any annual or special meeting of the ... shareholders." These provisions demonstrate that this association is a partnership and not a trust.

219 Mass. at 365-366. See Milton, 215 Mass. at 6-9.

[3] We note that the Internal Revenue Service has classified the Organization as a partnership for federal tax purposes.

[4] An "exempt interest dividend" under Code § 852 is:

...any dividend or part thereof (other than a capital gain dividend) paid by a regulated investment company and designated by it as an exempt-interest dividend in a written notice mailed to its shareholders not later than 60 days after the close of its taxable year. If the aggregate amount so designated with respect to a taxable year of the company (including exempt-interest dividends paid after the close of the taxable year as described in section 855) is greater than the excess of--

(i) the amount of interest excludable from gross income under section 103(a), over

(ii) the amounts disallowed under sections 265 and 171(a)(2), the portion of such distribution which shall constitute an exempt-interest dividend shall be only that proportion of the amount so designated as the amount of such excess for such taxable year bears to the amount so designated.

[5] This same result followed prior to the enactment of c. 62, § 2(a)(2)(I). See LR 83-59.

[6] This section also deducts interest which is directly received from obligations of the United States - if exempt from state income tax - to the extent included in federal gross income.