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Date: 08-19-2019
Case Style:
Ronald D. Mass v. Franchise Tax Board
Case Number: B286857
Judge: Dhanidina, J.
Court: California Court of Appeals Second Appellate District, Division Three on appeal from the Superior Court, County of Los Angeles
Plaintiff's Attorney: Mardiros H. Dakessian, Zareh A. Jaltorossian and Ruben Sislyan
Defendant's Attorney: Xavier Becerra, Diane S. Shaw, Brian D. Wesley and Matthew C. Heyn
Description:
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.
3
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
4
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
5
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
6
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.)
7
issue is whether dividends derived from interest retain their taxexempt
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.
Outcome: The judgment is affirmed. The parties are to bear their own costs on appeal.
Plaintiff's Experts:
Defendant's Experts:
Comments: