WASHINGTON -- Supreme Court Justice Sandra Day O'Connor warned yesterday that a ruling by the court that repurchase agreements are secured loans may have unintended effects on the regulation of such transactions.

Her comments came as the state of Nebraska asked the court to consider repurchase agreements, commonly known as repos, as secured loans for tax purposes. Such a characterization would reflect the "economic substance of the transaction, rather than mere form," the state said.

By recognizing repos as secured loans, rather than actual sales of securities, lower courts have allowed other states to tax income derived from repos that involve U.S. securities, without violating the tax-exempt status of such securities, a Nebraska official told the court.

But a mutual fund shareholder who is fighting an adverse Nebraska tax ruling told the court that repos are structured as purchases and sales "for valid business reasons unrelated to tax issues" that should be "respected."

States that tax income from repos involving federal securities are illegally taxing the exempted income earned from those securities, according to Nebraska investor John Loewenstein.

O'Connor, speaking during oral argument in the case, Nebraska v. Loewenstein, said, "I am concerned that calling [a repo] something here may have some unforeseen consequences" for purposes of Securities and Exchange Commission regulation of repo transactions.

But Justice Stephen Breyer said that like a "nectarine," which combines a peach and a plum, a repo has the characteristics of both a collateralized loan and a sale. He joined O'Connor and other justices in seeking guidance about what actually happens to the tax exemption i.n a repo transaction.

The case arose when Nebraska's department of revenue taxed income received by Loewenstein as a shareholder in two mutual funds that invest solely in U.S. government securities through repos and direct purchases. The funds, the Trust for Short-Term U.S. Government Securities and the Trust for U.S. Treasury Obligations, are no-load diversified investment companies.

In repurchase transactions, the trusts are buyer-lenders that buy government securities such as bonds and Treasury notes from dealers, or seller-borrowers, and simultaneously agree to sell them back to the seller-borrower at a higher price in the future, typically the next day. The resale back to the seller-borrower includes interest for the time the buyer-lenders hold the securities.

The interest paid by the seller-borrower to the trusts is typically less than that earned on the securities, with the difference representing the seller-borrower's profit margin.

The income distributed to Loewenstein flows both from the trusts' direct investment in the federal securities and from their participation in repos, Nebraska told the court.

A central question in the case is whether the interest paid to the trusts is interest paid by the United States on federal obligations, which is exempt from state taxation under the Constitution's supremacy clause and the internal revenue code.

Jay Bartel, assistant attorney general of Nebraska, argued that the interest payment is paid not by the United States but by private seller-borrowers based on prevailing market rates paid on loans or financing transactions of similar maturity and risk. The payment is unrelated to the interest rate or yield on the underlying federal securities, he contended.

But Justice Antonin Scalia asked, "Couldn't you say the same thing about U.S. Treasury bonds ?" The money an investor receives upon maturity "won't depend on the face interest on the government obligation, it will depend on what the market is at the time," he said.

Justice Anthony Kennedy said that if there is an exemption of $500 on interest income from a Treasury bill, and Nebraska taxes a portion of income from a repo transaction involving the T-bill, "will the full $500 exemption be accorded to someone?"

Bartel said the seller-borrower in a repo transaction would be accorded the exemption, but under Nebraska law, the seller-borrower would have to "add back" the cost of financing and thereby reduce the exemption.

Breyer sought to clarify what the state law meant, saying it appeared that the seller-borrower must subtract the interest paid to the buyer-lender from the exempted interest income from the underlying federal security.

"If the answer is yes, it diminishes the exemption" that is protected under the Constitution, Breyer said. The state is saying "maybe not. That bears upon the ... prudence of our allowing you to recharacterize the transaction in the way that you seek to do," he told Bartel, who was not sure how to answer Breyer's questions.

Justice Ruth Bader Ginsburg joined the other justices in seeking guidance. She asked why the U.S. Treasury Department has not weighed in with an opinion, since preserving the federal interest exemption is important for keeping federal borrowing costs down. "I have not heard anything but silence from the federal government," she said.

Ginsburg said Loewenstein "would have no case" if not for the Nebraska requirement that seller-borrowers "add back," or subtract the interest they pay, from the exempted interest income earned from federal securities.

"I would have no case, but I would also owe no tax," because the full exemption would have been accorded to the trusts in which Loewenstein invested, said Loewenstein's attorney, Terry Wittier of Lincoln, Neb. If Loewenstein knew he would not be accorded part of the exemption, he would cut a different deal with the trusts and ask for more money, Wittler said.

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