WASHINGTON -- Maryland and most other states got final clearance from the Supreme Court yesterday to continue taxing income that shareholders receive when their mutual funds put money indirectly into federal government securities.
In a unanimous decision, the court ruled that federal law does not bar states from taxing income earned from "repurchase agreements" that are entered into by mutual funds.
That ruling overturned a decision by the Nebraska Supreme Court that had granted state-tax immunity to those kinds of mutual fund investments. By contrast, courts in nine other states have ruled for the states.
In upholding the state taxes, the Supreme Court rejected an argument that such a ruling would disrupt the market for government securities. "We find no evidence that the taxation at issue will impair the market in federal securities or otherwise impair the borrowing ability of the federal government," Justice Clarence Thomas wrote.
The Thomas opinion used the same reasoning that Maryland's highest court, the Court of Appeals, used four years ago in allowing Maryland to tax shareholders' income that originates in repurchase agreements -- known as "repos."
Federal law makes clear that states may not tax the interest that the federal government pays directly to investors in its securities. A mutual fund that buys such securities outright gets a state tax exemption on the interest it earns. Investors do pay federal tax on the income earned.
But the state-tax status of a "repo" under federal law was not clear until yesterday's ruling.
Under a "repo" deal, a mutual fund does not buy government securities directly from the government for its own investment. Instead, the fund temporarily buys such securities from someone who already owns U.S. securities. The owner usually makes the sale to get some cash; the mutual fund makes the purchase to achieve an investment or to satisfy some trading goal.
The mutual fund agrees to sell those securities back to the original owner in the future. The owner pays a price high enough to include income to the mutual fund for having held the securities temporarily. This return is treated by some 40 states, including Maryland, as taxable income when it is passed on to mutual fund shareholders.
The Supreme Court said "repos" are not investments in government securities at all but rather are a form of loan of cash to the securities owner, in return for a profit on the deal.
When the same issue arose in Maryland several years ago, the state's Tax Court and a Maryland Circuit Court ruled that income earned on a "repo" was exempt from state taxes. But the state Court of Appeals overturned that decision in August 1990.
T. Rowe Price Associates Inc., a Baltimore-based mutual fund company, has always been their custom to treat interest from repurchase agreements as taxable on a state level, according to Sam Beardsley, a vice president and co-head of Price's tax department.