Background

By way of background, from 1981 until 1989, Connecticut issued certain "special purpose bonds." The state's general statutes exempted the interest from these bonds from its corporation business tax. This exemption was not available to interest on U.S. Government bonds or on any other state and local bonds, including other Connecticut obligations.

In 1983, the U.S. Supreme Court, in the Memphis Bank & Trust Co. v. Garner, 459 U.S. 392 (1983), invalidated a Tennessee law which subjected interest on Federal and out-of-state tax-exempt obligations to tax, while exempting interest on Tennessee state obligations. The Court found the law to be discriminatory and in violation of 31 U.S.C. 3124(a)(formerly 31 U.S.C. 742). This section of the U.S. Code prohibits states from taxing interest on U.S. obligations, unless that tax is a nondiscriminatory franchise or other nonproperty tax.

As a result of the exemption from Connecticut corporation business tax granted to the special purpose bonds, it appeared that Connecticut had discriminated against Federal obligations in violation of 31 U.S.C. 742 and the rule set forth in Memphis Bank & Trust and was prohibited from exempting interest on its own bonds without similarly exempting interest on Federal obligations. Many corporations had filed refund claims, and more claims were expected.

The March 8, 1995, legislation aggressively deals with this violation of Federal law by revoking the tax exemption on the special purpose bonds, which most people previously felt could not be done. Basing the legislation on a footnote in a U.S. Supreme Court decision U.S. Trust Company of New York v. New Jersey, 431 U.S. 975 (1977)!, the state invoked its power of eminent domain to revoke the tax exemption. In return, the state will compensate holders of the special purpose bonds for the estimated reduction in value of their bonds which resulted from the lost tax exemption. The state has estimated this cost at $17 million to $20 million, far less than the $1 billion in lost tax revenue it expected to lose over the life of the bond issues.

The main provisions of the legislation are as follows:

1. Interest on the special purpose bonds will be taxable, retroactive to January 1, 1992. Corporate holders of the bonds who claimed the tax exemption must amend their returns and report the interest on the special purpose bonds as taxable income. If the tax is paid by June 6, 1995, the taxpayer will not owe any interest or penalties. Taxpayers who pay the tax after that date will owe interest from the original due date of the return to the date of payment and may also be subject to penalties.

2. If a taxpayer files a refund claim with respect to a taxable year before 1992 to exclude U.S. Government bond interest, it must also increase its taxable income by expenses allocable to that income. Prior law contained no such requirement. This provision will reduce the amount of any refund claim which may be allowed. This rule will also apply to any claim for refund for post-1991 years if the retroactivity provisions are struck down.

The state has 180 days to determine whether it will challenge refund claims for years prior to 1992. Since its action in enacting this legislation is a strong indication that the state believed that it may have violated 31 U.S.C. 742, it is very possible that the state will decide to honor the claims for pre-1992 years. However, it is also expected that Connecticut auditors will be very aggressive in requiring expenses (presumably including interest expense, although the statute is not specific) to be offset against the U.S. Government bond interest.

Observations

The recent legislation placed a premium on filing refund claims for calendar 1991 tax years, since that is the last year where the discrimination is most clear and where a taxpayer has the greatest chance of prevailing. Claims for refund of corporation business tax must generally be filed within three years of the original due date of the return, although two taxpayers are currently litigating whether the three-year period should be measured from the extended due date of the return. Under the state's interpretation, the statute of limitations for filing a refund claim for the calendar year 1991 expired on April 1, 1995.

In addition, taxpayers who are currently under audit by the state may be able to file amended returns and request refunds on this issue for any open years. There also may be opportunities for taxpayers who have net operating losses (NOLs) coming into 1991 or later years. Connecticut allows NOLs to be carried forward for five years. An argument can be made that the three-year statute of limitations on refund claims does not bar a taxpayer with an NOL from "correcting" the amount of the NOL deduction in an open year. For example, if a taxpayer deducted an NOL of $1,000,000 from 1986 on its 1991 return, it could file a refund claim by April 1, 1995. The refund claim could not only include the exclusion of the U.S. Government bond interest included in taxable income for 1991, but also the increase in the NOL attributable to the exclusion of U.S. Government bond interest in 1986 and subsequent years. The reason for this position is that an NOL deduction is no different from any other deduction claimed on a tax return for an open year. It is subject to adjustment by the taxpayer or the state and the proper amount of the NOL deduction is dependent on the true taxable income or loss for the NOL year and any intervening years to which the NOL may first be carried.

For years after 1991, the state will probably vigorously contest any refund claims on the basis of the revocation of the exemption from tax on the special purpose bonds. However, it is by no means a certainty that the state will prevail on that issue. Thus, it would be prudent for taxpayers to file refund claims for all open years. In this regard, the NOL situation offers additional possibilities. Assume that a company incurred an NOL in 1987 which it carried to 1992. Although the state will contend that U.S. Government bond interest received in 1992 is taxable, it would appear that a taxpayer would be entitled to increase the amount of the NOL carryforward into 1992 by the amount of the interest on U.S. Government bonds received in the years 1987 through 1991. Other NOL situations may present additional planning opportunities.

Despite the fact that the recent legislation strengthens Connecticut's position that it has not illegally taxed U.S. Government bond interest, the issue is by no means clear and will not be settled for many years.