Full Text: Transcript Of Oral Argument Before High Court In Nebraska V. Loewenstein.

NEBRASKA DEPARTMENT OF REVENUE,

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The Supreme Court expressed concern over the effect its decision might have on the market when it heard oral arguments October 11 in Nebraska Department of Revenue v. John Loewenstein, concerning taxes on repurchase agreements, according to a transcript of the arguments.

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Washington, D.C.

The above-captioned matter came on for oral argument before the Supreme Court of the United States at 11:06 a.m.

APPEARANCES:

L. JAY BARTEL, ESQ., Assistant Attorney General of Nebraska, Lincoln, Nebraska; on behalf of the Petitioner.

TERRY R. WITTLER, ESQ., Lincoln, Nebraska; on behalf of the Respondent.

(11:06 a.m.)

CHIEF JUSTICE REHNQUIST: We'll hear argument next in Number 93- 823, Nebraska Department of Revenue v. John Loewenstein.

Mr. Bartel. Is that the correct pronunciation of your name?

MR. BARTEL: Yes, Your -- Mr. Chief Justice.

CHIEF JUSTICE REHNQUIST: Mr. Bartel.

ORAL ARGUMENT OF L. JAY BARTEL

MR. BARTEL: Mr. Chief Justice, and may it please the Court:

Section 3124, title 31 of the United States Code, prohibits State taxation of Federal obligations and the interest thereon. This prohibition extends to every form of State taxation that considers in its computation Federal obligations or the interest on Federal obligations.

The question presented in this case is whether Nebraska's taxation of income received by a mutual fund shareholder derived from repurchase agreements involving Federal obligations violates section 3124, repurchase agreements which we believe, in essence, were transactions that in substance were loans between private parties secured by Federal obligations.

The Nebraska supreme court erred in holding that Nebraska's tax violated section 3124. The computation of Nebraska's tax did not consider directly or indirectly either Federal obligations or interest on Federal obligations. The repurchase agreements entered into by the mutual funds which distributed income to Respondent Loewenstein were in essence secured loans in which Federal obligations merely served as collateral.

QUESTION: Could you describe in perhaps a little detail exactly what a typical agreement like this was, and why it was entered into?

MR. BARTEL: Repurchase agreements are called repos for short, and they're in essence contracts involving the simultaneous sale and future repurchase of an asset, usually Treasury securities. Repos generally consist of what is a two-part transaction. In step 1, the party that holds Federal securities, denominated as the seller, transfers the securities to another party, the buyer, in exchange for cash. In this case the buyer would have been the mutual funds.

The second step consists of a contemporaneous agreement by the seller to repurchase the securities at the original sale price, plus an agreed-upon amount of interest in a rate specified in the agreement.

QUESTION: Not dependent on the rate that the security pays?

MR. BARTEL: That is correct, Mr. Chief Justice. The interest paid by the seller is paid on prevailing market rates on loans or financing transactions of similar maturity and risk. In fact, it was stipulated below that the interest paid by the seller on repurchase is less than the interest rate accruing on the underlying obligations. That was in the second stipulation, paragraph 19.

QUESTION: But you could say the same thing about the normal sale of Treasury bonds, couldn't you? If you sell a bond that has a certain maturity price, and if, in fact, rates for other obligations have gone up, the money you get won't depend upon the face interest on the Government obligation. It will depend upon what the market is at the time, won't it?

MR. BARTEL: That is true. Yes, that's correct, Your Honor.

QUESTION: And yet that transaction, you acknowledge, is exempt from taxation, is it not?

MR. BARTEL: Yes. The distinction here, Your Honor, is that the way the repurchase agreement is structured, that the funds in essence are never, the owner is entitled to the Federal exemption. What they receive is interest at a rate agreed to between private parties that really doesn't bear a relation to the interest rate, and more importantly --

QUESTION: Yes, but I'm -- that factor is irrelevant, once you acknowledge that in just a straight sale of a Treasury bond, it -- the amount you pay for it has nothing to do with the interest rate on the face of the bond. It has to do with what the going market is, so I don't see how that's a point for you at all, the fact that the interest rate depends on market rate.

