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Revenue Administrative Bulletin 2020-22

Revenue Administrative Bulletin 2020-22

PART 1: INCOME TAX - TAX EXEMPT STATUS OF INCOME
FROM UNITED STATES OBLIGATIONS FOR INDIVIDUALS AND FIDUCIARIES

Approved:   December 15, 2020

(Replaces Revenue Administrative Bulletin 1989-10)

Pursuant to MCL 205.6a, a taxpayer may rely on a Revenue Administrative Bulletin issued by the Department of Treasury after September 30, 2006 and shall not be penalized for that reliance until the bulletin is revoked in writing.  However, reliance by the taxpayer is limited to issues addressed in the bulletin for tax periods up to the effective date of an amendment to the law upon which the bulletin is based or for tax periods up to the date of a final order of a court of competent jurisdiction for which all rights of appeal have been exhausted or have expired that overrules or modifies the law upon which the bulletin is based.

 

RAB 2020-22.  This Revenue Administrative Bulletin (RAB) describes the Michigan income tax treatment of income from obligations of the United States government and United States agencies and territories under Part 1 of the Michigan Income Tax Act for individuals and estate and trust fiduciaries.

Preemption of state tax under federal law

Income from direct obligations issued by the United States government is subject to federal income tax but is generally not subject to state income tax.  Federal law generally preempts states from taxing any income or gain from obligations of the United States.  31 USC 3124 provides in pertinent part:

(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 form of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax…

(b)   The tax status of interest on obligations and dividends, earnings, or other income from evidences of ownership issued by the Government or an agency and the tax treatment of gain and loss from the disposition of those obligations and evidences of ownership is decided under the Internal Revenue Code of 1986 (26 U.S.C. 1 et seq.). An obligation that the Federal Housing Administration had agreed, under a contract made before March 1, 1941, to issue at a future date, has the tax exemption privileges provided by the authorizing law at the time of the contract. This subsection does not apply to obligations and evidences of ownership issued by the District of Columbia, a territory or possession of the United States, or a department, agency, instrumentality, or political subdivision of the District, territory, or possession.

The preemption does not apply to secondary or contingent obligations (indirect obligations) of the United States government.[1]  States are also preempted from taxing income from obligations of:

  • United States government-sponsored enterprises and agencies (collectively “agencies”) for which the United States government is the primary obligor,
  • United States territories if the legislation creating the agency or giving the agency or territory authority to issue obligations contains specific language exempting it from state income taxes,
  • Exempt debentures relating to the General Insurance Fund.

The federal adjusted gross income (AGI) of individual taxpayers and the federal taxable income (FTI) of fiduciaries are adjusted so that the State does not tax income that is preempted by federal law.

Michigan law

Statutes.  Part 1 of the Michigan Income Tax Act, defines “taxable income” as AGI (individuals) or FTI (resident estates or trusts), subject to certain adjustments.[2] 

Add losses on the sale or exchange of obligations of the United States government, the income of which this state is prohibited from subjecting to a net income tax, to the extent that the loss has been deducted in arriving at adjusted gross income [or FTI for fiduciaries].[3]

Deduct, to the extent included in adjusted gross income [or FTI for fiduciaries], income derived from obligations, or the sale or exchange of obligations, of the United States government that this state is prohibited by law from subjecting to a net income tax, reduced by any interest on indebtedness incurred in carrying the obligations and by any expenses incurred in the production of that income to the extent that the expenses, including amortizable bond premiums, were deducted in arriving at adjusted gross income [or FTI for fiduciaries].[4]

Interest, dividends and other earnings. Income from the interest, dividends, or other earnings from the direct obligations of the United States government and obligations of agencies and territories that federal law prohibits the State from taxing are deducted to reach taxable income. The income is offset by any interest expense or amortized bond premium recognized in AGI or FTI.

Bond premiums offset income earned on United States obligations and reduce the investor’s total state tax deduction.  A bond premium occurs when an investor pays more than face value for a bond or other obligation. Investors pay a premium when interest on the face value of the bond is higher than the current market interest rate.[5] 

For example, an investor purchases a 10-year Treasury note with total face value of $100,000 and annual interest of $2,000. The investor pays $104,000 for the notes.  The premium of $4,000 is amortized over the 10-year life of the note at $400 each year.[6]  The investor’s annual Michigan deduction is $1,600.

Gains and losses from sales or exchanges.  Net losses on the sale or exchange of obligations of the United States government are added back to an individual’s AGI or a fiduciary’s FTI and gains are subtracted.[7] 

Gains and losses from the sale of indirect obligations of the United States government and the sale of the obligations of U.S. agencies and territories are not exempt from state income tax.

Items not subject to Michigan Income Tax

A. Exempt U.S. obligations

  • U.S. Government bonds
  • U.S. Saving Bonds - Series EE, HH and I
  • U.S. Government Certificates
  • U.S. Treasury Bills and Notes

Note: Treasury Bill Futures are not U.S. obligations.

