Opinion ID: 1591750
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Heading: Taxability of Repo Income.

Text: The basic question before us is whether the State may tax the income which a mutual fund distributes to its shareholders when that income is derived from a repo involving exclusively federal securities. The Everetts urge that the State is prohibited from taxing this income by the supremacy clause of the United States Constitution and 31 U.S.C. section 3124, which codifies the supremacy clause as it relates to state taxation. First Nat'l Bank v. Bartow County Bd. of Tax Assessors, 470 U.S. 583, 596, 105 S.Ct. 1516, 1522, 84 L.Ed.2d 535 (1985). In recognition of the constitutional prohibition, Iowa specifically excludes from net income interest and dividends from federal securities. Iowa Code § 422.7(1). This question has been addressed by several other states. See, e.g., Hammond Lead Prod. v. State of Indiana Tax Comm'rs, 549 N.E.2d 424 (T.C. of Ind. 1990); Borg v. Department of Revenue, 308 Or. 34, 774 P.2d 1099 (1989); Department of Revenue v. Page, 541 So.2d 1270 (Fla.App.1989) (rehearing denied); In re Thomas Sawyer Estate, 149 Vt. 541, 546 A.2d 784 (1987) (motion for reargument denied); Andras v. Illinois Dep't of Revenue, 154 Ill.App.3d 37, 106 Ill.Dec. 732, 506 N.E.2d 439 (2d Dist.1987); Matz v. Department of Treasury, 155 Mich.App. 778, 401 N.W.2d 62 (1986) (per curiam). All of these cases, with the exception of Hammond Lead, involve the same mutual fund as the case before us now, and they all, with the exception of Matz, a Michigan Court of Appeals per curiam opinion, held income derived from repo's is taxable by the state. The reasoning behind these decisions is that repurchase agreements, despite their name, are actually secured loans, and that the investor, at least for tax purposes, never really owns the federal securities. In a repurchase agreement, a buyer, in this case the trust, agrees to buy shortterm federal securities from a bank or broker (seller-repurchaser). The buyer simultaneously agrees to resell the securities back to the seller-repurchaser at a price that includes interest for the period of the sale. This interest paid to the buyer is generally less than that earned by the federal securities; this difference is the seller-repurchaser's margin of profit. The district court, in reversing the director's decision, reviewed the evidence in light of the Andras decision. In Andras, the appellate court of Illinois set out seven factors which, the court said, if present, tend to indicate that the transaction is a loan. Andras, 154 Ill.App.3d at 42-45, 106 Ill.Dec. at 736-37, 506 N.E.2d at 443-44. The district court in this case concluded, however, that the evidence was not sufficient to support a positive answer to all of the factors in Andras and went on to find the tax unconstitutional. The fundamental question, however, is whether the trust accepted the risks of ownership of the federal securities, not whether the seven factors were present. The factors are merely indicators. The assumption of the risks of ownership has been held to be the key to claiming exemptions from state taxation. Page, 541 So.2d at 1273; Andras, 106 Ill.Dec. at 737, 506 N.E.2d at 444 (citing American Nat'l Bank v. United States, 421 F.2d 442, 451 (5th Cir.1970)). In Hammond Lead, the court stated that ownership is evidenced by which party bears the risk of market fluctuations and which party has the ability to sell to third parties. 549 N.E.2d at 428. Here, as in Hammond Lead, the taxpayer neither bore the risk of market fluctuations nor possessed the ability to sell to third parties. More importantly, perhaps, the director in this case found that the trust accepted none of the risks of ownership. While the director did not purport to find each of the seven factors set out in Andras, based on his review of all the evidence, he found the trust did not really own the federal securities. We believe there was substantial evidence to support this finding of fact. Therefore, we are bound by it. Iverson Constr., 449 N.W.2d at 358. The United States Constitution Article VI clause 2, and 31 U.S.C. section 3124(a) prohibit any form of state taxation which requires an obligation of the United States Government or the interest thereon to be considered in computing a tax. Here the interest was not on the federal obligations but on the repo agreements; it was paid not by the federal government, but by the seller-repurchasers. Moreover, it was those seller-repurchasers, not the federal government, that set the interest rate to be paid under the repurchase agreements, and indeed the interest rates paid pursuant to the repo's were different from those paid on the federal obligations. The State's tax did not consider, either directly or indirectly, the federal obligations or the interest paid on them in calculating the Everetts' tax. Instead, the tax was based on the interest paid by private seller-repurchasers pursuant to a private sector loan agreement in which federal obligations served as collateral. In such a situation, neither the federal obligations nor the interest thereon is considered in calculating the state income tax. Borg, 308 Or. at 38-39, 774 P.2d at 1102; In re Thomas Sawyer Estate, 546 A.2d at 786. We hold that neither the supremacy clause nor 31 U.S.C. section 3124(a) prevents the State from taxing the income derived from the repurchase agreements. The district court's order is reversed. We remand to the district court for entry of an order affirming the director's decision and order. REVERSED AND REMANDED.