Cashmere Valley Bank v. State, Dep't of Revenue

• Decision Date: 25 September 2014
• Docket Number: No. 89367–5.,89367–5.
• Citation: 334 P.3d 1100,181 Wash.2d 622
• Court: Washington Supreme Court
• Parties: CASHMERE VALLEY BANK, Petitioner, v. STATE of Washington, DEPARTMENT OF REVENUE, Respondent.

181 Wash.2d 622

334 P.3d 1100

CASHMERE VALLEY BANK, Petitioner

v.STATE of Washington, DEPARTMENT OF REVENUE, Respondent.

No. 89367–5.

Supreme Court of Washington, En Banc.

Sept. 25, 2014.

George Carl Mastrodonato, Michael Barr King, Carney Badley Spellman PS, Seattle, WA, for Petitioner.

Heidi A. Irvin, Atty Generals Office/Revenue Div, Charles E. Zalesky, Attorney General of Washington, Dept of Revenue A.G. Office, Attorney at Law, Olympia, WA, for Respondent.

Dirk Jay Giseburt, Michele G. Radosevich, Davis Wright Tremaine LLP, Seattle, WA, for Amicus Curiae on behalf of Washington Bankers Association.

Opinion

WIGGINS, J.

¶ 1 This case turns on interpretation of a state tax deduction statute. Former RCW 82.04.4292 (1980) provided that in computing their business and occupation (B & O) tax, banks and financial institutions could deduct from their income “amounts derived from interest received on investments or loans primarily secured by first mortgages or trust deeds on nontransient residential properties.”¹ Between 2004 and 2007, Cashmere Valley Bank invested in mortgage-backed securities known as real estate mortgage investment conduits (REMICs) and collateralized mortgage obligations (CMOs). Cashmere claims that interest earned on these investments is deductible under RCW 82.04.4292.

¶ 2 We hold that Cashmere cannot claim the deduction because its investments in REMICs and CMOs were not “primarily secured” by first mortgages or trust deeds. Cashmere's investments in REMICs and CMOs gave it the right to receive defined income streams from a pool of mortgages, trust deeds, and mortgage-backed securities, held in trust for investors. The ultimate source of cash flow was mortgage payments. However, Cashmere's investments were not backed by any encumbrance on property nor did Cashmere have any legal recourse to the underlying trust assets in the event of default. Thus, Cashmere's investments were not “primarily secured” by mortgages or trust deeds. We affirm the Court of Appeals and deny Cashmere the deduction.

FACTS AND PROCEDURE

I. History and Overview of Mortgage–Backed Securities

¶ 3 A mortgage-backed security (MBS) is a type of tradable asset entitling its owner to principal and interest payments from a pool of mortgages.² The creation of an MBS begins when a home buyer borrows money from a lender to purchase a home.³ As security for the loan, the borrower gives the lender a mortgage on the home. The lender then may sell the mortgage to a buyer on the secondary market.

¶ 4 The secondary market buyer acquires the right to receive the borrower's principal and interest payments on the home loan and also the right to foreclose on the home if the borrower fails to make timely payments.⁴ The buyer often purchases numerous mortgages from various institutions and then “securitizes” the mortgages by pooling (or packaging) the mortgages and issuing interests based on those pools to investors. These interests—that is, these MBSs—vary in how they are structured and what kind of interest the investors receive. See Cashmere Valley Bank v. Dep't of Revenue, 175 Wash.App. 403, 305 P.3d 1123 (2013) (explaining creation of MBSs).

¶ 5 A simple type of mortgage security is known as a pass-through security. Investors who purchase a pass-through security own a portion of each of the underlying mortgage loans in the pool and are entitled to a pro rata share of principal and interest payments. The mortgages underlying the securities remain largely intact; any division of interest between investors is accomplished through warranties or proportionate ownership of those whole loans. The cash flows from these investments “pass through” from borrowers to investors. Thus, cash flows may vary from month to month depending on the actual payments borrowers make on the mortgages in the pool.

¶ 6 Pass-through securities may be pooled again to serve as collateral for a more complex type of mortgage security known as a collateralized mortgage obligation (CMO) or, since 1986, a real estate mortgage investment conduit (REMIC). CMOs and REMICs (terms that are often used interchangeably) are essentially the same type of investment instrument; REMICs are more recent, and they enjoy certain federal tax benefits.⁵ The remainder of this opinion will generally refer to these investments collectively as REMICs.

