Comptroller of the Treasury, Income Tax Div. v. First United Bank & Trust

• Decision Date: 01 September 1988
• Docket Number: No. 100,100
• Parties: COMPTROLLER OF THE TREASURY, INCOME TAX DIVISION v. FIRST UNITED BANK & TRUST as Guardian for the Property for Dale W. Alexander. ,
• Court: Maryland Court of Appeals

Page 352

320 Md. 352

578 A.2d 192

COMPTROLLER OF THE TREASURY, INCOME TAX DIVISION v. FIRST UNITED BANK & TRUST as Guardian for the Property for Dale W. Alexander.

No. 100, Sept. Term, 1988.

Court of Appeals of Maryland.

Aug. 30, 1990.

John K. Barry, Asst. Atty. Gen. (J. Joseph Curran, Jr., Atty. Gen. and Gerald Langbaum, Asst. Atty. Gen., all on brief), Annapolis, for appellant.

Harry D. Shapiro (Richard G. Solomon, Weinberg and Green, all on brief), Baltimore, for appellee.

Argued before MURPHY, C.J., and ELDRIDGE, COLE, RODOWSKY, McAULIFFE, ADKINS, and BLACKWELL ^*, JJ.

ELDRIDGE, Judge.

This Maryland income tax case involves a distribution to a shareholder made in 1985 by a money market mutual fund. The mutual fund's income from which the distribution was made was derived in two ways. One source (accounting for 53.55% of the income) was interest paid by the United States directly to the mutual fund as a holder of federal debt obligations. The other source of the distribution (accounting for 46.45% of the income) was income earned by the mutual fund in transactions known as repurchase agreements (repos) which involved United States government securities and which are hereafter described. The ultimate issue in this case is whether the distribution in the hands of a shareholder is exempt from state taxation, in whole or in part.

The mutual fund involved here is the Trust for Short-Term U.S. Government Securities, a Massachusetts business trust. It is a no load, open-end, regulated investment company, subject to the provisions of subchapter M of the Internal Revenue Code, 26 U.S.C. §§ 851-860G. The Trust's policy is to invest in United States government securities that mature in one year or less from the date of acquisition. The January 1985 prospectus of the Trust advised that it will also invest in repos, described therein as "arrangements in which banks, brokers, dealers, and other recognized financial institutions sell U.S. Government securities to the Trust and agree at the time of sale to repurchase them at a mutually agreed upon time and price within one year from the date of acquisition."

The appellee is a bank in Garrett County, First United Bank & Trust Co., in its capacity as guardian for the property of a minor, Dale W. Alexander (the Taxpayer). The Taxpayer held shares of beneficial interest in the Trust. The Trust distributed $798.90 in 1985 to the Taxpayer, on which $36 in income taxes were paid to Maryland. The Taxpayer claimed a refund of the $36.

This refund claim was denied by the appellant, the Comptroller of the Treasury of Maryland. The Taxpayer appealed to the Maryland Tax Court which held the entire distribution to be exempt from State income tax. On the Comptroller's appeal to the Circuit Court for Baltimore City, the Tax Court was affirmed. The Comptroller then appealed to the Court of Special Appeals but, prior to consideration by that court, we issued a writ of certiorari.

I.

We address first the 53.55% portion of the Trust's 1985 distribution to the Taxpayer, derived from interest paid by the United States directly to the Trust as a holder of federal debt obligations.

The Taxpayer contends that this income is exempt from State income tax because of (1) the provisions of 31 U.S.C. § 3124(a) and (2) the treatment under Maryland law of a shareholder's beneficial interest in the assets of a Massachusetts business trust. The Comptroller argues that, under both federal and Maryland law, the Trust is treated as a corporation for tax purposes, that its distributions are dividends taxable to its shareholders, and that there is no statute which requires continued characterization of this income as interest on federal obligations once it is paid to the shareholders. Because we shall hold that this income is exempt from State taxation as a matter of federal law, under 31 U.S.C. § 3124(a), we need not address the Taxpayer's argument based on Maryland law. ¹ The Taxpayer's federal income tax return for the calendar year 1985 included the $798.90 distribution from the Trust in the taxable income therein reported. The Public Debt Act of February 19, 1941, § 4(a), 55 Stat. 7, 8, codified in relevant part, as amended, at 31 U.S.C. § 3124(b), made interest on federal obligations thereafter authorized and issued, in general, fully taxable by the United States. See IRS Reg. §§ 1.61-7(b)(3) and 1.103-4(b).

The starting point for computing the Taxpayer's 1985 Maryland income tax liability was the Taxpayer's federal adjusted gross income for that year. See Maryland Code (1957, 1980 Repl.Vol.), Art. 81, § 280(a). ² Pursuant to Art. 81, § 280(c)(1), interest on United States government obligations was subtracted from federal adjusted gross income in computing taxable income for the Maryland return. ³ While the Taxpayer did not receive interest payments directly from the United States, § 280(c)(1) acknowledged that the Taxpayer may subtract, from federal adjusted gross income, "any ... income to the extent includable in gross income for federal income tax purposes, but exempt from State income taxes under the laws of the United States."

