Court Opinion

ID: 9561461
Source: CourtListenerOpinion
Date Created: 2023-08-21 18:10:04.229744+00
Date Added: 2024-06-11T09:13:49.552928
License: Public Domain

KENNARD, J., Dissenting.
The question presented in this case is whether a title insurance company (insurer) that issues a policy of title insurance receives taxable income when an underwritten title company with which the insurer has a separate contractual arrangement pays a claim against the insurer by a policyholder on behalf of the insurer, or compensates the insurer for a claim that the insurer has paid. Looking beyond form to substance, I would hold that under these circumstances the insurer has received income, and is therefore subject to taxation under the California Constitution. Accordingly, I respectfully dissent.
Background
The seven plaintiff insurers each issue policies through underwritten title companies that act as their agents. The relationships between the insurers *734and the title companies are set forth in separate underwriting agreements that are concededly not policies of insurance. Under these agreements, the title companies conduct title searches, prepare title reports, issue the title insurance policies to the policyholders using forms prepared by the insurers, determine the premiums from schedules supplied by the insurers, and collect premiums. The underwriting agreements between the title companies and the insurers also provide that the title companies retain about 90 percent of the premiums, and pay the remainder to the insurers. The policyholders are not parties to the underwriting agreements.
According to the underwriting agreements, when a policyholder makes a claim under a title insurance policy one of two procedures is followed. Under the procedure set forth in four of the seven underwriting agreements at issue here, the insurer pays the claim directly. Then the title company compensates the insurer for the amount of the claim the insurer has just paid its policyholder, up to a specified limit. Under the alternative procedure set forth in the remaining three underwriting agreements, when a claim is made by a policyholder, the title company pays the policyholder’s claim directly up to the specified amount, and the excess of the claim over the limit, if any, is then paid by the insurer.
The insurers here did not report as income or pay taxes on the payments made to them by the title companies to pay claims they had paid to the policyholders, nor on the claims that were paid by the title companies to the policyholders on behalf of the insurers. The Board of Equalization issued deficiency assessments against the insurers for certain years between 1975 and 1984, on the ground that the payments to the insurers by the title companies to compensate the insurers for claims the insurers had paid and the payments made directly to the policyholders by the title companies on behalf of the insurers were income to the insurers on which taxes must be paid. The insurers unsuccessfully contested those assessments in administrative proceedings, and then the insurers paid the claims and sued for refunds. The trial court found in favor of the insurers, but the Court of Appeal reversed the judgment.
Discussion
Under article XIII, section 28, subdivision (c) of the California Constitution, title insurers must pay a tax on “all income upon business done in this state.” Subject to certain exceptions not applicable here, this tax is “in lieu of all other taxes and licenses, state, county, and municipal, upon such insurers and their property.” (Cal. Const., art. XIII, § 28, subd. (f).) In place of these other taxes, title insurers are taxed at an annual rate of 2.35 percent on “all *735income.” (Cal. Const., art. XIII, § 28, subd. (d).) Section 28 does not define the phrase “all income.” The parties in this case, however, agree that the federal income tax concept of “gross income” is analogous. Indeed, Congress in defining “gross income” used the phrase “all income.” “Gross income,” under federal law, “means all income from whatever source derived . . . .” (26 U.S.C. § 61(a).)
Under the precedents of the United States Supreme Court, the concept of “income” is broad. It has been described as encompassing all “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” (Commissioner v. Glenshaw Glass Co. (1955) 348 U.S. 426, 431 [99 L.Ed. 483, 490, 75 S.Ct. 473]; accord, e.g., Commissioner v. Kowalski (1977) 434 U.S. 77, 83 [54 L.Ed.2d 252, 259, 98 S.Ct. 315]), and, more recently, simply as “any ‘accessio[n] to wealth’ ” (United States v. Burke (1992) 504 U.S. _ [119 L.Ed.2d 34, 42-43, 112 S.Ct. 1867, 1870]). The high court has emphasized that the statutory language indicates an intent to include all sources of income to the fullest extent of constitutional taxing power. (Ibid.; Commissioner v. Kowalski, supra, 434 U.S. at p. 82 [54 L.Ed.2d at pp. 258-259].)
