Bewley v. Franchise Tax Bd.

• Decision Date: 23 January 1995
• Docket Number: No. S033257,S033257
• Citation: 9 Cal.4th 526,37 Cal.Rptr.2d 298,886 P.2d 1292
• Court: California Supreme Court
• Parties: , 886 P.2d 1292 Ross BEWLEY et al., Plaintiffs and Respondents, v. FRANCHISE TAX BOARD, Defendant and Appellant.

Page 298

37 Cal.Rptr.2d 298

9 Cal.4th 526, 886 P.2d 1292

Ross BEWLEY et al., Plaintiffs and Respondents, v. FRANCHISE TAX BOARD, Defendant and Appellant.

No. S033257.

Supreme Court of California In Bank.

Jan. 23, 1995.

Daniel E. Lungren, Atty. Gen., Richard Finn and Joyce E. Hee, Deputy Attys. Gen., for defendant and appellant.

Nossaman, Guthner, Knox & Elliott, Stanley S. Taylor III, Claude M. Stern, Patrick J. Richard, Michael G. Thornton and Kurt W. Melchoir, San Francisco, for plaintiffs and respondents.

KENNARD, Justice.

A federal statute exempts stocks and obligations of the United States government from state taxation. (31 U.S.C. § 3124(a) (hereafter section 3124(a)).) The federal statute prohibits "each form of taxation that would require the [federal] obligation, the interest on the obligation, or both, to be considered in computing a tax...." We granted review in this case to determine whether section 3124(a) prohibits California from imposing state income tax on shareholder dividend income derived from repurchase agreements involving federal securities.

After this court had heard oral argument in this case, the United States Supreme Court decided Nebraska Department of Revenue v. Loewenstein (1994) 513 U.S. 123, 115 S.Ct. 557, 130 L.Ed.2d 470, holding that section 3124(a) does not exempt from state taxation income derived from repurchase agreements involving federal securities. ¹ The parties agree that this holding is dispositive of the issue on which we granted review. Accordingly, we reverse the judgment of the Court of Appeal insofar as it held that section 3124(a) exempts repurchase agreement income from state taxation.

Because the judgment of the superior court in this case is based on a summary adjudication and neither the parties nor the trial court nor the Court of Appeal has addressed a separate challenge to the tax raised by the complaint, we must remand this matter for further proceedings.

I

Plaintiff Trust for Short-Term United States Government Securities (hereafter Trust) is a federally regulated mutual fund that invests exclusively in federal government securities and repurchase agreements involving such securities. Plaintiffs Ross and Marilyn Bewley own shares in the trust.

In 1987, the Bewleys received dividends from the Trust, reported the dividends as taxable income, and paid income tax on the dividends. In 1989, the Bewleys filed a claim for refund with defendant Franchise Tax Board (hereafter Board), which denied the claim. The Bewleys and the Trust then filed a complaint in the San Francisco Superior Court for refund of taxes and for a declaratory judgment. The first two causes of action in the complaint sought refunds on the grounds that the imposition of the state income tax violated section 3124(a), the supremacy clause of the United States Constitution (U.S. Const., art. VI, cl. 2), and the provision of the California Constitution recognizing the United States Constitution as the supreme law of the land (Cal. Const., art III, § 1).

After the Board answered the complaint, the Bewleys and the Trust moved for summary judgment, and, in the alternative, for summary adjudication of issues. The trial court denied the motion for summary judgment, but granted the motion for summary adjudication as to the first two causes of action. The parties then stipulated to dismissal of the remaining causes of action and to entry of judgment for plaintiffs on the first two causes of action. The dismissals and judgment were entered accordingly, and the Board appealed the judgment.

The Court of Appeal affirmed. Citing its previous decision in Brown v. Franchise Tax Bd. (1987) 197 Cal.App.3d 300, 242 Cal.Rptr. 810, the court held that section 3124(a) exempted from state taxation all distributions of income originating in federal securities regardless of whether the mutual fund itself owned the federal securities. We granted the Board's petition for review.

