D.A. Pincus and Co., Inc. v. Meehan

• Decision Date: 30 January 1996
• Docket Number: No. 15175,15175
• Citation: 235 Conn. 865,670 A.2d 1278
• Parties: D.A. PINCUS AND COMPANY, INC. v. James F. MEEHAN, Commissioner of Revenue Services.
• Court: Connecticut Supreme Court

Page 1278

670 A.2d 1278

235 Conn. 865

D.A. PINCUS AND COMPANY, INC. v. James F. MEEHAN, Commissioner of Revenue Services.

No. 15175.

Supreme Court of Connecticut.

Argued Dec. 7, 1995.

Decided Jan. 30, 1996.

Paul M. Scimonelli, Assistant Attorney General, with whom, on the brief, was Richard Blumenthal, Attorney General, for appellant (defendant).

William H. Narwold, Hartford, with whom, on the brief, was Charles D. Ray, for appellee (plaintiff).

Before CALLAHAN, BORDEN, BERDON, KATZ and PALMER, JJ.

KATZ, Justice.

The principal issue in this appeal is whether the difference in tax treatment that General Statutes § 12-217(a)(A) accords investments in federally tax-exempt municipal bonds and federally taxable bonds with respect to the deductibility of interest expenses incurred in holding such investments violates the equal protection clauses of the state and federal constitutions. We conclude that it does not.

The following pertinent facts are undisputed. The plaintiff, D.A. Pincus and Company, Inc., is a properly registered broker-dealer that is engaged solely in the business of buying municipal obligations and selling them primarily to other broker-dealers. The plaintiff earns interest income on its inventory of municipal bonds. In order to maintain its inventory of such bonds, the plaintiff borrows money on which it pays interest.

For the fiscal years ending on October 31, 1983, 1984, 1985, 1986, and 1987, the plaintiff was qualified to do business in Connecticut, and consequently, was subject to the Connecticut corporation business tax. See General Statutes § 12-213 et seq. The plaintiff timely filed its tax returns for those years as required and timely paid in full all taxes and other charges as reported by the plaintiff to be due thereon. In those returns, the plaintiff included in its gross income all interest that it received from its inventory of municipal obligations. The plaintiff in turn deducted from its gross income the interest expenses on the indebtedness incurred to carry the municipal obligations.

Subsequent to October 31, 1985, the defendant, the commissioner of revenue services, examined the plaintiff's Connecticut corporation business tax returns for the fiscal years ending on October 31, 1983, 1984 and 1985. On the basis of his interpretation of § 12-217(a)(A), ¹ the defendant concluded that the plaintiff had improperly deducted the interest expenses. Accordingly, the defendant added those amounts back into the plaintiff's gross income. Thereafter, the defendant mailed a notice to the plaintiff of an assessment of additional tax due in the amount of $24,867, plus interest for those years. Pursuant to General Statutes § 12-236, ² the plaintiff requested a hearing and correction of that tax assessment. The defendant subsequently examined the plaintiff's Connecticut corporation business tax returns for the fiscal years ending on October 31, 1986, and 1987 and, similarly concluding that the plaintiff had improperly deducted the interest expenses from its gross income, mailed a second notice to the plaintiff of an assessment of additional tax due in the amount of $16,342, plus interest for those years. Again, the plaintiff filed a request for a hearing and correction of the tax assessed by the defendant. After a hearing, the defendant denied both requests for correction.

Thereafter, pursuant to General Statutes (Rev. to 1995) § 12-237, ³ the plaintiff appealed to the trial court from the defendant's adverse decisions. In both appeals, the plaintiff claimed that if § 12-217(a)(A) allows a broker-dealer carrying a portfolio of federally taxable bonds to deduct the interest expenses incurred in connection with those bonds, but does not allow a broker-dealer carrying a portfolio of federally tax-exempt bonds to deduct the interest expenses incurred in connection with those bonds, ⁴ in the absence of a rational basis for the disparate treatment of such broker-dealers, both of whose earned interest is taxable for state tax purposes, the statute violates the equal protection clauses of the state and federal constitutions. ^{5 5} The appeals were consolidated for trial. The trial court, Blue, J., concluded that § 12-217(a)(A) did violate the equal protection clauses and sustained the appeal. The defendant thereafter appealed to this court pursuant to General Statutes § 51-199(b)(2). We reverse the judgments of the trial court.

