TECHNICAL ASSISTANCE ADVISORY 87-003Re: PIT and CNIT Treatment of Interest Income From General Obligations of Puerto Rico; and PIT and CNIT Treatment of Distributions From Regulated Investment Companies (RIC) Investing Solely in General Obligations of Puerto Rico. Recently advice was requested from this office on whether interest earned on general obligation bonds of Puerto Rico is included in West Virginia taxable income for personal or corporation income tax purposes; and whether distributions to shareholders in an investment company registered under the Investment Company Act of 1940, is taxable if the investment company's assets are comprised entirely of general obligation bonds of Puerto Rico.Personal Income Tax. The West Virginia Personal Income Tax Act is codified in article twenty-one, chapter eleven of the West Virginia Code. It is a conformity statute, in that federal adjusted gross income is used as the starting point to determine West Virginia taxable income. W. Va. Code § 11-21-12. The meaning of terms used in the West Virginia personal income tax have been updated and brought into conformity with their meaning, as of December 31, 1986, for federal income tax purposes. Enr. S.B. No. 536 enacted into law April 7, 1987, effective generally July 1, 1987; changes in personal income tax definitions retroactive to January 1, 1986. Federal adjusted gross income must be modified to determine West Virginia adjusted gross income. W. Va. Code § 11-21-12. Modifications increasing federal adjusted gross income are set forth in subsection (b) of section 11-21-12. Decreasing modifications are set forth in subsection (c) thereof. Our analysis begins with examination of whether interest on general obligation bonds of Puerto Rico directly held by an individual is included in adjusted gross income for federal income tax purposes. Section 103 of the Internal Revenue Code of 1986, Interest on State And Local Bonds, provides: (a) Exclusion. -- Except as provided in subsection (b), gross income does not include interest on any State or local bond. (b) Exceptions. -- Subsection (a) shall not apply to: (1) Private activity bond which is not a qualified bond. -- Any private activity bond which is not a qualified bond (within the meaning of section 141). (2) Arbitrage bond. -- Any arbitrage bond (within the meaning of section 148). (3) Bond not in registered form, a set-up period. -- Any bond unless such bond meets the applicable requirements of section 149. (c) Definitions. -- For purposes of this section, and Part IV [credit against income taxes]: (1) State or local bond. -- The term "state or local bond" means an obligation of a State or political subdivision thereof. (2) State. -- The term "State" includes the District of Columbia and any possession of the United States. Treas. Reg. § 103-1, Interest Upon Obligations of a State Territory, etc., provides in subsection (a) that: "Interest on obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (hereinafter collectively or individually referred to as "State or local governmental unit") is not includable i gross income except as provided under section 101(c) and (d) and the regulations thereunder." The question becomes whether any of the modifications increasing federal adjusted gross income set forth in W. Va. Code § 11-21-12(b) require adding this excluded interest to the individual's federal adjusted gross income when determining West Virginia adjusted gross income. W. Va. Code § 11-21-12, West Virginia adjusted gross income of resident individual, reads in pertinent part: (a) General. -- The West Virginia adjusted gross income of a resident individual means his federal adjusted gross income as defined in the laws of the United States for the taxable year with the modifications specified in this section. (b) Modifications increasing federal adjusted gross income. -- There shall be added to federal adjusted gross income unless already included therein the following items. . .: (1) Interest income on obligations of any state other than this state, or of political subdivision of any such other state unless created by compact or agreement to which this state is a party. . . . If Puerto Rico is a "state" as that term is used in W. Va. Code § 11-21-12(b)(1), then interest on general obligation bonds of Puerto Rico must be added to federal adjusted gross income when determining the individuals's West Virginia adjusted gross income, unless some other provision of the United States Code intervenes to negate this increasing modification. The meaning of terms used in the West Virginia personal income tax is governed by W. Va. Code § 11-21-9, Meaning