Filed 8/15/19

CERTIFIED FOR PUBLICATION

IN THE COURT OF APPEAL OF THE STATE OF CALIFORNIA

SECOND APPELLATE DISTRICT

DIVISION THREE

RONALD D. MASS et al.,

Plaintiffs and Appellants,

v.

FRANCHISE TAX BOARD,

Defendant and Respondent.

 B286857

 (Los Angeles County

 Super. Ct. No. BC627648)

APPEAL from a judgment of the Superior Court of Los 

Angeles County, David Sotelo, Judge. Affirmed.

Dakessian Law, Mardiros H. Dakessian, Zareh A. 

Jaltorossian and Ruben Sislyan for Plaintiffs and Appellants.

Xavier Becerra, Attorney General, Diane S. Shaw, 

Assistant Attorney General, Brian D. Wesley and Matthew C. 

Heyn, Deputy Attorneys General, for Defendant and Respondent.

——————————
2

Ronald D. and Pamela S. Mass (Taxpayers) bought shares 

in a company that invests in government bonds. They received 

dividends derived from interest on those bonds. Because the 

California Constitution exempts interest on government bonds 

from taxation, Taxpayers contend that their dividends were 

unconstitutionally taxed. We disagree.

BACKGROUND

The parties stipulated to the following facts. Taxpayers 

reside in California. They held shares in The Blackrock Insured 

Municipal Term Trust, Inc. (BMT), a regulated investment 

company (RIC). (Int.Rev. Code, § 851.) BMT received

12.41 percent of its interest income from its holdings in 

California municipal bonds. During the 2010 tax year, Taxpayers

received interest dividends1 from their investments in BMT, but 

did not report the interest dividends as taxable income. The 

Franchise Tax Board (the Board) assessed taxes against 

Taxpayers on the interest income, which they protested.

The amount of tax in controversy is $7,384, which is the tax 

assessed on the interest dividends Taxpayers received from BMT 

that were derived from California bonds. Taxpayers filed a claim 

for refund, which the Board denied. They also filed an appeal 

with the State Board of Equalization, which was denied.

Taxpayers then filed a complaint for a refund of taxes in 

the superior court. The parties stipulated to the facts and did not 

present any witness testimony. Taxpayers argued that Revenue 

and Taxation Code section 17145 (section 17145), which purports 

to tax interest income on bonds exempted from taxation under 

 

1 The parties describe the distributions from BMT as 

“interest dividend,” and we adopt that description.
3

article XIII, section 26, subdivision (b) of the California 

Constitution (article XIII), is unconstitutional on its face. 

Taxpayers also argued that, because BMT is an RIC that passes 

through bond interest to investors, the taxability of the interest 

income does not change merely because it changes hands. The 

Board countered that because the bond interest was distributed 

to Taxpayers as a “dividend” by a corporation, it lost the 

exemption.

The trial court ruled in favor of the Board, reasoning that 

even though the Constitution exempts interest income on state 

bonds from taxation, the Legislature had the authority to create 

an exception to the exemption for certain interest on state bonds.

DISCUSSION

I. Standard of review

Taxpayers’ facial challenge to the constitutionality of 

section 17145 is a question of law that we review de novo. (See 

Sanchez v. State of California (2009) 179 Cal.App.4th 467, 486.) 

When deciding a facial challenge, we consider only the text of the 

statute and not its application to any particular circumstance. 

(Tobe v. City of Santa Ana (1995) 9 Cal.4th 1069, 1084.) There 

are two tests for a facial challenge. Under the stricter test, the 

statute will be upheld unless it conflicts with the Constitution in 

all circumstances. Under the more lenient test, the statute will 

be upheld unless it conflicts with the Constitution in most

circumstances. (City of Bellflower v. Cohen (2016) 245 

Cal.App.4th 438, 443.) Regardless of which test is applied, “the 

party challenging the constitutionality of the statute bears a 

heavy burden and cannot prevail simply by suggesting a 
4

hypothetical in which the application of the statute would be 

unconstitutional.” (Ibid.) 

II. Article XIII

Our analysis begins with the constitutional exemption in 

article XIII. We apply the basic principles of constitutional 

interpretation and statutory construction. (Richmond v. Shasta 

Community Services Dist. (2004) 32 Cal.4th 409, 418.) If the 

language is clear and unambiguous, the plain meaning governs. 

