Exempt interest on a fund that holds federal reserve repurchase agreements

[samzandt]

I own a money market fund. I looked at the year end portfolio distribution to determine how much of the fund interest (in form of dividends) is tax exempt. A portion is US Treasury Bonds which is known to be exempt from state income tax, but a large portion of the fund holds repurchase agreements with various banks including the Federal Reserve bank with the underlying collateral as US Treasuries. The heading for this portion of the portfolio is titles "U.S. TREASURY REPURCHASE AGREEMENTS 85.2%" and listed the various banks under which the fund has agreements with. Is this interest exempt?

[tagteam]

See file:///C:/1/028224_GT%20Alert_Tax%20Issues%20for%20Repo%20Buyers%20and%20Sellers.pdf

@Mike9241 

[Mike9241]

Money Market Mutual Funds, Repurchase Agreements, and State/Local Tax Exemptions
JULY 13, 2023 BY JONATHAN PING 3 COMMENTS

In particular, even though the Vanguard Treasury Money Market Fund has “Treasury” in its name, it doesn’t only hold Treasury Bonds. It can also hold something called repurchase agreements (“repos”). These are often sold on a very short-term basis (overnight or less than 48 hours). While a repo is considered a very, very safe loan backed by government securities, it is not itself a government security, which means the income it creates is taxable at the state and income level.

[samzandt]

I've done some research, and I think its a bit more complicated then that. The way I understand a repurchase agreements or in this case a reverse repurchase agreement, to work is that the money market fund actually buys the US Treasury and agrees to sell back the US treasury a few days later. While the MMF holds the UST is accrues interest. The price the counterparty pays to repurchase the UST is equal to the accrued interest on the UST +/- an amount such that the all in yield to the MMF is equal to repurchase rate agreed at the start of the repurchase agreement. Given where rates are a significant majority, if not all, of the income earned by the MMF is actually due to the accrued interest holding the UST. So I would think the MMF income on UST collateralized repos would be exempt from state tax. What do you think?

[SusanY1]

The interest is not going to be exempt.  The interest must be paid by the United States in order to be tax exempt and in the case of the Repurchase Agreements, it is not. The seller of the repurchase agreement collects the exempt interest and the buyer is paid the agreed upon price later.  While that interest may be set based on the interest of the obligation, it's not paid by the issuer, and is therefore not eligible to be exempt.

Several states have addressed this in rulings or court cases.  Though I didn't check all states with income taxes, it is safe to assume they will all view it the same way.  The interest being received on a repurchase agreement is considered interest on the loan of the securities, not interest on the treasury obligation.  That treasury interest is paid to the 

If take a look at SC Revenue Ruling #91-15 you can see a few examples of how courts have ruled on this in a handful of states and the legal underpinning of those decisions. 

The discussion on Repurchase Agreements begins near the bottom of page 5.  

I didn't check every state with a state income tax, so I suppose it is possible that your state views it differently, but it is not likely. 

[samzandt]

Thank you. That's helpful. Based on your comment I did some additional research and found that the US Supreme Court ruled on this very topic in December 1994 (Nebraska v. Loewenstein, No. 93-823) and confirmed it. Not sure how the US Supreme Court can rule on a state income tax issue, but I don't plan on wasting the time on that one.

The last question on this topic relates to repurchase agreements with the Federal Reserve. The Federal Reserve is an agency of the United States like the Federal Home Loan Bank. So it would make sense that interest the Federal Reserve pays the MMF under a repo agreement should be exempt, while interest that a corporate bank pays to the MMF under a repo would not.