Case Name: MASSMAN CONSTRUCTION COMPANY, Appellant. v. DIRECTOR OF REVENUE, STATE OF MISSOURI, Respondent
Court: Supreme Court of Missouri
Jurisdiction: Missouri
Decision Date: 1989-02-14
Citations: 765 S.W.2d 592
Docket Number: No. 70636
Parties: MASSMAN CONSTRUCTION COMPANY, Appellant. v. DIRECTOR OF REVENUE, STATE OF MISSOURI, Respondent.
Judges: BILLINGS, C.J., and ROBERTSON, RENDLEN, HIGGINS and COVINGTON, JJ., concur.
Reporter: South Western Reporter Second Series
Volume: 765
Pages: 592–597

Head Matter:
MASSMAN CONSTRUCTION COMPANY, Appellant. v. DIRECTOR OF REVENUE, STATE OF MISSOURI, Respondent.
No. 70636.
Supreme Court of Missouri, En Banc.
Feb. 14, 1989.
Rehearing Denied March 14, 1989.
Arnold R. Day, Sylvan Siegler, Kansas City, for appellant.
William L. Webster, Atty. Gen., Richard L. Wieler, Asst. Atty. Gen., Jefferson City, for respondent.
J. Michael Dryton, Glenn A. Jewell, Kansas City, for amicus curiae, Federated Securities Corp.

Opinion:
BLACKMAR, Judge.
The appellant taxpayer, Massman Construction Company, is so fortunate as to regularly have large balances in its checking accounts for which it has no immediate need. It understandably wants to obtain the best available return on these sums, even though its needs may preclude durable commitments. During the year 1981 it entered into arrangements with two of its depository banks, Commerce Bank of Kansas City N.A. and Security National Bank of Kansas City, Kansas, by means of which it would receive the interest derived from government bonds then owned by the banks. On every business day its treasurer or comptroller would call each of the banks to report the amount of cash available for short term investment. The bank would then issue, simultaneously, a confirmation of the immediate purchase by the taxpayer of government bonds and a confirmation of the resale of these same bonds by the taxpayer to the bank, usually effective the next business day.
The bonds did not exist in tangible form, but rather were shown on the books of the Federal Reserve Bank of Kansas City as being held for the Commerce and Security Banks. No entries were made on the books of the Federal Reserve evidencing the taxpayer's interest in the securities.
Interest and principal on the bonds were paid directly to the owner banks by the federal government. The return for the period of the taxpayer's "ownership" was computed for each transaction based on the prevailing market rate for short term investments. This interest rate was related to the yield quoted for government securi ties, but was not related to the coupon rate on the tinderlying securities. The taxpayer's entitlement is reflected in the difference between the "purchase price" and the "selling price" as shown on the confirmation form, and of course ultimately found its way to the taxpayer's bank account. Arrangements of this type are not uncommon in financial circles, and are known as repurchase agreements, or REPOS.
The taxpayer claims that it is the owner of the bonds from the time of purchase until mandatory resale and that its monetary return consists of interest on obligations of the United States government, which is exempt from state income taxes by reason of the federal constitution and statutes, as recognized by the Missouri income tax statutes. It filed its 1981 state income tax return on this theory. The director of revenue assessed a deficiency which the taxpayer challenged before the Administrative Hearing Commission. The commission denied the relief sought, finding in effect that the taxpayer had lent money to the banks and that the bonds stood as security for these loans. We conclude that the decision is legally correct and affirm it.
The exemption of obligations of the United States has constitutional origins, but its scope is expressed in 31 U.S.C. Sec. 3124, reading 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,....
The state law does not fight with the federal, but rather expressly recognizes it, in the following provision (Sec. 143.121.3, RSMo 1986):
There shall be subtracted from his federal adjusted gross income the following amounts to the extent included in federal adjusted gross income:
(a) Interest or dividends on obligations of the United States and its territories and possessions or of any authority, commission or instrumentality of the United States to the extent exempt from Missouri income taxes under the laws of the United States....