(People v. Lopez (2003) 31 Cal.4th 1051, 1056.) Only if the 

language is ambiguous will we consider extrinsic evidence and 

legislative history. (Silicon Valley Taxpayers’ Assn., Inc. v. Santa 

Clara County Open Space Authority (2008) 44 Cal.4th 431, 444–

445.) Article XIII states plainly: “Interest on bonds issued by the 

State or local government in the State is exempt from taxes on 

income.” Interest means compensation for the use or forbearance 

of money. (Deputy v. Du Pont (1940) 308 U.S. 488, 498.) A state 

or local bond is a long-term, interest-bearing debt, instrument 

issued by a government entity. (Black’s Law Dict. (11th ed. 2019) 

p. 220.) Accordingly, the constitutional provision means what it 

says, interest on state or local government bonds is tax-exempt

and excludable from income.

III. Section 17145 

Because article XIII exempts interest on state and local 

bonds from personal taxable income, the issue becomes whether 

section 17145 violates that exemption. Section 17145 provides 

that an RIC is qualified to pay exempt interest dividends if, at 

the close of each quarter of its taxable year, at least 50 percent of 

the value of its total assets consists of obligations which, when 

held by an individual, the interest therefrom would be exempt 
5

from taxation. Thus, Taxpayers contend, when an RIC has less 

than 50 percent of the value of its total assets in tax-exempt 

bonds, but still pays dividends to its shareholders with funds 

derived from the interest on those bonds, the resulting tax on the 

shareholder violates article XIII’s exemption as an indirect tax on 

constitutionally exempt interest. The Board argues that RIC’s 

like BMT, are not true pass-through entities and may only pass 

on the character of tax-exempt interest on government bonds 

when the asset threshold conditions of section 17145 are met. 

IV. Section 17145 does not conflict with the constitution

“ ‘Unlike the Federal Constitution, which is a grant of 

power to Congress, the California Constitution is a limitation or 

restriction on the powers of the Legislature.’ [Citations.] Thus, 

‘the entire law-making authority of the state, except the people’s 

right of initiative and referendum, is vested in the Legislature, 

and that body may exercise any and all legislative powers which 

are not expressly or by necessary implication denied to it by the 

Constitution.’ [Citations.] ‘[W]e do not look to the Constitution 

to determine whether the Legislature is authorized to do an act, 

but only to see if it is prohibited.’ [Citations.]

“The above stated principle ‘is of particular importance in 

the field of taxation, in which the Legislature is generally

supreme.’ [Citations.] ‘Generally the Legislature is supreme in 

the field of taxation, and the provisions on taxation in the state 

Constitution are a limitation on the power of the Legislature 

rather than a grant to it.’ [Citation.] ‘In other words, the 

Legislature’s authority to impose taxes and regulate the 

collection thereof exists unless it has been expressly eliminated 

by the Constitution.’ ” (Howard Jarvis Taxpayers’ Assn. v. Fresno 
6

Metropolitan Projects Authority (1995) 40 Cal.App.4th 1359, 

1374–1375.) 

Article XIII is silent on exempt interest dividends paid to 

shareholders. Therefore, based on its plain language, there is no 

conflict between the constitutional exemption and section 17145. 

“Constitutional provisions and statutes granting exemption from 

taxation are strictly construed to the end that such concession 

will be neither enlarged nor extended beyond the plain meaning 

of the language employed.” (Cedars of Lebanon Hosp. v. County

of L. A. (1950) 35 Cal.2d 729, 734.) “Grants of immunity from 

taxation, in derogation of a sovereign power of the state, are 

strictly construed.” (Pacific Co. v. Johnson (1932) 285 U.S. 480, 

491.) “The Legislature may grant or deny a tax credit in any 

manner it sees fit, aside from constitutional constraints not at 

issue here, and the scope, application, and terms of eligibility are 

entirely for the Legislature to establish. Our role is confined to 

ascertaining what the Legislature has actually done, not assaying 

whether sound policy might support a different rule.” (General 

Motors Corp. v. Franchise Tax Bd. (2006) 39 Cal.4th 773, 790.) 

Any doubts as to the application of the exemption must be 

resolved in favor of the Board.

2 (Ibid.) 

Essentially, the parties’ fundamental disagreement is

whether the distributions received by Taxpayers should be 

classified as dividends or interest on a bond. In other words, the

 

2 This is not an endorsement of the trial court’s ruling that 

the Legislature was authorized to create an “exception to the 

exemption.” While the Legislature’s authority to impose taxes is 

generally supreme, it cannot run afoul of the Constitution. 