II

Repurchase agreements, commonly known as "repos," sound esoteric and can be quite complicated. They are, however, in essence nothing more than financing arrangements by which one party provides funds to another for a short period of time. There are two parties to a repurchase agreement: one has money to lend, the other needs cash and has securities. The repurchase agreement itself consists of two transactions that are agreed to simultaneously, but are performed at different times: (1) the seller-borrower agrees to transfer securities to the buyer-lender in exchange for cash; and (2) the seller-borrower agrees to repurchase the securities from the buyer-lender at the original price plus "interest" on a specified future date or upon demand. (See, e.g., Nebraska Department of Revenue v. Loewenstein, supra, --- U.S. at p. ----, 115 S.Ct. at p. 560; Securities & Exch. Com'n v. Miller (S.D.N.Y.1980) 495 F.Supp. 465, 467; Matter of Bevill, Bresler & Schulman Asset (D.N.J.1986) 67 B.R. 557, 566-567; Note, Lifting the Cloud of Uncertainty Over the Repo Market: Characterization of Repos as Separate Purchases and Sales of Securities (1984) 37 Vand.L.Rev. 401, 403; see generally, Note, The Characterization of Repurchase Agreements in the Context of the Federal Securities Laws (1987) 61 St. John's L.Rev. 290.)

The repurchase agreements here in issue were created and are governed by a "Dealer Master Repurchase Agreement" (Agreement). The Agreement's most relevant provisions are: (1) the seller-borrower will sell to the Trust securities with a market value equal to the price agreed to by the parties (the Sale Price) for delivery to a designated custodian bank; and (2) the seller-borrower will repurchase the securities on a date fixed by the parties or upon demand "at the Sale Price plus interest at the agreed upon interest rate ('Interest Rate')...."

The Agreement further provides that the seller-borrower retains the right to the interest paid by the issuer of the securities (the United States Government). Any interest received by the Trust before the securities are repurchased by the seller-borrower must be paid by the Trust, as soon as it is received, to the seller-borrower. Any principal, interest and other sums paid by the issuer and not previously paid by the Trust to the seller-borrower must be paid to the seller-borrower by the Trust at the time of repurchase of the securities by the seller-borrower. ²

Under the Agreement, the seller-borrower may, before the date fixed for repurchase or before a demand for repurchase has been made by the Trust, repurchase the securities and substitute other securities of equal value. ³ If the market value of the securities falls below the level required by the Agreement, the Trust may require the seller-borrower to deposit "cash collateral" or additional securities sufficient to make up the difference.

In the event the seller-borrower defaults, the Trust may sell the securities or register the securities in its name and apply any cash collateral to the amount owed by the seller-borrower. If the securities are insufficient to satisfy the seller-borrower's obligation to the Trust at the time of default, the seller-borrower is liable for the difference.

III

Section 3124(a) provides: "Stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State. The exemption applies to each form of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax...." The exemption extends to state taxes that either directly or indirectly consider the federal obligation in computing the tax. (First National Bank of Atlanta v. Bartow Co. Board (1985) 470 U.S. 583, 585 fn. 1, 105 S.Ct. 1516, 1518 fn. 1, 84 L.Ed.2d 535; H.R.Rep. No. 97-651, 2d Sess., p. 94 (1982), reprinted in 1982 U.S.Code Cong. & Admin.News, p. 1988.) ⁴

On December 12, 1994, the United States Supreme Court in Nebraska Department of Revenue v. Loewenstein, supra, 513 U.S. 123, 115 S.Ct. 557 (hereafter Loewenstein ), held that section 3124(a) does not prohibit states from taxing income derived from repurchase agreements involving federal securities. In Loewenstein, which involved the state taxation of dividend income from the same trust that is a plaintiff here, the court concluded that the income from the repurchase agreements was not interest on "obligations of the United States Government." (Id. at p. ----, 115 S.Ct. at p. 560.)

The high court based its conclusion in Loewenstein on four features of the repos at issue in that case. "First, at the commencement of a repo, the Trusts pay the Seller-Borrower a fixed sum of money; at the repo's termination, the Seller-Borrower repays that sum with 'interest.' As explained above, this repo interest bears no relation to either the coupon interest paid or the discount interest accrued on the federal securities during the term of the repo.

"Second, if the Seller-Borrower defaults on its obligation to pay its debt, the Trusts may liquidate the federal securities. But like any lender who liquidates collateral, the Trusts may retain the proceeds of liquidation only up to the amount of the debt plus expenses; any excess must be paid to the Seller-Borrower. Moreover, if the proceeds are insufficient to satisfy the debt, the Trusts "Third, if the market value of the federal securities involved in the repo falls below 102% of the amount the Trusts originally paid to the Seller-Borrower, the latter must immediately deliver cash or additional securities to the Trusts to restore the value of the securities held by the Trusts to 102% of the original payment amount. On the other hand, if the market value of the securities rises above 102% of this amount, the Seller-Borrower may require the Trusts to return some of the securities to the Seller-Borrower. These provisions are consistent with a lender-borrower relationship in which a prudent lender desires to protect the value of its...