If the taxpayer has received "interest or dividends on obligations of the United States ." it is entitled to exclude these from the income shown on its Missouri tax return. Otherwise the deficiency was correctly assessed and the taxpayer's petition for review is without merit. The parties have cited us to numerous REPO cases. Some hold that the purchaser becomes the owner of the underlying securities, at least for certain purposes. Others hold that the stated transaction is essentially a collat-eralized loan, and that the ownership of the securities is not changed. The cases con strue different contract transactions, for varying legal purposes. We have had to resort to them, but find it most satisfactory to analyze the transactions now before us and to assess their legal significance by our own standards. Having done this, we hold that the taxpayer did not receive "interest or dividends on obligations of the United States government," by reason of the REPO transactions. It rather received compensation from the bank for money paid to the bank out of its checking account. We believe that our conclusion is consistent with the weight of the applicable and pertinent authorities.
The director points out that the taxpayer never has physical possession of the securities. These remain on the books of the Federal Reserve Bank. After the taxpayer has "resold" them, there is no change in this bookkeeping entry. The securities are again available to the bank for a REPO transaction, with this taxpayer or others, or for outright sale by the banks without agreement to repurchase, or for whatever other use the banks may choose to make of them. The absence of physical delivery of the securities may not be the definitive circumstance, but it is an item to be considered in our evaluation.
More persuasive is the circumstance that the bank, rather than the taxpayer, bears the risk of market fluctuations. The taxpayer's rights are fixed at the time of the opening transaction, which specifies both a purchase price and a higher repurchase price. The difference between the two figures represents the taxpayer's return on the transaction. The confirmation slips bear notations of the percentage of return and the taxpayer is entitled to that amount upon resale to the bank. While substantial market fluctuations are unlikely for the short time for which each particular REPO transaction is open, no possible fluctuation could affect the amount that the taxpayer is entitled to as shown by the confirmation of repurchase slips.
The banks, by contrast, stand to gain or lose by the daily changes in market price. We believe the risk of market fluctuations is the prime incident of ownership of securities. Under the facts of this case, that risk was borne by the banks and not by the taxpayer.
The taxpayer's contractual obligation to resell the securities to the banks is also indicative of a collateralized loan. True ownership of securities is indicated by the owner's ability to sell to third parties. Citizen's Nat'l Bank of Waco, 551 F.2d 832, at 842, 213 Ct.Cl. 236 (1977). Counsel for the taxpayer admits the taxpayer could not effectively sell its interest to anyone other than the banks. Any "sale" would be subject to the already confirmed repurchase. The taxpayer's inability to transfer its interest to third parties is further evidenced by REPO documentation stating that the taxpayer's power to "exercise all rights of ownership including the right to sell the securities" was contingent upon the bank's default in failing to repurchase or failure to transfer additional securities in the event of market value decline of presently "owned" securities.
The record does not demonstrate the advantage to the banks in furthering these transactions, but we assume that their purposes are not eleemosynary. Each bank maintains inventories of government bonds and notes, and so the taxpayer's funds assist it in maintaining this inventory. The bank is also relieved of any liability or burden on account of the taxpayer's de mand deposits, for the duration of the REPO transaction.
The taxpayer argues about the risk of the bank's insolvency. It is difficult to see that this is a significant question. Let us assume that a REPO transaction is to be consummated on a Friday, with the resale to take place the following Monday, and that on Saturday the bank's insolvency is established. By the taxpayer's theory the bonds would belong to it and so would be protected from claims of the bank's liquidator or creditors. By the director's theory, the taxpayer would seem to have a security interest in the bonds. For these reasons we do not find further speculation about the situation in the event of insolvency helpful.
The taxpayer points to the bank's rights against the taxpayer, under the contract between them, if the latter refuses to go through with its obligation to purchase or, having purchased, refuses to resell. These are phantom provisions. At the inception of the transaction the bank debits the taxpayer's account and issues a confirmation stating that it has done so. When the time for repurchase arrives the purchase price is credited to the taxpayer's account, in accordance with the resale confirmation issued at the time of purchase. The taxpayer has no opportunity to default at either end of the transaction.