of terms, which reads in pertinent part as follows: Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to income taxes, unless a different meaning is clearly required. . . . The context in which the term "state" is used in section 11­21-12(b)(1), is precisely the same context in which the term "State" is used in I.R.C. § 103. In other words, "state" as used in section 11-21-12(b)(1) "includes the District of Columbia and any possession of the United States," I.R.C. § 103(c)(2). The Commonwealth of Puerto Rico is a possession of the United States. I.R.C. § 7701(d). Therefore, interest on general obligation bonds issued by Puerto Rico is excluded from federal gross income under I.R.C. § 103(a). We note that "state is also defined in I.R.C. § 7701, Definitions, which reads in pertinent part as follows: (a) When used in this title, where not otherwise distinctively expressed or manifestly compatible with the intent thereof. . . (10) State. -- The term "State" shall be construed to include the District of Columbia, where such construction is necessary to carry out provisions of this title. The definition of "state" in I.R.C. § 103(c)(2) is broader, more encompassing than is its definition in I.R.C. § 7701(a)(10); and it is the Section 103 definition that is controlling here. Interest on general obligation bonds issued by Puerto Rico is not, however, exempt from federal income tax solely by reason of I.R.C. § 103(a). It is also exempt because of 48 U.S.C § 745, which reads: All bonds issued by the Government of Puerto Rico or by its authority, shall be exempt from taxation by the Government of the United States, or by the Government of Puerto Rico. . .or by any State, Territory or possession, or by any country, municipality or other municipal subdivision of any state, territory, or possession of the United States, or by the District of Columbia. therefore, even without I.R.C. § 103(a), interest on Puerto Rican bonds would be exempt from federal income taxes; and for purposes of state income taxes, this interest is exempt to the same extent interest is exempt on obligations of the United States under 31 U.S.C. § 742 [now 31 U.S.C. § 3124(a)]. Rochester Bank & Trust co. v. The Commissioner of Revenue, Minn. , 305 N.W.2d 776 (1981). Recently enacted Senate Bill No. 536, supra, amends W. Va. Code § 11-21-12(c), modifications reducing federal adjusted gross income , to exclude therefrom: (12) Any other income which this state is prohibited from taxing under the laws of the United States. The net effect of the increasing modification required by section 11­21­12(b)(1) and the decreasing modification required by section 11­21­12(c)(12) is that interest on Puerto Rican obligations is exempt from West Virginia personal income tax.Corporation Net Income Tax. The rule is somewhat different for corporations taxable under the West Virginia Corporate Net Income Tax Act, codified in article twenty-four, chapter eleven of the West Virginia Code. It too is a conformity statute; however, it is the corporation's federal taxable income that is used as the starting point to determine West Virginia taxable income. W. Va. Code § 11-24-6. Terms used in the West Virginia corporate net income tax law have been updated to incorporate changes in federal income tax law enacted prior to January 1, 1987. Enr. H.B. No. 3189, enacted March 12, 1987; effective upon passage and applicable, as appropriate, to taxable years beginning after December 31, 1986. In determining the West Virginia taxable income of a corporation, its federal taxable income for the taxable year must be modified as provided in W. Va. Code § 11-24-6, Adjustments in determining West Virginia taxable income. Modifications increasing federal taxable income are set forth in W. Va. Code § 11-24-6(b), which reads in pertinent part as follows: (b) Adjustments increasing federal taxable income. -- There shall be added to federal taxable income, unless already included in the computation of federal taxable income, the following items. . .: (1) Interest or dividends on obligations or securities of any state or of a political subdivision or authority thereof. . . . Like the personal income tax law, terms used in the West Virginia Corporation Net Income Tax Act are generally defined by federal income tax law. W. Va. Code § 11-24-3, Meaning of terms; general rule, reads in pertinent part as follows: Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to federal income taxes, unless a different meaning is clearly required by the context or by definition in this article. . . . Employing the same analysis used to determine the meaning of "state," as