MR. BARTEL: It is in purposes of the overall analyzation, I think, of the nature of the agreements, because what we are contending, again, is that the real substance, the true substance of the agreements is that the mutual funds were not the true owners or substantive owners of the underlying obligations.

QUESTION: Well, what kind of unforeseen consequences would result from our characterization of this as a loan? If there is a bankruptcy by the entity that is acquiring the bonds temporarily, then if it's the owner there would be one consequence, if it was a loan there would be another. What about treating the thing as a loan for purposes of SEC regulation of the sales? I mean, I'm concerned that calling it something here may have some unforeseen consequences.

MR. BARTEL: We are not asking the Court to adopt a secured loan characterization of all repos for all purposes. With respect to your concern with respect to the treatment of the purchase agreements in bankruptcy, Congress has in large part, of course, dealt with that concern by an amendment to the Bankruptcy Code. There may be purposes for securities law transactions to be viewed again as differently.

It's pointed out in the amicus briefs filed by the Investment Company Institute and the Federal Reserve Bank of New York that not all repos are identical to the precise transactions involved in this case.

QUESTION: Are there other instances where something is characterized one way for bankruptcy purposes, yet another way for security purposes, yet another way for tax purposes? Is that -- is it extraordinary to have a different characterization for tax purposes than for other purposes?

MR. BARTEL: I would not think so, although I don't have any ready examples.

I think the mere fact that when you look at repos themselves and that there has been a division of the characterization and treatment, depending upon the purpose served, even the bankruptcy decisions, the Bevill case, that discuss the characterization of repos for tax purposes recognize that there may be different reasons why a rule or a principle of construction should be adopted for tax purposes that is different than the concerns in a bankruptcy context.

And that, in essence, is why we think that the economic substance principle, which has been recognized by Federal courts, construing the exemption of repurchase agreements involving cases construing section 103 of the Internal Revenue Code, which deals with the exemption of interest on State and local obligations, and State court cases that have also relied on the economic substance analysis to look at --

QUESTION: In the respondent's brief, the red brief at about page -- it's at page 26 -- he sets forth a hypothetical transaction where a $10,000 Treasury bill is due in 360 days, and he has a series of hypotheticals, and the first one, of course, is if the taxpayer just holds it for 360 days, and he paid $9,500 for it, he redeems it for $10,000, there's then $500 worth of interest, and all of that is covered by the exemption. Everybody agrees with that.

Do you agree with his second example -- I take it you do -- that if the bill is sold, just as an outright sale, no repo agreement, just an outright sale, 180 days down the road, that the exemption of $500 is given $250 to each holder?

MR. BARTEL: It appears in the hypothetical that what he's dealing with is a short-term Treasury bill that may be an obligation issued with discount. That, to the extent that I believe that is the nature of the hypothetical, that is correct, but we don't --

QUESTION: So that it's correct that if I own a bill for 180 days, a 360-day bill, and I then transfer it to a second holder, we each split the exemption?

MR. BARTEL: I believe under the OID rules under the Federal Income Tax Code there would be -- if you are the actual holder and there is a transfer in substantive owner, then that holder who is a substantive owner is required to report that portion as income, that's correct.

QUESTION: Well, and they each get the exemption under Nebraska law, don't they?

MR. BARTEL: Yes, that's correct.

QUESTION: All right. Now, when we get to the repo transaction, do you agree with the characterization he gives of how the repo transaction works?

MR. BARTEL: No, we do not, Your Honor, because we believe it, again as we explain in our brief, fails to take into account the fact that the funds do not receive exempt interest from the Federal Government.

QUESTION: Under Nebraska law under your theory, if you prevail, will the full $500 of exemption be accorded to someone in this transaction?

MR. BARTEL: We believe that it is accorded to someone in the transaction. It is accorded to the seller- borrower-repurchaser. They are the substantive owner of the obligations, and they're the ones who maintain the entitlement to the exemption.

Now, what respondent seems to be saying is that the fact that most States have a statute which disallows deduction for interest expense incurred to carrier hold the Federal obligation. Now, the seller-borrower may be required to make application of such a statute if it pays interest, to hold or acquire that Federal obligation.

QUESTION: -- Nebraska requires the add-back?

MR. BARTEL: Yes, most States do, that's correct. In fact, I think all States do according to amicus Investment Company Institute.