¶ 7 To create a REMIC, a secondary market buyer pools MBSs and/or whole mortgage loans and deposits them into a REMIC trust account. The securities and mortgages in the pool are divided into individual principal and interest payments due under each instrument:

For example, a 30–year fixed-rate mortgage requiring monthly principal and interest payments would consist of 720 individual payments—360 principal payments and 360 interest payments. A pool with 1,000 of these kinds of mortgages would thus have 720,000 separate payments of principal and interest.

Cashmere Valley Bank, 175 Wash.App. at 412 n. 9 . The REMIC issuer reconfigures these payments into new combinations of principal and interest called “tranches.”⁶ Each tranche represents a new security and has a unique risk profile.⁷

¶ 8 Investors buy securities in the different tranches, which entitle the investors to a specific payment stream. The issuing trust collects principal and interest from the underlying assets and then pays out distributions to the different tranches based on the terms of the security. Usually, this creates a “waterfall” of payments, where the most senior tranches are paid first and subordinated tranches are paid later.

¶ 9 Unlike pass-through investors who purchase slices of each mortgage in the pool, REMIC investors purchase fractional shares in the different tranches. That tranche may have a claim on principal payments, interest payments, or both. Typically, investors are not promised that they will receive 100 percent return on their initial investment. They are merely buying a cash flow over time and assume that, overall, this cash flow will equal more than the initial investment.

II. Facts in This Case

¶ 10 Cashmere Valley Bank operates 11 branch banks in several central Washington cities. Cashmere's business includes banking, mortgage, insurance, investment, and leasing services. Between 2004 and 2007, Cashmere invested some of its surplus capital in REMICs.

¶ 11 During discovery, Cashmere identified six REMICs as representative of all of its investments during this tax period: two Federal Home Loan Mortgage Corporation (“Freddie Mac”) REMICs, two Federal National Mortgage Association (“Fannie Mae”) REMICs, and two private-label REMICs. The underlying loans in the various REMICs were primarily secured by first mortgages or deeds of trust on nontransient residential real properties.

¶ 12 One exemplar REMIC is the Fannie Mae REMIC Trust 2000–38. The assets held by the Fannie Mae REMIC Trust 2000–38 are not mortgage loans, but MBSs called Fannie Mae MBS and Ginnie Mae (Government National Mortgage Association) certificates. Fannie Mae essentially had rights to a cash flow from purchasing MBSs. It divided the cash flow into tranches and sold interests in the tranches to different investors, including Cashmere. This REMIC offered 16 tranches designated by letters. About one-half of classes were bonds paying fixed interest and several classes had floating interest rates. One class paid principal only, and two classes paid interest only.

¶ 13 Cashmere purchased a Z class bond in this REMIC, which received a fixed interest rate of 7.00 percent during the time Cashmere owned this investment. Notably, the weighted average coupon rate for the mortgage loans comprising the pools in the underlying MBSs ranged from 7.25 percent to 9.50 percent. So there was no direct correlation between the interest mortgage borrowers paid and interest Cashmere received. In addition, because the Z class represented an “accrual” bond, interest was not paid to the Z class as it was received. Rather, interest was first paid to two other bond classes with equivalent amounts added to the principal amount of the Z class bond.⁸ Cashmere received principal and interest payments on its investments only after the other bond classes were fully paid.⁹

¶ 14 Another exemplar REMIC is the Washington Mutual REMIC (WAMMS 2004–R4), a private-label REMIC. This REMIC had nine regular classes and an R class. In addition, it offered three private certificates that provided credit enhancement to the offered certificates. As losses came in, these losses were allocated first to the privately held certificates and then up the waterfall starting with the most junior tranches. In addition, to protect senior tranches from prepayment risks, this REMIC had a “shifting interest” credit enhancement. Thus, if borrowers prepaid their mortgages in the first year, the money would be locked up for a certain period of time to allow senior tranche holders to receive some interest on their investments before being paid off. Cashmere invested in Tranche III–A of this REMIC—a senior tranche with a 7.5 percent fixed interest rate.

III. Procedure

¶ 15 The Department of Revenue (DOR) audited Cashmere's books and records for the years 2004 through 2007.

During this time, Cashmere received $17,837,861 in interest income from investments in REMICs and CMOs. DOR assessed B & O taxes on this income, totaling $267,568. Cashmere paid the tax assessment in full on June 4, 2009, and subsequently filed an action for refund under RCW 82.32.180.¹⁰

¶ 16 The parties filed cross motions for summary judgment, filing excerpts from depositions of three experts. Michael Gamsky testified that REMIC investments are not secured transactions because issuers do not pledge any property as security for the investments. He explained that investors who purchase REMIC certificates are beneficiaries of a trust and they have contractual rights under the pooling and servicing agreement, but they are not secured investors.

¶ 17 Professor Alan Hess testified and prepared a report on behalf of...