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California Taxpayer Will Go To Court Over Muni Bond Interest Law

This article is reproduced with permission from Spidell Publishing, Inc.

In late 2015, attorney Marty Dakessian, Esq., on behalf of his clients, Ronald and Pamela Mass, started the process to declare that California’s law taxing exempt government bond interest passed through from a mutual fund is unconstitutional. California taxes such interest if less than 50% of the mutual fund is invested in California exempt bonds. On April 26 of this year, the California Board of Equalization (BOE) declined to rule on the law’s constitutionality, and the case will go on to court.

After the California Franchise Tax Board (FTB) assessed over $60,000 in additional tax on California obligation interest because the mutual fund contained less than 50% of exempt California obligations, the taxpayers filed an appeal with the BOE. The taxpayer argues that California Revenue and Taxation (R&TC) Section 17145(a) is unlawful because, under the California Constitution, “Interest on bonds issued by the State or a local government in the State is exempt from taxes on income.” The constitution does not distinguish between interests passed through from mutual funds that have more than 50% of their assets in California tax-exempt bonds from mutual funds that have less than 50% of their assets in California tax-exempt bonds. The taxpayer contends that the constitutional exemption cannot be altered by statute and that because qualified regulated investment companies (RICs) are conduits, the interest earned by RICs is passed through to taxpayers and treated as interest earned by the taxpayers directly. Therefore, the interest earned on all California exempt obligations is exempt from tax regardless of how many of the assets held by the RIC are California-exempt obligations.

FTB’s argument
The FTB cited the Appeal of H. Lon Henry, in which the Board ruled that Article III Section 3.5 of the California Constitution precludes the Board from deciding constitutional issues and from declaring statutory provisions to be unconstitutional. However, in a similar case, the Board noted that … “the Board upheld and applied R&TC Section 17145, holding that: (1) ‘[S]ince appellant did not provide us with any written statement(s) from the mutual funds stating that the dividends he received therefrom were tax-exempt … we conclude that respondent properly denied appellant’s refund claim[;]’ and (2) ‘..with regard to appellant’s constitutional arguments, Article III, Section 3.5 of the California Constitution precludes this Board from deciding constitutional issues and from declaring statutory provisions to be unconstitutional.'” The FTB also argues that the law, as written, was applied correctly. Under federal law, as modified by California, distributions from RICs are treated as exempt corporate distributions unless a specific exception applies. According to the FTB, the 50% floor provided by R&TC Section 17145 provides such an exception.

Taxpayer must push on
Because the Board could not address the constitutionality of the law, the FTB’s decision was sustained and the Masses will file in superior court in the near future.

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