(Abbott Laboratories v. Franchise Tax Bd. (2009) 175 Cal.App.4th 

1346, 1359–1360.)
7

issue is whether dividends derived from interest retain their taxexempt status when distributed from an RIC holding less than 

50 percent in state and local bonds. Relying on Brown v. 

Franchise Tax Bd. (1987) 197 Cal.App.3d 300, 304–305, the 

Taxpayers argue that the distinction between tax-exempt interest 

and dividends to shareholders that are derived from that interest 

is “economically meaningless.” 

However, Brown is factually and legally distinguishable. 

Unlike BMT, which only had 12.41 percent of its interest income 

from California municipal bonds, the investment companies in 

Brown had 100 percent of their funds invested in federal 

obligations and all distributions to their investors originated from

those obligations. (Brown v. Franchise Tax Bd., supra, 197 

Cal.App.3d at p. 302.) Notably, after Brown was decided, the 

Legislature amended section 17145 (Stats. 1988, ch. 671, § 1, 

p. 2269) to allow an RIC’s holdings in federal obligations to count 

towards the 50 percent threshold. Hence, there was no need for 

Brown to consider the effect of section 17145’s threshold 

requirement because the companies were indisputably over the 

threshold, and federal obligations were excluded from 

section 17145. The distinction between exempt interest and 

dividends to shareholders, which the Taxpayers claim Brown

rejected, was considered in a wholly different context, where no 

interest on federal obligations was exempt regardless of how 

much an RIC invested in those obligations. Brown’s suggestion

that distributions to a shareholder made by an RIC retain their 

tax-exempt status as interest is therefore inapplicable here. 

Taxpayers simply have not established that section 17145 

conflicts with the tax exemption under article XIII. 
8

DISPOSITION

The judgment is affirmed. The parties are to bear their 

own costs on appeal.

CERTIFIED FOR PUBLICATION.

DHANIDINA, J.

I concur:

MURILLO, J.*

 

* Judge of the Los Angeles Superior Court, assigned by the 

Chief Justice pursuant to article VI, section 6 of the California 

Constitution.
LAVIN, Acting P. J., Concurring:

Article XIII, section 26(a) of the California Constitution 

authorizes the Legislature to impose income taxes on persons, 

corporations, and other entities. Subdivision (b) of that section 

(Section 26(b)) exempts from state income tax interest on bonds 

issued by the State or a local government in the State (California 

government bonds). I write separately to emphasize that Section 

26(b) does not prohibit the Legislature from imposing state 

income tax on corporate shareholder dividends comprised, in 

part, of interest on California government bonds.

California Revenue and Taxation Code section 17145 

(Section 17145) authorizes a regulated investment company 

(RIC) to designate a portion of its shareholder dividends as 

exempt from state income tax if, and to the extent that, at least 

50 percent of the RIC’s assets consist of tax-exempt California 

government bonds. Appellants Ronald and Pamela Mass 

(taxpayers) invested in an RIC with an investment portfolio that 

contains some California government bonds but does not meet 

the 50 percent threshold. They claim the 50 percent threshold in 

Section 17145 is facially unconstitutional because it violates 

Section 26(b). Essentially, the taxpayers contend that a 

shareholder dividend from an RIC must be exempt from state 

income tax if, and to the extent, any portion of that dividend 

could be traced back to interest earned on California government 

bonds. They are wrong.

Section 26(b) restricts the Legislature’s ability to impose 

income tax on “[i]nterest on bonds issued by the State or a local 

government in the State[.]” I agree with the taxpayers that 

Section 26(b) means what it says: bond interest is tax exempt. 

And if the taxpayers had received interest on a California 
2

government bond, that interest would be exempt from personal 

income tax. They did not, however, receive interest on a 

California government bond. Instead, the taxpayers received 

dividends from a corporation in which they are shareholders. 

To hold that Section 17145 is facially unconstitutional, we 

must conclude that the statute’s provisions “inevitably pose a 

present total and fatal conflict with applicable constitutional 

prohibitions.” (Pacific Legal Foundation v. Brown (1981) 29 

Cal.3d 168, 181.) Because Section 26(b) says nothing about 

shareholder dividends, there is no conflict between Section 26(b) 

and Section 17145, which specifically addresses the taxation of 

corporate shareholder dividends. Reading Section 26(b) broadly 

enough to include shareholder dividends is, in my view, 

inconsistent with well-settled principles of constitutional 

interpretation.

