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

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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

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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

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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

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issue dividends to its shareholders that are exempt from state

income tax. For these reasons, I concur in the judgment.

LAVIN, Acting. P. J.

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