The parties agree that, unlike the federal government, the state of Connecticut, pursuant to General Statutes § 12-213, ⁶ does not exclude from gross income the interest earned on municipal bonds for purposes of the corporation business tax. See Connecticut Bank & Trust Co. v. Tax Commissioner, 178 Conn. 243, 423 A.2d 883 (1979). ⁷ Accordingly, on its tax returns for the fiscal years 1983 to 1987, the plaintiff properly included the interest income earned on its portfolio of municipal obligations. The parties, however, disagree as to the application of § 12-217(a)(A) to the interest paid on the indebtedness incurred to carry these municipal obligations. In order to understand the basis of their disagreement, and because § 12-217(a)(A) partially depends on federal corporate tax law, we turn there first.

Pursuant to title 26 of the United States Code, § 103(a), ⁸ interest income on municipal obligations is excluded from gross income as that term is defined in title 26 of the United States Code, § 61(a) (1994). ⁹ Interest income on corporate obligations, in contrast, is included in gross income. Additionally, although, as a general rule, title 26 of the United States Code, § 163(a) ¹⁰ provides a deduction for all interest paid on corporate indebtedness, title 26 of the United States Code, § 265(a)(2) ¹¹ expressly provides that no deduction shall be allowed for interest on indebtedness incurred and paid in connection with carrying federally tax-exempt municipal obligations. Put simply, under the federal tax provisions, a taxpayer does not include the interest earned on municipal bonds in income and does not deduct the interest paid on money borrowed to carry these bonds. The taxpayer, however, must include the interest earned on corporate bonds and may deduct the interest expense incurred to carry those bonds.

In contrast, under Connecticut's corporate tax scheme, interest earned on both municipal and corporate obligations is included in the taxpayer's gross income. Furthermore, § 12-217(a)(A) provides that, in general, only those items deductible under federal tax law are deductible in Connecticut. The plaintiff acknowledges that there is no specific deduction provided in Connecticut's corporation business tax law for interest expenses incurred in carrying a portfolio of municipal obligations. Therefore, broker-dealers in Connecticut who engage in the trade of federally taxable obligations, such as corporate bonds, who are also taxed in Connecticut on interest earned, receive a deduction for interest expenses incurred in connection with these obligations. On the other hand, broker-dealers in Connecticut, who engage in the sale of federally tax-exempt obligations, such as the plaintiff, who are similarly taxed in Connecticut on interest earned, do not receive a deduction on interest expenses incurred in carrying these obligations. Consequently, the type of obligation in which one deals dictates whether the related interest expenses are deductible for Connecticut corporation business tax purposes. Because the plaintiff cannot deduct the expenses incurred in maintaining its municipal obligations, it claims that it is being discriminated against in violation of the equal protection provisions of the state and federal constitutions.

The defendant responds that § 12-217(a)(A) does not single out broker-dealers in municipal obligations from broker-dealers in corporate bonds as a particular class to whom differing treatment is afforded. Rather, all broker-dealers are treated alike in that all interest received is included in gross income under the Connecticut corporation business tax no matter what the nature, source or purpose of such interest received. Additionally, a broker-dealer who has investments in both corporate bonds and municipal bonds would be able to deduct the interest expenses related to corporate bonds but not the interest expense related to municipal bonds. The defendant maintains that this case involves two types of investment income, and that it is simply the type of security in which the plaintiff chose to deal that brings about differing results. We agree with the defendant.

The plaintiff in this case sought a deduction from otherwise taxable income. Because deductions and exemptions from otherwise taxable income are matters of legislative grace, they must be strictly construed. Yaeger v. Dubno, 188 Conn. 206, 212, 449 A.2d 144 (1982). With that principle in mind, we turn to an examination of the plaintiff's claims.

The plaintiff chose to deal in municipal bonds. As we stated in Bolt Technology Corp. v. Commissioner of Revenue Services, 213 Conn. 220, 231-32, 567 A.2d 371 (1989), there is no constitutional significance to a taxpayer's voluntary decision to do business one way in preference to another. In Bolt Technology Corp., we upheld the constitutionality of § 12-217(a)(D)(1) despite the different tax treatment afforded to domestic international sales companies (DISCs) operating on a commission agent basis as opposed to those DISCs operating on a buy-sell basis. Id. "The taxpayers in these cases elected to do business by way of a commission agent DISC rather than by a buy-sell DISC. The fact that one method of doing business has less beneficial tax consequences than the other does not warrant this court's interference with the tax policies formulated by the legislature regarding DISCs. We, therefore, decline to attempt to equalize the tax consequences of the two DISCs by interpreting § 12-217 in a manner contrary to the plain words of the...