Additionally, I reject the taxpayers’ contention that Section 

26(b)’s tax exemption must apply without limitation because, in 

their view, an RIC is a conduit designed to pass investment 

income to its investors. On that point, the taxpayers find 

Brown v. Franchise Tax Board (1987) 197 Cal.App.3d 300 

(Brown), persuasive. I do not. 

In Brown, the court analyzed whether a state tax imposed 

on distributions from RICs that held only federal securities 

violated a federal law exempting federal obligations, and interest 

paid on them, from state tax. (Brown, supra, 197 Cal.App.3d at 

pp. 303–304.) The court concluded the state tax violated the 

federal statute, but its analysis is of limited (if any) utility in this 

case because the federal law at issue in Brown was substantially 

broader in scope and more specific in its prohibitions than 

Section 26(b).
3

Specifically, in Brown, the court interpreted a federal 

statute providing: “ ‘[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 exemption 

extends to every form of taxation that would require that either 

the obligations or the interest thereon, or both, be considered, 

directly or indirectly, in the computation of the tax, except 

nondiscriminatory franchise or other nonproperty taxes in lieu 

thereof imposed on corporations and except estate taxes or 

inheritance taxes.’ ” (Brown, supra, 197 Cal.App.3d at p. 303, 

fn. 3.) And as the court recognized, the United States Supreme 

Court had already explained the federal statute was “intended 

‘ “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.” ’ [Citation.] It applies to any tax ‘regardless of its form if 

federal obligations must be considered, either directly or 

indirectly, in computing the tax.’ [Citation.] In this context, 

‘considered’ means ‘taken into account, or included in the 

accounting.’ [Citation.]” (Id. at p. 304.) 

Based on that statute, as well as the Supreme Court’s 

construction of it, the court in Brown rejected the Franchise Tax 

Board’s argument that the tax on RIC dividends—dividends 

derived entirely from interest on federal securities—was not 

measured “directly or indirectly” by income from federal 

obligations. Instead, the court concluded that the computation of 

the tax “involves indirect consideration of federal obligations.” 

(Brown, supra, 197 Cal.App.3d at pp. 304–305.)

As already noted, Section 26(b) is simple and 

straightforward. It exempts from income tax only “[i]nterest on 
4

bonds issued by the State or a local government in the State[.]” 

Section 26(b) does not cast the expansive net that the federal 

statute under consideration in Brown did, exempting from 

income tax “every form of taxation that would require that either 

the obligations or the interest thereon, or both, be considered, 

directly or indirectly, in the computation of the tax ... .” (Brown, 

supra, 197 Cal.App.3d at p. 303, fn. 3) For that reason, Brown is 

distinguishable and its rationale is inapplicable here.

One other point merits discussion. In support of their 

analysis, the taxpayers consistently reject any distinction 

between a shareholder dividend and bond interest. They point 

out, correctly, that if they “received the identical income from a 

direct purchase of municipal bonds, that income unquestionably 

would have been covered by the constitutional exemption.” 

Summing up their argument, they assert that the Franchise Tax 

Board “has articulated no rational reason why [the taxpayers] 

should be deemed to have lost the exemption merely because that 

same interest income was passed to them by BMT.” In sum, they 

posit, “[w]hatever label is attached to it, the bond interest [the 

taxpayers] received was just that—bond interest.” I reject the 

taxpayers’ oversimplified approach.

The tax treatment the taxpayers seek—a complete pass 

through of all tax exemptions to which a corporation is entitled—

is available under some circumstances. A brief illustration is of 

some assistance here. A typical corporation defined under 

subchapter C1 of the Internal Revenue Code2 engages in a 

 

1 26 U.S.C. § 301 et seq.

2 All subchapter references are to the Internal Revenue Code 

(26 U.S.C. § 1 et seq.).
5

business of some type—making widgets, for example. The 

corporation makes and sells widgets, brings in income, incurs 

expenses, and, hopefully, generates profit. Importantly for our 

purposes, under subchapter C, corporate profits are taxed to the 

corporation. (26 U.S.C. § 11.) And distributions in the form of 

shareholder dividends are generally taxed as ordinary income to 

the shareholder. (Id., § 301(c).) This traditional structure results 

in what is commonly referred to as double taxation.

