Doneski v. Comptroller of Treasury

BISHOP, Judge. The Doneskis, appellants, filed an amended Maryland income tax return with the Comptroller of the Treasury (“Comptroller”), appellee, seeking partial refunds for state taxes they paid in the years 1985, 1986, 1987, and 1988. The Doneskis believed that the gains they recognized from the sale of United States Government obligations and the military retirement pay received by Bernard Doneski, both of which they included in their Maryland taxable income, were not properly taxable by the State of Maryland. The Comptroller disallowed the requested refunds, and the Doneskis appealed the decision to the Maryland Tax Court.

On August 15, 1990, the Maryland Tax Court affirmed the ⁶¹⁷ Comptroller’s decision to disallow the refund. Again the Doneskis appealed, this time to the Circuit Court for Montgomery County. On May 2, 1991, the Circuit Court affirmed the decision of the Tax Court. Still not satisfied, the Doneskis have appealed to this court.

The Doneskis’ various complaints with the Comptroller’s determination that they were not entitled to a refund can be broken down into two contentions: (1) that the State of Maryland cannot tax the gains realized as the result of the sale of United States Government obligations, and (2) that the State of Maryland discriminates against federal retirees by taxing their pensions differently than state retirees. Facts The Doneskis filed joint resident Maryland income tax returns for all four years in dispute. Each of the four years included as income the pension received by Bernard Doneski from the Department of the Army. Additionally, for the year 1986 their calculation of taxable income included the gain realized from the sale of United States Government obligations.

The Doneskis applied to the Comptroller, seeking to amend their returns by using an adjusted calculation of taxable income that did not include these two sources of income. This revised calculation would result in tax refunds of $1,274.60 for 1985, $4,064.70 for 1986, $1,337.02 for 1987, and $1,061.43 for 1988 (a total of $7,737.75). The Comptroller denied the Doneskis’ request for a refund. The Doneskis appealed to the Tax Court which also denied their requested refunds.

The Tax Court found that nothing in 31 U.S.C. § 3124 (a) prohibited states from taxing the gain on the sale of federal obligations. Additionally, the court found that Maryland’s system of taxing pensions did not discriminate in violation of the standard announced in Davis v. Michigan Department of Treasury, 489 U.S. 803 , 109 S.Ct. 1500 , 103 L.Ed.2d 891 (1989). In a Memoran ⁶¹⁸ dum Opinion and Order dated May 2, 1991, the Circuit Court for Montgomery County affirmed the decision of the Tax Court on the same grounds. Discussion (1) Taxation of United States Government Obligations The Doneskis argue that 31 U.S.C. § 3124 prohibits the taxation of obligations of the United States.

That section reads in pertinent part as follows: (a) Stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State. The exemption applies to each form of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax, except— (1) a nondiscriminatory franchise tax or another non-property tax, imposed on a corporation; and (2) an estate or inheritance tax. (b) The tax status of interest on obligations and dividends, earnings, or other income from evidences of ownership issued by the Government or an agency and the tax treatment of gain and loss from the disposition of those obligations and evidences of ownership is decided under the Internal Revenue Code of 1986 (26 U.S.C. 1 et seq.). 31 U.S.C. § 3124 (1988). (Section 3124 of the 1988 Code is substantively the same as it was in the tax years in question except the reference to the Internal Revenue Code was updated from “1954” to “1986.”) Although section (a) does not expressly exempt the gain or loss recognized from the disposition of United States obligations, the Doneskis contend that it is broad in scope and covers all forms of taxation including those which tax the gain.

They find support for their argument in the fact that section (b), which was enacted to terminate the federal tax exemption of United States obligations, does specifically mention gain ⁶¹⁹ which would be necessary only if section (a) prohibits taxing the gain. The Comptroller, however, responds that § 3124 does not preclude taxation of a gain realized on a sale of the obligation but only prohibits taxation on the obligation itself and interest generated by it. He reaches this conclusion based on the fact that “[sjection 3124(a) does not, within the scope of its prohibition, mention ‘profit’ or ‘gains’ ” and had Congress intended the gain to be exempt from taxation it would have specifically drafted the statute to so indicate. “The cardinal rule of statutory construction is to ascertain and effectuate the actual intent of the Legislature.” Montgomery County v. Lindsay, 50 Md.App. 675, 678 , 440 A.2d 411 (1982) (citations omitted). The intent of the legislature is to be determined through examination of the words of the statute and consideration of the objective of the statute.

