Mass v. Franchise Tax Bd.

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., B286857
Plaintiffs and Appellants, (Los Angeles County
Super. Ct. No. BC627648)
v.
FRANCHISE TAX BOARD,
Defendant and Respondent.
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.
——————————
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.
2
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
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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
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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
5
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.)
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issue is whether dividends derived from interest retain their tax-
exempt 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.
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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.
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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
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).
2
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
3
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.).
4
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.
5
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
6
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 tax-
exempt 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
7
issue dividends to its shareholders that are exempt from state
income tax. For these reasons, I concur in the judgment.
LAVIN, Acting. P. J.
8