used in W. Va. Code § 11-21-12(b)(1), the term "state," as used in W. Va. Code § 11-24-6(b)(1), includes the District of Columbia and possessions of the United States. Additionally, and unlike the West Virginia Personal Income Tax Act, certain terms are specifically defined for purposes of the West Virginia Corporation Net Income Tax Act; and such specific definitions are controlling, W. Va. Code § 11-24-3. The term "state" is specifically defined in W. Va. Code § 11­24-3a, Specific terms defined, which reads in pertinent part as follows: For purposes of this article: (17) State. -- The term "state" means any state of the United States, the District of Columbia, the Commonwealth of Puerto Rico, any territory or possession of the United States, and any foreign country or political subdivision thereof. Consequently, a corporation that invests in general obligation bonds of any "state," as above defined, including general obligations bonds of this State, is required to increase its federal taxable income by the amount of interest income with respect to such bonds excluded from federal adjusted gross income; and no decreasing modification is allowed for the amount of interest included in federal adjusted gross income derived from obligations which the laws of the United States prohibit this State from taxing. Adjusted federal taxable income is then modified as provided in W. Va. Code § 11-24-6(f), resulting in an allowance for tax exempt income based on the cost which assets exempt from tax bears to the cost of total assets owned by the corporation, as reported on Schedule L of Federal Form 1120. It is in this manner that taxpayers receive an allowance for investing in obligations which cannot be taxed by this State; and interest on Puerto Rican obligations is exempt to the same extent interest is exempt on obligations of the United States. Rochester Bank & Trust co. v. Commissioner of Revenue, supra. Electing small business corporations (S corporations) are exempt from the West Virginia corporate net income tax under W. Va. Code § 11-24-5(d). The income of S corporation is taxed to its shareholders in accordance with the federal income tax law and the provisions of the West Virginia Personal Income Tax Act.Regulated Investment Companies (RIC). An investment company registered under the Investment Company Act of 1940 is a Regulated Investment Company (RIC). Special rules apply to RIC's and their shareholders for purposes of determining federal adjusted gross income, if the requirements of I.R.C. § 852, Taxation of Regulated Investment Companies and Their Shareholders, are satisfied for the taxable year. Assuming the RIC qualifies, what this means is that interest income of the RIC that is exempt from federal income tax under I.R.C. § 103(a) is passed through to its shareholders as an exempt-interest dividend under I.R.C. § 852(b)(5), and is treated by the recipient shareholders as an item of interest excludable from federal gross income under Section 103(a). I.R.C. § 852(b)(5)(B). For West Virginia income tax purposes, the shareholders, whether they be individuals or corporations, will treat this income just like they would treat it if they directly held the obligations that gave rise to the exempt income.Summary. In summary: (1) Interest on general obligation bonds of Puerto Rico held by an individual, estate or trust is excluded from the West Virginia taxable income of such taxpayers pursuant to application of W. Va. Code § 11-21-12(b)(1); 48 U.S.C. § 745; and W. Va. Code § 11-21-12(c)(12). (2) Interest on general obligation bonds of Puerto Rico held by a corporation subject to the West Virginia corporation net income tax, is excluded from West Virginia taxable income pursuant to application of W. Va. Code § 11-24-6(b)(1); 48 U.S.C. § 745; and W. Va. Code § 11-24-6(f). (3) Interest on general obligation bonds of Puerto Rico held by an eligible RIC passes through to its shareholders retaining under I.R.C. § 852 the interest's tax exempt status under I.R.C. § 103(a) for federal income tax purposes. For West Virginia personal and corporation net income tax purposes, such federal exempt-interest dividends are excluded from West Virginia taxable income i the manner described in (1) or (2), above, depending on whether the shareholder is taxable as an individual (estate or trust) or as a corporation.Application. This Technical Assistance Advisory applies to individuals (estates and trusts) for taxable years beginning after December

31, 1986, and to corporations for taxable years beginning after June

30, 1987. Michael E. Caryl State Tax Commissioner Issued: April 22, 1987MEC:dss