B. Exempt U.S. Agency obligations

  • Banks for Cooperatives
  • Central Banks for Cooperatives
  • Commodity Credit Corp.
  • Consolidated Bonds
  • Consolidated Discount Notes
  • Consolidated System Bond, Series L
  • Consolidated Systemwide
  • Discount Notes
  • District of Columbia
  • Farm Credit Banks
  • Farmer Home Corp.
  • Federal Deposit Insurance Corp.
  • Federal Farm Credit Bank
  • Federal Farm Loan Corp.
  • Federal Farm Mortgage Corp.
  • Federal Financing Banks
  • Federal Home Loan Banks
  • Federal Housing Administration (General Insurance Fund Debentures)
  • Federal Intermediate Credit Banks
  • Federal Intermediate Credit Corp.
  • Federal Land Banks
  • Federal Land Banks Association
  • Home Owners Loan Corp.
  • Joint Stock Land Banks
  • Maritime Administration
  • Production Credit Association
  • Small Business Administration
  • Student Loan Marketing Association
  • Tennessee Valley Authority (bonds only)
  • U.S. Housing Authority
  • U.S. Maritime Commission
  • U.S. Postal Service (bonds)

C.  The General Insurance Fund exempt debentures

  • Mutual Mortgage Insurance Fund
  • Rental Housing Mortgage Insurance
  • War Housing Insurance
  • Rental Housing Insurance
  • Armed Services Housing Mortgage Insurance
  • National Defense Housing Insurance

D. U.S. territories/possessions exempt obligations

  • American Samoa
  • Guam
  • Northern Mariana Islands
  • Puerto Rico
  • Virgin Islands

Note: Income from exempt U.S. obligations received by the taxpayer from Money Market Funds, Money Market Certificates, Mutual Funds, Trusts, etc., generally qualifies for a Michigan deduction. Losses from exempt U.S. obligations received by the taxpayer from Money Market Funds, Money Market Certificates, Mutual Funds, Trusts, etc. are generally added back.

Items Subject to Michigan Income Tax

A. Organization debt that is taxable

  • Government National Mortgage Association  (Ginnie Mae) (debentures, notes, and participation certificates)
  • Federal National Mortgage Association (Fannie Mae) participation and other instruments (debentures, notes, and participation certificates)
  • Federal Home Loan Mortgage Corporation (Freddie Mac) mortgages and other securities
  • Federal Housing Administration
  • Rural Development Insurance Fund
  • Export-Import Bank of Washington, D.C.
  • International Bank for Reconstruction and Development (World Bank)
  • Building and Loan Associations (Thrifts)
  • Credit Union Share Accounts
  • Federal Savings and Loan Associations
  • Philippine Bonds
  • U.S. Government Insured Merchant Marine Bonds

B. Other obligations that are taxable

  • Interest-bearing certificates issued in lieu of tax-exempt securities (such that income loses its identity when merged with other funds)
  • Debentures issued to mortgages or mortgages foreclosed under the provisions of the National Housing Act
  • Promissory notes of a federal instrumentality
  • Federal Home Loan Time deposits
  • Government National Mortgage Association participation certificates and on Federal
  • Home Loan Mortgage Corporation participation certificates in mortgage pools
  • U.S. Postal Service Certificates and savings deposits
  • Participating loans in the Federal Reserve System for member banks (Federal Funds)
  • Repurchase agreements[8]

[1] For example, Ginnie Mae certificates are indirect obligations. “Government National Mortgage Association (Ginnie Mae) certificates …are neither direct nor certain obligations of the United States. As the certificate provides, it is the issuer that bears the primary obligation to make timely payments—the United States’ obligation is secondary and contingent. In short, the United States is the guarantor—not the obligor. This distinction is more than adequate to support our conclusion that Ginnie Maes do not qualify as ‘other obligations of the United States’ for the purposes of [31 USC 3124].”  Rockford Life Insurance Co v Illinois Dep’t of Revenue, 482 US 182 (1987).

[2] MCL 206.30(1) for individuals and MCL 206.36(1) for resident estates or trusts.

[3] For individuals, MCL 206.30(1)(c); for fiduciaries, MCL 206.36(1)(c).

[4] For individuals, MCL 206.30(1)(d); for fiduciaries, MCL 206.36(1)(d).

[5] By paying more than face value, the investor, in effect, reduces the rate of return on the bond.

[6] Amortization of bond premiums in the example uses the straight-line method.

[7] For individuals, MCL 206.30(1)(c) for losses and MCL 206.30(1)(d) for gains. For fiduciaries, MCL 206.36(1)(c) for losses and MCL 206.36(1)(d) for gains.

[8]Repurchase agreements involve a Seller (Borrower) that transfers U.S. securities to a Buyer (Lender) for cash. At a later date, the Seller (Borrower) repurchases the U.S. securities from the Buyer (Lender) for an amount equal to the cash originally paid for the securities plus interest at a rate that bears no relation to the yield on the U.S. securities.  See also Nebraska Dep't of Revenue v. Loewenstein, 513 US 123 (1994) holding repurchase agreements are not U.S. obligations.