The labels parties attach to their transactions do not determine whether there is income. The high court “has recognized that ‘income’ may be realized by a variety of indirect means. . . . [T]he substance, not the form, of the agreed transactions controls.” (Diedrich v. Commissioner (1982) 457 U.S. 191, 195 [72 L.Ed.2d 777, 781, 102 S.Ct. 2414].) This court has also stressed that the judicial task is “to look beyond the formal labels the parties have affixed to their transactions and seek ... to discern the true economic substance of the . . . arrangement.” (Metropolitan Life Ins. Co. v. State Bd. of Equalization (1982) 32 Cal.3d 649, 656-657 [186 Cal.Rptr. 578, 652 P.2d 426].)
1. Are the title companies’ payments to the insurers to compensate the insurers for claims the insurers have paid “income” to the insurers?
The first question is whether the payments made by the title companies to the insurers to compensate the insurers are “income” to the insurers. In my view, when an insurer receives a payment from a title company, the insurer has received income within the meaning of the broad statutory concept “all income.”
The insurers in their briefs treat the underlying transactions as if they were of labyrinthine complexity. They are not. What happens is this: A policyholder makes a claim under a title insurance policy. The insurer pays the *736claim. The title company then compensates the insurer for the total amount the insurer has just paid to the policyholder, up to the limit specified in the contract between the title company and the policyholder.
There is no difference between payment or compensation received by an insurer when a title company pays it money under a contract and payment or compensation received by any business under a contract with any other business. Both are income. The payment the insurer receives is not a gift. It is consideration for services rendered. The insurer has provided a service to the title company—it has made insurance for the title company’s title services available, and the title company benefits from this because it is then able to sell its services (searching title, etc.) in a package with insurance to the customer, who is the policyholder. In return for this service that the insurer provides to the title company, the title company assumes certain obligations. Among them is the obligation to compensate insurers for the claims insurers pay.
In any other business context, there would be no question that payment for services rendered is included within gross income. Indeed, under 26 United States Code section 61(a)(2), “gross income derived from business” is specifically included within “gross income,” which, as noted, is itself within “all income.”
The insurers contend that they receive no income when the title companies pay them for claims the insurers have paid. This contention might have merit if the insurers could somehow demonstrate that even though they had been paid, they received no “accession to wealth.” But they cannot do so. The Board of Equalization correctly points out in its brief that, as far as the record in this litigation shows, when an insurer pays a claim and then receives money from a title company, the money it receives is completely unrestricted. From the insurer’s point of view, all dealings with the insurance policy are over when it pays the claim. The later payment from the title company to the insurer is made under a separate business contract between the insurer and the title company, and the payment received makes the insurer that much “wealthier” than it would have been had the payment never been made. The payment may be used for salaries to executives or dividends to shareholders, or for any other legal purpose. The insurer has “complete dominion” over such funds. It defies logic to suggest that when an insurer receives money from a title company with which it has a business relationship, its wealth is not thereby increased.
Several of the plaintiff insurers suggest that the funds they receive from the title companies when they have paid claims are not “income” because *737those funds offset the claims the insurers have paid out to the policyholders. This argument, however, confuses the concept of “income” with that of “profit.” Profit is, of course, what remains after the expenses of doing business are deducted from the funds an enterprise receives. (See Nofziger v. Holman (1964) 61 Cal.2d 526, 528 [39 Cal.Rptr. 384, 393 P.2d 696].) California law distinguishes between income and profit in the taxation of insurers. For example, ocean marine insurers are not taxed on “all income,” as are title insurers; instead, they are taxed on their “underwriting profit” (Cal. Const., art. XIII, § 28, subd. (g)), which is measured in part by deducting losses paid out in claims (Rev. & Tax. Code, § 12073). If the drafters of section 28 intended that title insurers could deduct losses paid out in claims from the amount on which they were taxed, article XIII, section 28 would have used the concept of “profit” rather than the broad phrase “all income” in defining the sums on which title insurers are taxed.
Therefore, as a matter of economic reality, when an insurer receives money from a title company under a contractual arrangement requiring the title company to compensate the insurer for claims the insurer has paid, the insurer receives income. Under article XIII, section 28 of the California Constitution, that income is taxable at a rate of 2.35 percent per year.
2. Are the title companies’ direct payments to policyholders to discharge the obligations of the insurers “income" to the insurers?
As noted above, there is an alternative procedure set forth in three of the underwriting agreements at issue here. Under that procedure, when a claim is made by a policyholder, the title company, rather than compensating the insurer for the claims it has paid, simply pays the policyholder’s claim directly. In my view, this procedure also results in income to the insurer.
