Opinion ID: 2220618
Heading Depth: 1
Heading Rank: 1

Heading: Exemption from taxation

Text: (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.... Section 3124 is a revision and recodification of 31 U.S.C. § 742 (1976). In § 742, the last sentence from the quote above read as follows: 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.... (Emphasis supplied.) See Act of Sept. 22, 1959, Pub.L. No. 86-346, § 105(a), 73 Stat. 621, 622. When Congress recodified § 742 as § 3124, the words directly or indirectly were omitted as surplus. H.R.Rep. No. 97-651, 97th Cong., 2d Sess. 94, reprinted in 1982 U.S.Code Cong. & Ad.News 1895, 1988. It was the intention of Congress to reformulate § 742 without a substantive change. See Act of Sept. 13, 1982, Pub.L. No. 97-258, § 4(a), 96 Stat. 877, 1067. Since the recodification did not substantively change the statute, the U.S. Supreme Court's construction of § 742 is also binding authority in the construction of § 3124. The Court has `treated [§ 742] as principally a restatement of the constitutional rule [that federal government property is immune from state taxation].' First National Bank v. Bartow Cty. Tax Assessors, 470 U.S. 583, 593, 105 S.Ct. 1516, 1522, 84 L.Ed.2d 535 (1985), quoting Memphis Bank & Trust Co. v. Garner, 459 U.S. 392, 103 S.Ct. 692, 74 L.Ed.2d 562 (1983). The Court has interpreted the exemption for federal securities provided in § 742 as a sweeping and broad exemption. See, American Bank & Trust Co. v. Dallas County, 463 U.S. 855, 103 S.Ct. 3369, 77 L.Ed.2d 1072 (1983); Memphis Bank & Trust Co. v. Garner, supra . This exemption is 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.' Memphis Bank & Trust Co. v. Garner, 459 U.S. at 396, 103 S.Ct. at 396, quoting Smith v. Davis, 323 U.S. 111, 65 S.Ct. 157, 89 L.Ed. 107 (1944). However, the Court has also stated that the tax exemption provided by § 742 is not a tax shelter. First National Bank v. Bartow Cty. Tax Assessors, supra . The trusts invest in federal securities in two ways. In the first method, direct purchase and sale, the trusts purchase federal securities without any restrictions on them, hold them for an indeterminate period of time, then either collect the interest from the federal government on those obligations when they mature or sell them at a later date prior to maturity. When the interest income from such a transaction is passed on to the shareholders of the trusts, it is exempt from state taxation under § 3124. See, American Bank & Trust Co. v. Dallas County, supra ; Memphis Bank & Trust Co. v. Garner, supra ; Brown v. Franchise Tax Bd., 197 Cal.App.3d 300, 242 Cal.Rptr. 810 (1987). The second method of investment used by the trusts is to purchase federal securities and simultaneously enter into a repurchase agreement, agreeing to resell the obligations back to the seller at a specified date and price. The dispute in this case involves the state's taxation of the income which the trusts' shareholders receive from these repurchase transactions. The Department argues that the trusts' repo transactions were really collateralized loans, whereby the trusts did not own the federal securities, but, rather, took the U.S. obligations as security for a short-term loan to the seller of the securities, a broker-dealer. Therefore, the income earned by the trusts (and subsequent income distributions by the trusts to their shareholders) from a repurchase transaction constituted interest payments on a loan and not interest income from the sale of federal securities. The Department further asserts that this loan was the obligation of the second party (a private party) to the repo agreement, not the obligation of the federal government. The Department concludes that since the income received by the shareholders constituted interest payments from a private party on a loan, a state tax on such income did not involve the consideration of a U.S. obligation, or the interest thereon, in computing the tax. Thus, the subject income is not tax-exempt under § 3124. The issue in this case is one of first impression for this court. Yet, there are a few jurisdictions which have addressed this issue and have determined that the income from a repo transaction involving federal securities is not exempt from state taxation. See, Hammond Lead Products v. Tax Com'rs, 575 N.E.2d 998 (Ind.1991); Department of Revenue v. Page, 541 So.2d 1270 (Fla.App.1989); Capital Preservation v. Rev. Dept., 145 Wis.2d 841, 429 N.W.2d 551 (Wis.App.1988); Andras v. Department of Revenue, 154 Ill.App.3d 37, 106 Ill.Dec. 732, 506 N.E.2d 439 (1987). See, also, Union Planters Nat. Bank of Memphis v. United States, 426 F.2d 115 (6th Cir.1970); American National Bank of Austin v. United States, 421 F.2d 442 (5th Cir.1970) (income from repo transactions involving municipal bonds not exempt from federal taxation). These courts apply a rationale similar to that proposed by the Department. That is, in a repo transaction, the seller-repurchaser (i.e., the broker-dealer) is the party who has the rights and risks associated with ownership of the securities, and as the true owner of the securities, the seller-repurchaser is the only party in the transaction who can claim the tax exemption provided by § 3124. Hammond Lead Products v. Tax Com'rs, supra ; Department of Revenue v. Page, supra ; Capital Preservation v. Rev. Dept., supra ; Andras v. Department of Revenue, supra . The rationale applied by these courts in determining whether a mutual fund shareholder's income from a repo transaction is exempt under § 3124 is based entirely on whether that party is deemed the true, or direct, owner of the securities. We do not believe that direct ownership determines whether income from a repo agreement is exempt under § 3124. The U.S. Supreme Court stated that the long-established congressional intent of § 3124 is to prevent state 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. See Smith v. Davis, supra . Also, because § 742 was recodified without substantive change, § 3124 still exempts from state taxation those federal obligations, and interest thereon, which are directly and indirectly considered in computation of the tax. Furthermore, the Court has interpreted this exemption as broad and sweeping. See, American Bank & Trust Co. v. Dallas County, supra ; Memphis Bank & Trust Co. v. Garner, supra . Thus, the income received by the appellee in this case, at the very least, is considered indirectly in computation of the tax. In addition, the state tax clearly imposes a burden on the market for federal securities. A review of the expert testimony of Sternlight makes it clear that a state tax on such income would diminish the market value and the investment attractiveness of federal securities, that the tax would impose a burden on the federal government's regulation of the nation's money supply, and that such tax would increase the costs to the federal government in financing the national debt. We conclude that the rationale and decision in Revenue Ruling 22-85-1 are invalid and that the income received by the appellee from repo transactions executed by the trusts involving federal securities is exempt from state taxation under § 3124. We thus affirm the district court's judgment with respect to Revenue Ruling 22-85-1. AFFIRMED. HASTINGS, C.J., not participating.