Every court that has faced this issue has held that a distribution from a mutual fund to a shareholder, representing interest paid by the United States directly to the fund as a holder of federal debt obligations, is exempt from state taxation under federal law. See Brown v. Franchise Tax Bd., 197 Cal.App.3d 300, 242 Cal.Rptr. 810 (1987); Andras v. Illinois Dept. of Revenue, 154 Ill.App.3d 37, 106 Ill.Dec. 732, 506 N.E.2d 439 (1987), cert. denied, 485 U.S. 960, 108 S.Ct. 1223, 99 L.Ed.2d 424 (1988); Matz v. Department of Treasury, 155 Mich.App. 778, 401 N.W.2d 62 (1986); Borg v. Dept. of Rev., 308 Or. 34, 774 P.2d 1099 (1989); In re Thomas C. Sawyer Estate, 149 Vt. 541, 546 A.2d 784 (1987); Capital Preservation Fund v. Dept. of Rev., 145 Wis.2d 841, 429 N.W.2d 551 (Wis.App.1988).

The controlling statute is 31 U.S.C. § 3124(a), which provides as follows:

"(a) 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, except--

"(1) A nondiscriminatory franchise tax or another nonproperty tax instead of a franchise tax, imposed on a corporation; and

"(2) An estate or inheritance tax."

In American Bank and Trust Co. v. Dallas County, 463 U.S. 855, 858, 103 S.Ct. 3369, 3372, 77 L.Ed.2d 1072 (1983), the Supreme Court summarized the status of the law prior to the 1959 amendments to what is now 31 U.S.C. § 3124:

"Until 1959, Rev.Stat. § 3701, 31 U.S.C. § 742, provided, in pertinent part, that '[a]ll stocks, bonds, Treasury notes, and other obligations of the United States, shall be exempt from taxation by or under State or municipal or local authority.' This Court consistently held that this language prohibited state taxes imposed on federal obligations, either directly, or indirectly as part of a tax on the taxpayer's total property or assets. See Society for Savings v. Bowers, 349 U.S. 143, 147-148 [75 S.Ct. 607, 609-610, 99 L.Ed. 950] (1955). The Court also consistently held, however, that § 3701 did not prohibit nondiscriminatory taxes imposed on discrete property interests such as corporate shares or business franchises, even though the value of that discrete interest was measured by the underlying assets, including United States obligations. See Werner Machine Co. v. Director of Taxation, 350 U.S. 492, 493-494 [76 S.Ct. 534, 535-536, 100 L.Ed. 634] (1956); Society for Savings v. Bowers, 349 U.S., at 147-148 ; Des Moines National Bank v. Fairweather, 263 U.S. 103, 112 [44 S.Ct. 23, 26, 68 L.Ed. 191] (1923); Home Savings Bank v. Des Moines, 205 U.S. 503, 518-519 [27 S.Ct. 571, 575-576, 51 L.Ed. 901] (1907); Provident Institution v. Massachusetts, 6 Wall. 611, 629-632 (1868). Similarly, the Court interpreted Rev.Stat. § 3701 not to prohibit taxes imposed on a discrete transaction, such as an inheritance, even though the value of the inheritance was measured according to the value of the federal obligations transferred. Plummer v. Coler, 178 U.S. 115, 133-134 [20 S.Ct. 829, 836-837, 44 L.Ed. 998] (1900). In 1956, the Court observed that this formal but economically meaningless distinction between taxes on Government obligations and taxes on separate interests was 'firmly embedded in the law.' Society for Savings v. Bowers, 349 U.S., at 148 ."

Congress amended § 3701 by the Act of September 22, 1959, § 105(a), 73 Stat. 621, 622, adding a new sentence: "This exemption extends to every form of taxation that would require that either the obligation or the interest thereon, or both, be considered, directly or indirectly, in the computation of the tax...." ⁴ In 1982, when § 3701 was replaced by 31 U.S.C. § 3124, there were no substantive changes. American Bank and Trust Co. v. Dallas County, supra, 463 U.S. at 859 n. 1, 103 S.Ct. at 3373 n. 1. See generally Dept. of Assess. & Tax. v. Nat. Bank, 310 Md 664, 667-669, 531 A.2d 294 (1987), appeal dismissed, 486 U.S. 1048, 108 S.Ct. 2812, 100 L.Ed.2d 913 (1988).

The Supreme Court has declared that the "exemption for federal obligations provided by [31 U.S.C. § 3124] ... is sweeping...." American Bank, supra, 463 U.S. at 862, 103 S.Ct. at 3374. There is a " 'long established Congressional intent to prevent taxes which diminish in the slightest degree the market value or the investment attractiveness of obligations issued by the United States in an effort to secure necessary credit.' " Memphis Bank & Trust Co. v. Garner, 459 U.S. 392, 396, 103 S.Ct. 692, 695, 74 L.Ed.2d 562 (1983), quoting Smith v. Davis, 323 U.S. 111, 117, 65 S.Ct. 157, 160, 89 L.Ed. 107 (1944). See Matz v. Department of Treasury, supra, 155 Mich.App. at 783-784, 401 N.W.2d at 65 (state taxation of mutual fund...