State to Refund Taxes on Fund Dividends

California tax authorities announced Wednesday that they expect to refund state income taxes paid on dividends from three mutual funds that invested in U.S. Treasury bonds.

The move by the Franchise Tax Board, following a tentative decision not to pursue the issue further in court, opens the way for investors in similar funds to seek refunds by filing amended tax returns for the past four years.

Nearly 20,000 Californians who bought shares in three funds offered by Benham Capital Management will receive tax refunds totaling $6.1 million plus interest that could bring the settlement to as much as $15 million, board spokesman Jim Reber said.

Interest paid to individual owners of Treasury bonds is not subject to state income taxes. But California and 22 other states have taxed dividends from mutual funds that invest solely in the U.S. government securities, said Douglas A. Paul, staff counsel for Benham, an investment firm based in Palo Alto.

Benham sued the state in 1982, asking that California investors in its three Treasury bond mutual funds receive refunds of taxes paid on their fund dividends from 1978 to 1981. In June, 1986, the San Francisco Superior Court ruled that the California tax violated a federal law prohibiting states from taxing interest payments from Treasury bonds.

The board has now tentatively opted not to appeal to the U.S. Supreme Court, which has refused to review very similar rulings against the Illinois and Vermont tax boards, said Calvin J. Abe, the California deputy attorney general who has represented the board in the case.

Investors in other mutual funds that invest exclusively in Treasury issues will be able to file amended returns for 1984 through 1987 but not earlier because of the statute of limitations, Reber said. “That money is gone.”

There are at least four other such funds, Benham’s Paul said. The Benham funds have assets totaling $2 billion, he said.

Legislation is pending in the Assembly Ways and Means Committee that would make mutual fund dividends partially exempt from state taxes if the fund has 50% or more of its assets invested in U.S. government bonds, Paul added. The legislation would make the rules on such funds match those for funds that invest in California municipal bonds.

The possible change in tax rules is unlikely to produce a flood of money into Treasury bond funds, said William E. Donoghue, publisher of Donoghue’s Money Fund Report, a newsletter in Holliston, Mass. Even after the Oct. 19 stock market crash, the funds--often touted as a conservative investment--remained less popular than more diversified mutual and money market funds, he said.