The conclusion that this alternate procedure produces income to the insurer is supported by both logic and case law. The case law is clear that substance, not form, determines whether a transaction gives rise to income. (Diedrich v. Commissioner, supra, 457 U.S. at p. 195 [72 L.Ed.2d at pp. 781-782]; Metropolitan Life Ins. Co. v. State Bd. of Equalization, supra, 32 Cal.3d at pp. 656-657.) Here, the distinction between the contracts specifying that the insurers pay the claims directly and then seek compensation from the title companies, and the contracts that specify that the title companies pay the claims in the first instance, is one of form and not substance. If, as I have shown, contracts of the first type produce income to the insurers, then surely contracts of the second type do as well.
Moreover, the conclusion that when a title company pays a claim on behalf of an insurer the insurer has received income is also compelled by the *738rule governing discharge of indebtedness. Under that rule, the “discharge of liability by the [third party’s] payment of the [first party’s] indebtedness constitute^] income to the [first party] and is to be treated as such.” (United States v. Hendler (1938) 303 U.S. 564, 566 [82 L.Ed. 1018, 1019-1020, 58 S.Ct. 655]; accord, e.g., Diedrich v. Commissioner, supra, 457 U.S. at p. 195 [72 L.Ed.2d at pp. 781-782].) An illustration of this principle is found in Old Colony Trust Co. v. Comm’r Int. Rev. (1929) 279 U.S. 716 [73 L.Ed. 918, 49 S.Ct. 499]. There, an employer agreed to pay an employee’s income taxes. The high court held that payment of the employee’s income tax indebtedness was income to the employee. (Id. at p. 729 [73 L.Ed. at pp. 927-928].)
This case is in substance no different. The insurer is legally obliged to pay all valid claims under its insurance policies. When a title company steps in and pays a policy claim on behalf of the insurer, it discharges a debt of the insurer. Accordingly, this discharge constitutes income to the insurer, and is to be treated as such.
The majority attempts to distinguish Old Colony Trust Co. v. Comm’r Int. Rev., supra, 279 U.S. 716; Diedrich v. Commissioner, supra, 457 U.S. 191; and United States v. Boston & M. R. Co. (1929) 279 U.S. 732 [73 L.Ed. 929, 49 S.Ct. 505]. It writes that “[i]n each of these cases, the taxpayer realized a gain by being relieved of a tax obligation for which the taxpayer alone was liable. Such is not the case here, where the insurers and the title companies contracted in advance to divide the premium, labor, risk and liability between themselves.” (Maj. opn. ante, at p. 727.) According to the majority, this case presents “a situation in which the taxpayer has reached an arm’s-length agreement in advance with a third party by which that third party assumes certain risks in return for a consideration that reflects the value of those risks.” (Id. at p. 728.) The factor of risk assumption by the title companies somehow, in the majority’s view, means that when the title companies pay claims on behalf of the insurers, the discharge of the insurers’ indebtedness is not income to the insurers.
The majority’s reasoning is defective, for two reasons.
First, it proves too much. An allocation of risk between contracting parties is certainly not unique to the insurer-title company relationship. Indeed, one court has stated that “[a]ll commerce and all contracts allocate risks and benefits.” (Valley Bank of Nevada v. Plus System, Inc. (9th Cir. 1990) 914 F.2d 1186, 1190.) To use a simple example, a private investor lends money to a manufacturer at a specified rate of interest for a fixed term. The loan contract by its nature allocates risks and benefits; the manufacturer bears the risk, among others, that deflation will occur and it will thereby be more *739costly, in real economic terms, to repay the loan. When the manufacturer repays the loan to the investor, we do not say that, because the manufacturer has borne the risk that the value of money will increase, the money it pays to the investor does not result in income to the investor. Similarly, the mere fact that the title company may assume some quantum of risk cannot mean that the money it pays to the insurer does not result in income to the insurer.1
Second, the majority’s reasoning ignores the fact that the insurers, not the title companies, are primarily and ultimately liable to the policyholders for the payment of claims. The insurer is the obligor under the insurance contract; the title company is not even a party to the contract. And the insurer remains ultimately liable under the policy. This is an indisputable proposition of law. A title insurance policy is a contract that insures the owner of property or another interested party against defects in title or liens and encumbrances that affect title, the invalidity of liens or encumbrances, or the incorrectness of title searches. (Ins. Code, §§ 12340.1, 12340.2.) Under California law, the function of title insurance can only be performed by an admitted insurer that had been issued a certificate of authority by the Insurance Commissioner to transact title insurance. (Ins. Code, §§ 700, 12360.) The functions of a title company are also precisely delineated by statute, and a title company has no statutory authority to become a party to a contract of title insurance. (Ins. Code, §§ 12340.5, 12389.) To the extent that a title company has any role in the title insurance function, it can only be as an agent of an admitted title insurer. Indeed, the stipulation executed *740by all the parties in this case, and the underwriting agreements between the insurers and the title companies on which that stipulation is based, all specifically refer to the title companies as agents of the insurers.
