23VAC10-110-142. Virginia taxable income; subtractions

A. To the extent included in FAGI, the items enumerated below shall be subtracted from FAGI in determining Virginia taxable income. If an item was partially excluded or deducted in determining FAGI, it shall be subtracted from FAGI only to the extent included therein. If an item has already been excluded from Virginia taxable income, it shall not be subtracted again pursuant to this section. 1. Interest or dividends on obligations of the United States or Virginia. a. "Obligation" means a debt obligation or security issued by the United States or any authority, commission, or instrumentality of the United States or by the Commonwealth of Virginia or any of its political subdivisions, which obligation or security is issued in the exercise of the borrowing power of the United States or Virginia and is backed by the full faith and credit of the United States or Virginia. b. Guarantees by the United States or Virginia of obligations of private individuals or corporations are merely contingent obligations of the United States or Virginia even though the guarantees may be backed by the full faith and credit of the United States or Virginia. The obligation does not become an obligation of the United States or Virginia because of the guarantee and interest and dividends paid on such guaranteed obligations do not qualify for the subtraction unless specifically exempted by statute. c. Specific statutory exemptions exist for certain securities issued by particular federal or Virginia agencies or political subdivisions. If a federal or Virginia statute exempts from state taxation the interest or dividends on specific securities of a particular agency or political subdivision, then such interest or dividends qualify for the subtraction. d. Repurchase agreements are usually obligations issued by financial institutions that are secured by U.S. obligations exempt from Virginia income taxation under subdivisions 1 a and c of this section. In such cases, the interest paid by the financial institutions to purchasers of repurchase agreements does not qualify for the subtraction. Repurchase agreements issued following current commercial practice will invariably be regarded as obligations of the issuing financial institution. However, if the purchaser is regarded as the true owner of the underlying exempt obligation, the interest will qualify for the subtraction even though collected by the seller and distributed to the purchaser. Any claim of such ownership must be substantiated by a taxpayer claiming a subtraction. e. Interest received from regulated investment companies. Interest on exempt obligations received by a regulated investment company and passed through to the stockholders in qualifying distributions, as defined in IRC § 852, will retain its exempt status in the hands of the shareholders. If a shareholder receives a distribution that includes interest from both exempt and non-exempt obligations, all distributions will be deemed taxable unless the shareholder can substantiate the exempt portion of the distributions. Any individual requiring advice as to the taxable status of distributions from any regulated investment company should contact such company. Due to the turnover in investments held by such companies and the commingling of interest from exempt and non-exempt obligations, the department cannot render such advice. f. Expenses. The subtraction for interest on exempt obligations must be reduced by any expenses attributable to such interest and by interest or indebtedness incurred or continued to purchase or carry exempt obligations pursuant to IRC § 265. 2. Interest or dividends from pass-through entities. a. Under federal law, certain income received by a partnership, estate, trust, or regulated investment company (pass-through entity) and distributed to a partner, beneficiary, or shareholder (recipient) retains the same character in the hands of the recipient. If a pass-through entity receives interest or dividends on U.S. or Virginia obligations that is distributed to the recipients in a manner that the distributions retain their character in the hands of the recipients under federal law, then such interest or dividends may be subtracted by the recipients in computing Virginia taxable income. b. A pass-through entity may invest in several types of securities, some of which are U.S. or Virginia obligations. When taxable income is commingled with exempt income, all income is presumed taxable unless the portion of income that is exempt from Virginia income tax can be determined with reasonable certainty and substantiated. The determination must be made for each distribution to each shareholder. For example, if distributions are made monthly, then the determination must be made monthly. As a practical matter, only pass-through entities that invest exclusively in U.S. or Virginia obligations or that have extremely stable investment portfolios will be likely to make such determinations. c. Examples: (1) ABC Fund, a regulated investment company, invests exclusively in U.S. Treasury notes and bills, which are exempt from state taxation under 31 USC § 3124. All distributions are considered to be interest on U.S. obligations and may be subtracted by the recipient. (2) Va. Fund, a regulated investment company, invests exclusively in obligations of Virginia and its political subdivisions. Distributions are considered to be interest on Virginia obligations and qualify for the subtraction to the extent that such distributions are included in the recipient's federal taxable income. (3) XYZ Fund, a regulated investment company, invests in a variety of securities, including obligations of the U.S., Virginia, other states, corporations, and financial institutions (repurchase agreements). Due to the commingling of taxable and exempt income, the turnover in XYZ Fund's investments and the fluctuation in a shareholder's investment in XYZ Fund, all distributions are considered taxable income and do not qualify for the subtraction unless XYZ Fund determines the portion of distributions that is interest and dividends from U.S. and Virginia obligations for each distribution to each shareholder. Note that any portion of XYZ Fund's distributions that is excluded from federal taxable income as interest on obligations of other states must be added to Virginia taxable income. 3. Social Security and Railroad Retirement benefits. The amount of any Social Security benefits received under Title II of the Social Security Act (Old Age and Survivors Disability Insurance) and any other benefits included in FAGI solely by virtue of IRC § 86 shall be subtracted from FAGI in computing Virginia taxable income. "Other benefits" under IRC § 86 includes Tier 1 Railroad Retirement benefits and workers' compensation to the extent that it reduces OASDI benefits. Tier 2 Railroad Retirement benefits shall be subtracted from FAGI in computing Virginia taxable income by virtue of the Railroad Retirement Act. B. See § 58.1-322.02 of the Code of Virginia for provisions defining computation of subtractions in figuring Virginia taxable income.