WASHINGTON -- The Supreme Court handed states a major victory yesterday when it unanimously ruled that Nebraska may tax shareholder income derived from repurchase agreements that involve U.S. government securities.
Forty-one states now tax such income earned by shareholders in mutual funds that invest in repurchase agreements, or repos, according to Roxanne Davis, attorney with the Federation of Tax Administrators, which represents tax officials from all states.
A dollar figure on how much revenue states collect from repo income is hard to estimate, but "you are talking about big, huge amounts of money" in the billions, Davis said.
A spokeswoman for the Federal Reserve Board of New York said the repo market is difficult to quantify because of the short-term nature of the transactions and widely varying terms. For the week ended Sept. 21, overnight and longerterm repo financings by the 39 primary U.S. government securities dealers totaled $175.7 billion, the spokeswoman said.
The high court avoided legally defining repos as either secured loans or actual sales of securities under bankruptcy, banking, commercial, and local government laws. Parties in the case, Nebraska v. Loewenstein, had said that a finding that repos are secured loans could hurt market liquidity and change the way repos are regulated.
For example, school districts and other municipalities actively participate in the government securities market through repos, but they can do so only if repos are not characterized as collateralized loans, the New York Fed told the high court last May.
Municipalities "are not empowered to make collateralized loans," and repos offer a way for them to earn interest in a short-term transaction with little or no risk of loss, the New York Fed said.
As the New York Fed had requested, the court sidestepped the issue, saying the key question is whether taxable income is earned from interest on U.S. obligations, not who actually owns the federal securities.
If the high court had ruled against Nebraska, states probably would have faced "massive refund liability" that goes beyond what states have experienced under a line of rulings starting with Davis v. Michigan in 1989, Davis said.
The Davis decision held that state taxation of federal retirement income is unconstitutional if state retirement income is not similarly taxed. More than 20 states were liable for refunds after the Davis ruling, Davis said. Just last week, the court issued a decision in Reich v. Collins that faulted state handling of retiree refunds.
"It would have been Davis all over again, on a much larger scale," if the high court had found state taxation of repos to be illegal, said Davis.
The highest courts in Indiana, Iowa, Maryland, Oregon, Missouri, and Vermont had upheld state taxation of repos that involve federal securities by the time the Nebraska case reached the high court.
The high court also said yesterday that federal courts have upheld federal taxation of repos whose underlying securities are tax-exempt municipal bonds.
While the justices did not legally define repos, they characterized such transactions as loans for purposes of determining how interest income was earned and whether its taxation by Nebraska violated the doctrine of intergovernmental tax immunity and the Constitution's supremacy clause.
The clause bars states from directly taxing federal property in a way that would hurt the U.S. government's borrowing ability.
Writing for the court, Justice Clarence Thomas concluded that "the interest earned by taxpayers is interest on loans to a private party, not interest on federal securities."
The case arose from a challenge by investor John Loewenstein to a 1985 Nebraska Department of Revenue ruling, which held that the income Loewenstein received as a shareholder in two mutual funds that invest in U.S. government securities through repos is subject to state taxation.
The funds, the Trust for Short-Term U.S. Government Securities and the Trust for U.S. Treasury Obligations, are noload diversified investment companies that invest solely in U.S. securities through repos and direct purchases.
In a typical repo transaction, the trusts buy government securities such as bonds and Treasury notes from a dealer and agree to sell them back at a higher price in the future. The resale back to the dealer includes interest for the time the trusts hold the securities, which can be a short as one day.
The interest paid to the trusts usually is less than that earned on the underlying securities, with the difference representing the dealer's profit margin.
The dealer normally does such deals to get cash, while funds such as the trusts use the securities for an investment or some other trading purpose.
Loewenstein argued that taxing repurchase agreements amounts to illegal taxation of underlying government securities that results in raising government borrowing costs. The Nebraska Supreme Court ultimately accepted that argument in a 1993 ruling that struck down the state tax.
Federal law bars state taxation if federal obligations must be considered, either directly or indirectly, in computing the tax, the high court said.
After examining the typical repo transaction used by the trusts, the high court concluded that even though Nebraska admittedly considered interest in computing its tax, the trusts did not earn either coupon or discount interest on the federal securities.
Individual repos may involve a mix of U.S. securities with varying maturities and yields, but the trusts earn interest from dealers at an agreed-upon rate that is not based on any of these yields, the court said.
"Rather, in economic reality, the trusts receive interest on cash they have lent to the seller-borrower" dealer, the court said. The federal securities are involved as "collateral" for these loans, it said.
The court acknowledged that repos could lose their characteristics of flexibility and liquidity if they became unavailable to investors such as municipalities. "These possibilities might develop if repos were to be characterized as secured loans for purposes of federal bankruptcy and banking law or of commercial and local government law," the court said.
"Our decision today, however, says nothing about how repos should be characterized for those purposes," the court said. An affidavit by former New York Fed official Peter Sternlight, which was submitted by Loewenstein and expressed concern about constraints on the repo market, does not apply to the Nebraska case, the court said.
The court said it found no evidence that state taxation of repos would impair the federal securities market or hurt the federal government's borrowing ability.
The court also declined to decide a question raised at oral argument -- but not in legal briefs filed at the court -- on whether Nebraska's income tax scheme lets a repo dealer claim the full federal tax exemption on the underlying federal securities in the transactions with the trusts.
If, for example, the dealer receives $100 in interest as the holder of federal securities and pays out $90 to the trusts in accordance with terms of repos involving those securities, Nebraska might give the dealer an income tax exemption worth only the $10 difference, rather than the full $100 exemption intended by Congress, Loewenstein's attorney told the court during arguments in October.
But the court said it did not grant review of that issue because it was not addressed by the Nebraska Supreme Court.
Cathy Heron, vice president and senior counsel for the Investment Company Institute, said the ruling should not result in changes to portfolio investment strategies. The court appeared to recognize the conduit nature of mutual funds, which pass investment income on to their shareholders, and that taxation of dividends depends on whether the dividend came from federal obligation interest or repo interest, Heron said.