Because title companies can, as a matter of law, assume none of the functions of title insurers, but can only act as the agents of such insurers, the conclusion is unavoidable that title companies cannot ultimately assume any portion of the risk that a claim will be made, and that the title companies are mere conduits for claims payments for which the insurers remain primarily and ultimately liable. And because the title companies cannot be ultimately responsible for payment of any claims made under the insurers’ policies, it follows that, even under the majority’s reasoning that the allocation of risk can defeat the conclusion that income was received, the insurers transferred no risk and thus cannot escape the conclusion that they received income when the title companies paid claims on their behalf.
Conclusion
Title insurance exists to compensate policyholders for losses resulting from what may be described broadly as title defects. Although insurers that issue policies of title insurance are in the business of compensating these losses, the majority holds that when an insurer enters into an underwriting agreement with a title company under which the title company assumes the burden of paying policy claims—either directly to the policyholder or by way of offset to the insurer—these payments are not income to the insurer. The theory appears to be that when the title insurance policy and the underwriting agreement are read together, the insurer can be viewed as a mere passive intermediary or conduit of funds flowing from the title company to the policyholder to discharge the insurer’s liabilities under the policy. This theory is based on the supposition that the insurer has transferred the risk against which insurance is purchased from itself to the title company. But, as I have explained, the insurer’s role in paying policy losses is neither as slight nor as passive as the majority suggests. Ultimately, the insurer cannot transfer the risk against which the policyholder has purchased insurance to a title company or to any other third party that is not an admitted insurer. And the transfer of risk itself cannot transform a taxable receipt of income into the receipt of funds without tax consequences.
I would conclude that when a title company pays a claim on behalf of an insurer or pays the insurer directly to compensate it for a claim it has paid, the economic reality is that the insurer has received a gain; thus, the insurer *741has received income, and is subject to taxation under article XIII, section 28 of the California Constitution.2
I would affirm the judgment of the Court of Appeal.
Mosk, J., concurred.
Respondent’s petition for a rehearing was denied March 18, 1993. Mosk, J., and Kennard, J., were of the opinion that the petition should be granted.

If, as the majority asserts, the transfer of risk in a contractual context somehow negates the receipt of income, one wonders how the majority would respond to the following scenario: A corporation employs an attorney. As part of the attorney’s compensation package, the corporation agrees to make all monthly payments due on an adjustable rate mortgage on the attorney’s residence. Thus, the corporation contractually agrees to allocate to itself the risk that the mortgage rate will rise during the life of the contract. On the basis of her reading of the majority opinion in this case, the attorney does not report as income on her California tax return any of the payments on her adjustable rate mortgage made by her employer. The Board of Equalization then issues a deficiency assessment against her for taxes due on the theory that the mortgage payments constitute income.
The attorney pays the tax under protest and sues for a refund. What result? Certainly, under the logic of the majority’s position, there can be no principled distinction between the insurers here and the attorney in this scenario. Just as in this case, the factors the majority identifies as dispositive to its conclusion of no income are present; both are “situationfs] in which the [party seeking to avoid taxes] has reached an arm’s length agreement in advance with a third party by which that third party assumes certain risks in return for a consideration that reflects the value of those risks.” (Maj. opn, ante, at p. 728.)
If there is no principled way to distinguish the insurers’ claim to tax exemption in this case from the attorney’s claim in this scenario, then the majority has created a “tax loophole” of potentially immense proportions. No doubt many highly compensated persons will wish to take advantage of the majority’s beneficence to have their employers transfer income to them free of state income taxes in the form of agreements to pay adjustable rate mortgages and variable interest rate credit card balances.

Because I conclude that the claims payments are income to the insurers, I also conclude that the insurers are not entitled to a refund. I therefore find it unnecessary to consider whether any possible refund would be subject to an offset, or whether the Board of Equalization properly preserved the offset issue in administrative proceedings.