Id. When analyzing the words of a statute, a court should not insert or delete words when the language is plain and free from ambiguity. Id. at 679 , 440 A.2d 411 . Originally, United States obligations were exempt from both federal and state taxation.

In 1917, Congress passed an Act authorizing an additional issue of bonds to help finance the war. Section 11 of the 1917 Act provided “[t]hat any certificates of indebtedness ... issued shall be exempt from all taxes or duties of the United States ... as well as from taxation in any form by or under State, municipal, or local authority____” Act of Sept. 24,1917, ch. 56, § 11, 40 Stat. 288 , (1917). Then Congress, when enacting the Public Debt Act of 1941, removed the federal tax exempt status of United States obligations but made “no change in the existing law with respect to the taxation of Federal securities by the States and their political subdivisions.” H.R. 20, 77th Cong., 1st Sess. at 2-3 (1941); S.R. 41, 77th Cong., 1st Sess. at 3 (1941). As a result of a 1942 amendment, section 4 of the Public Debt Act provided that obligations of the United States should not have any exemption as such “under the Federal tax acts now or hereafter enacted.” Corporate Counsel for the District of Columbia construed the words ⁶²⁰ “Federal tax acts” to include the act of Congress dated July 1,1902 ( 32 Stat. 619 ) that authorized an annual tax upon the gross earnings of national banks in the District of Columbia.

Corporate Counsel concluded that the District may tax, as part of a bank’s gross earnings, interest on obligations issued by the United States. Congress reacted by once again amending the Act in 1947. These changes were designed to make it clear that no other jurisdiction except the federal government was permitted to tax federal securities. H.R. 423, 80th Cong., 1st Sess. at 1-3 (1947), S.R. 275, 80th Cong., 2nd Sess. at 1-4 (1947).

The 1959 amendment to § 3124, which added the second sentence to § 3124(a), was intended to abolish the formalistic inquiry into whether the tax is on a distinct interest (i.e., a property interest or transaction separate from the ownership of federal obligations), and to replace it with the inquiry into whether computation of the tax requires consideration of federal obligations. American Bank and Trust Co. v. Dallas County, 463 U.S. 855, 862 , 103 S.Ct. 3369, 3374 , 77 L.Ed.2d 1072 (1983), reh’g denied 463 U.S. 1250 , 104 S.Ct. 39 , 77 L.Ed.2d 1457 (1983). Under the 1959 amendment “the tax is barred regardless of its form if federal obligations must be considered, either directly or indirectly, in computing the tax.” Id. (emphasis supplied).

Federal obligations are “considered” when they are “taken into account or included in the accounting.” Id.; First Nat. Bank of Atlanta v. Bartow County Bd., 470 U.S. 583, 588 , 105 S.Ct. 1516, 1519 , 84 L.Ed.2d 535 (1985). In American Bank, the Court found that a tax computed by determining the amount of the bank’s capital assets takes into account, at least indirectly, the federal obligations that constitute a part of the bank’s assets. 463 U.S. at 863, 103 S.Ct. at 3377 . Further, the 1959 amendment sought to make “ ‘it clear that both the principal and interest on United States obligations are exempt from all state taxes except nondiscriminatory franchise, etc. taxes’ (emphasis supplied).” American Bank, 463 U.S. at 867, 103 S.Ct. at 3377 (quoting S.Rep. ⁶²¹ No. 909, 86th Cong. 1st Sess., 11 (1959) and H.R.Rep.