A corporation that elects to be taxed under subchapter S3

avoids double taxation. (26 U.S.C. §§ 1362, 1363.) It may, like a 

C corporation, sell widgets and generate profits. But for tax 

purposes, the corporation is disregarded. (Id., § 1363(a).) No 

dividends are issued by the corporation to its shareholders and no 

taxes are paid by the corporation. Instead, income, losses, 

deductions, and credits are reported by the shareholder(s) on a 

pro rata basis on their individual return(s). (Id., § 1366(a).) And 

tax exemptions to which the corporation would otherwise be 

entitled may be claimed on a pro rata basis by the shareholder(s). 

(Ibid.) Thus, it is commonly said that an S corporation is a “pass 

through” because “[t]he character of any item included in a 

shareholder’s pro rata share ... shall be determined as if such 

item were realized directly from the source from which realized 

by the corporation, or incurred in the same manner as incurred 

by the corporation.” (Id., § 1366(b).)

A qualified RIC, which is defined under subchapter M4, is 

unlike either a C corporation or an S corporation because, among 

other things, it does not operate a business such as making 

 

3 26 U.S.C. § 1361 et seq.

4 26 U.S.C. § 851 et seq.
6

widgets. An RIC’s only corporate objective is to make investments 

on behalf of its shareholders and to distribute investment income, 

after expenses, to its shareholders in the form of dividends. For 

this reason, an RIC is sometimes described as an investment 

conduit. (See, e.g., Brown, supra, 197 Cal.App.3d at p. 305 [noting 

RICs “provide a conduit for investment in federal securities by 

persons who might otherwise be unable or unwilling to enter that 

market”].) In order to qualify as an RIC, the company must file 

an election with its tax return and derive at least 90 percent of its 

gross income from investments in stocks, securities, currencies, 

and the like. (26 U.S.C. § 851(a) & (b).) Further, in each quarter 

of the taxable year, an RIC must derive at least 50 percent of its 

value from cash, government securities, securities of other RICs, 

and other securities with some limitations, and it must be 

diversified as provided. (Id., § 851(b)(3).) 

Qualifying RICs are treated favorably under federal tax 

law in a number of ways. Specifically, and unlike a C corporation, 

an RIC may deduct dividends paid to its shareholders as an 

expense, thereby reducing the RIC’s taxable income. (26 U.S.C. 

§ 852(b)(2)(D).) And because a qualifying RIC must pay out at 

least 90 percent of its earnings (id., § 852(a)), an RIC may nearly 

or entirely avoid taxation at the corporate level. For this reason, 

an RIC is somewhat similar to an S corporation in that most, if 

not all, of its income passes through the corporation to its 

investors without being taxed to the corporation. But an RIC is 

not a “pass through” as that term is understood with reference to 

S corporations, where the corporate form is disregarded for tax 

purposes. Instead, an RIC is taxed at the corporate level, just as a 

C corporation is. (Id., § 852(b).) The difference is that an RIC has 

a substantially greater ability to reduce its corporate tax liability 
7

by operating within the strict boundaries of subchapter M. The 

minimization—or avoidance—of corporate tax liability translates 

directly into larger dividends for shareholders and is a distinct 

feature of an RIC. 

Further, and of particular interest here, when a qualifying 

RIC issues a shareholder dividend, the RIC may designate the 

character of the dividend (or portions of the dividend) as ordinary 

income, long- or short-term capital gains, tax-exempt interest, or 

return of capital. In this way, the shareholder may take 

advantage of the lower tax rates (or tax exemptions) applicable to 

each designated category. Importantly, under federal law, an RIC 

may only characterize a dividend (or portion thereof) as taxexempt interest if at least 50 percent of its total assets at the end 

of the year consists of tax-exempt obligations (i.e., State or local 

bonds). (26 U.S.C. § 852(b)(5).) In Section 17145, California 

imposes the same requirement but specifically limited to 

California government bonds. 

In any event, Section 17145 is not, as the taxpayers argue,

a subversion of Section 26(b)’s income tax exemption for 

California government bonds. Quite the opposite: Section 17145 

extends the exemption to corporate dividends under certain 

limited conditions (i.e., where the corporation invests 

substantially in California government bonds). And in my view, it 

is plainly within the Legislature’s discretion to decide whether, 

and when, to allow a corporation to issue a shareholder dividend 

that is exempt from state income tax.

In sum, Section 26(b) cannot reasonably be read to limit the 

Legislature’s ability to define corporate structures and permit 

some corporations, under extremely limited circumstances, to 
8

issue dividends to its shareholders that are exempt from state 

income tax. For these reasons, I concur in the judgment.

LAVIN, Acting. P. J.