The taxpayer argues, finally, that the parties have the right to cast the transactions in any form they choose, and that the director is bound by their choice of a transaction form in which the taxpayer becomes the owner of the securities. We always reserve the right to characterize the substance of transactions without regard to their form, when precise distinctions are legally significant. The paper trail is not conclusive. We conclude, from the totality of the evidence, that the taxpayer did not become the owner of the securities and did not receive interest on obligations of the United States during the period in issue.
We limit our holding to the facts of this record. We do not hold that a person may not become the owner of securities unless there is a transfer of possession. Nor do we hold that a number of owners may not hold securities as tenants in common, or that shareholders in a mutual fund, who bear the risk of market fluctuations, may not enjoy the tax benefits of the underlying securities. What we do hold is that this taxpayer received only a payment from the banks for their use of the taxpayer's money, rather than interest on the underlying obligations.
The decision of the Administrative Hearing Commission is affirmed.
BILLINGS, C.J., and ROBERTSON, RENDLEN, HIGGINS and COVINGTON, JJ., concur.
WELLIVER, J., dissents in separate opinion filed.
. The mechanics of REPO transactions and the economic considerations thereof are well documented in Matter of Bevill, Brester & Schulman Asset, 67 B.R. 557, 566-71 (D.N.J.1986). See also, Note, Lifting the Cloud of Uncertainty Over the Repo Market: Characterization of Repos as Separate Pinchases and Sales of Securities, 37 Vand.L.Rev. 401, 402-03 (1984).
. In 1981 the transactions were evidenced only by confirmation slips, which existed in several different versions. We consider the confirmation forms most favorable to the taxpayer's theory. We give no consideration to more elaborate contracts adopted in 1981, because they are wholly immaterial to this litigation.
. Citizens Natl Bank of Waco v. United States, 551 F.2d 832, 213 Ct.Cl. 236 (1977); Bank of California v. Commissioner of Internal Revenue, 30 B.T.A. 556 [1934 WL 268] aff'd 80 F.2d 389 (9th Cir.1935) (income tax cases); Matter of Bevill, Bresler & Schulman Asset, 67 B.R. 557 (D.N.J.1986); Gilmore v. State Bd. of Admin., 382 So.2d 861 (Fla.1980) (bankruptcy proceedings); Bache Halsey Stuart Shields, Inc. v. University of Houston, 638 S.W.2d 920 (Tex.App.1982) (REPO not debt under state constitution).
. American Natl Bank of Austin v. United States, 421 F.2d 442 (5th Cir.), cert. denied, 400 U.S. 819, 91 S.Ct. 36, 27 L.Ed.2d 46 (1970); Union Planters Natl Bank of Memphis v. United States, 426 F.2d 115 (6th Cir.), cert. denied, 400 U.S. 827, 91 S.Ct. 53, 27 L.Ed.2d 56 (1970); First American Nat'l Bank of Nashville v. United States, 467 F.2d 1098 (6th Cir.1972); Capital Preservation Fund, Inc. v. Wisconsin Dept. of Revenue, 145 Wis.2d 841, 429 N.W.2d 551 (1988); Andros v. Illinois Dept. of Revenue, 154 Ill.App.3d 37, 106 Ill.Dec. 732, 506 N.E.2d 439 (1987) (all income tax cases).
. We also note that the banks had a contractual right to substitute other securities for those described in the confirmation statement. While the mechanics of any such attempt are hard to fathom because simultaneous purchase and sale confirmations are issued, the contract provision indicates that the taxpayer never "owned" any specific securities.
. Under the terms of the REPO agreements, the banks were obligated to add more securities to the transaction in the event the market value of those securities already purchased fell significantly prior to repurchase by the bank. This provision appears to be phantom as applied to the transactions in evidence, because the bank fully performs its obligation by crediting the resale price to the taxpayer's account, but the obligation to add securities is surely inconsistent with a claim that the taxpayer bears the risk of market fluctuation.