No. 1148, 86th Cong., 1st Sess., 12 (1959)). “Congress intended to sweep away formal distinctions and to invalidate all taxes measured directly or indirectly by the value of federal obligations.” Id. “The exemption for federal obligations provided by § 3701 (now § 3124), as amended in 1959, is sweeping: with specific exceptions, it ‘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.’ ” Id. at 862, 103 S.Ct. at 3374 (emphasis supplied). The extent of this exemption was set forth in earlier Supreme Court cases. In New Jersey Realty Title Ins. Co. v. Division of Tax Appeals, 338 U.S. 665, 675 , 70 S.Ct. 413, 418 , 94 L.Ed. 439 (1950), the Supreme Court addressed the issue of “whether in practical operation and effect the tax [on net worth of a corporation, measured by corporate capital and surplus less liabilities] is in part a tax upon federal bonds.” Id. at 673 , 70 S.Ct. at 417 .

The Court noted that the legislative purpose of § 3701, “ ‘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[,]’ Smith v. Davis, 323 US 111, 117 , 89 L Ed 107, 111 , 65 S Ct 157 [160] (1944)”, required the exemption from tax assessment of “interest on federal securities which had accrued but was not yet paid.” Id. at 675-76, 70 S.Ct. at 418-19 . And in People, ex rel., Leonard v. Commissioners of Taxes, etc., of New York, 90 N.Y. 63, 65 , 55 N.Y.S. 812 (1882), the Supreme Court extended the tax exempt status not only to the par value of United States bonds but also to the premium value of the bonds, namely, the actual market value of the bond in excess of the par value. Id. at 65 , 55 N.Y.S. 812 . The court said: When therefore a government loan is put upon the market, it is plain to be seen that it may be materially affected if it were known that, whenever the bonds to be issued should, in the market, from any cause, happen to ⁶²² be at a premium when the assessors came to make their assessment, such premium could be assessed in tax.

Such a tax would affect the value of the bonds and embarrass the government in affecting a loan in the same way, if not in the same degree, that a tax upon the bonds, eo nomine, would. Id. at 66 , 55 N.Y.S. 812 . The Court reasoned that a tax upon the premium, which is not distinct and cannot exist apart from the bond, “would affect the value of the bonds and embarrass the government in effecting a loan in the same way, if not in the same degree, that a tax upon” the principal or interest of the bond would and such a tax on principal and interest is clearly exempted. Id. at 66-67 , 55 N.Y.S. 812 . “The premium is part of the entire value of the bond, and when that is taxed the bond is taxed, or what is equally condemned, the value or a part of the value of the bond is taxed.” Id. at 67 , 55 N.Y.S. 812 .

With that background, we must now examine the tax scheme as it presently exists in Maryland. The calculation of an individual’s Maryland tax liability is based upon that individual’s federal adjusted gross income. Md. Tax-General Code Ann. § 10-203 (previously § 10-204) (1991). The federal adjusted gross income includes interest earned from United States obligations issued after March 1, 1941 but excludes interest on state and local bonds.

See Internal Revenue Code § 103 (1990) and Treas.Reg. § 1.103-4. Whether federal adjusted gross income includes the gain realized upon the sale or transfer of a bond depends on a number of factors, including the type of bond or debt instrument held, when it was issued, and whether the issuer had an intention to call the bond before maturity. See Maxwell MacMillian, Federal Taxes 2nd 1992 Federal Tax Handbook ¶ 1317 (1991). In order to calculate the Maryland adjusted gross income, certain adjustments are made to the federal adjusted gross income amount.

Various items, which are listed in Md. Tax-General Code Ann. §§ 10-204 and 10-205 (previously §§ 10-205 and 10-206) (Supp.1991), are added to the federal ⁶²³ adjusted gross income. Additionally, under Md. Tax-General Code Ann. §§ 10-207 — 10-210 (Supp.1991), several classes of income are subtracted. These subtractions include dividend and interest income from United States obligations (§ 10-207(c)) and the profit realized from the sale or exchange of bonds issued by the State (10 — 207(j)). The net result is that the interest from United States obligations is always taxed by the federal government and never taxed by Maryland.

The gain from sale of United States obligations is sometimes taxed by the federal government and when it is, the amount is included in the federal adjusted gross income and is thereby taxed by the State because there is no provision in Maryland’s code which permits its subtraction from federal adjusted gross income. On the other hand, interest on obligations issued by Maryland are not taxed by either the federal government or the State of Maryland. Gains from the sale of Maryland obligations are sometimes taxed by the federal