QUESTION: Well, under Nebraska law in the repo transaction, would the original holder who is the seller- borrower receive under this hypothetical a $500 exemption?

MR. BARTEL: Well, the effect of the add-back provision could be to reduce the economic benefit. They would still receive a $500 exemption, but there may be a requirement to add back, but we don't believe that that is an impairment or a violation of section 3121.

QUESTION: But it does bring up the question that if you're wrong about 3124 and what it requires, it may not follow that Loewenstein or the mutual fund is the person Nebraska would look at to make the cure? What about just not allowing -- not requiring the add-back?

MR. BARTEL: That would be an application to the dealer. It would not be an application --

QUESTION: Yes. If the argument is that what 3124 requires is that every dollar of interest be fully reflected, I suppose Nebraska could do that two ways. One way would be to say, Loewenstein gets the benefit. Another way would be to say this person, whatever we call -- the repoer, some briefs have called it, doesn't have to add back the expense of the financing.

MR. BARTEL: It's our position, of course, that section 3124 doesn't require that result, and we would rely on the Court's decision on First National Bank of Atlanta v. Bartow County.

QUESTION: But would you pick one or the -- would you be -- do you know which one Nebraska would pick if it were required to make that decision?

MR. BARTEL: No, I do not.

QUESTION: That's the key question to me, I mean, these two questions that Justice Kennedy brought up and this. I don't understand this statute, Nebraska 77- 2716(e), which is the add-back.

Now, in order to make this clear, I have to take a second, and I want to use a slightly more realistic example. I mean, you've been arguing is it really a collateralized loan, or is it really a sale? Well, it has some characteristics of each. Is a nectarine really a plum? Is it really a pear? Is it really an -- I mean, it's some of each, or whatever.

All right. Suppose you start there and say, that doesn't solve it. But what might solve it is that the Government, when it issues the bill at an original issue discount, it's easy to figure out what the interest of that is. The IRS does it all the time, and then you allocate it day-by-day, and just say the State can't tax that. Is that right, and if that is right, how does this statute fit into it?

I mean, let me give you -- suppose that the repoer has $1 million of Treasuries, 90-day bills. Let's say they pay $15,000 of interest at 6 percent for 90 days, and suppose what he does is he repos it out to the Ford Motor Company for 1 day, which my calculation says is worth about $167 in interest. That T-bill interest goes right to the repoer.

Now, what the repoer has got is, he's got $1 million in cash for a day, and he's had to pay, say, $150 for it. Does this Nebraska statute mean on his tax return he puts in $167 of tax-free interest, and then reduces that by $150? To me, that's an odd reading of the statute, because I would say the $150 is not an expense of this repo transaction. Rather, it's an expense related to whatever transaction he will engage in with the $1 million cash that he's got.

He might, for example, take in -- I guess that's called a reverse. He takes in $1 million of Treasuries from Solomon Brothers, and what he hopes to do is charge them $152 for that 1-day's use of the million, so he's got $152, subtracts the $152, and it's $2. That's how I'd read that statute of Nebraska.

But they've said, your opponents, that isn't how it's read, the $150 is allocated to the $167, and now I want to know from you, is it, or isn't it?

Have you followed -- have you followed it all right? I'm sorry to be so -- but you see what I'm saying? I'm saying that the payment to Ford, the payment to Ford from the repoer, is a payment for the $1 million in cash that the repoer got. It shouldn't be allocated to the $167 interest on those Treasury bills that are in the hands of Ford for the day. It should be allocated to whatever income that million dollars is used in the hands of the repoer to generate.

Is that the right reading of the statute? If it is, you are only taxing the -- you're not -- you're leaving the whole 10 percent, or whatever it is, free of tax. If it isn't, you're taxing some of it. If it's too complicated to follow, forget it. I'm sorry. I'll have to find out the answer.

The question is, I want to know how this particular statute works, (e).

MR. BARTEL: We attempted to respond in our brief with a response to their example. I hope that's -- that's adequate.

QUESTION: Is part of your response that in respect to how you treat that deal, you treat it just the way the Feds treat municipal and State bonds with respect to the add-back of the expense?

MR. BARTEL: In our view, the Nebraska statute is the counterpart to Internal Revenue Code section 265, which denies interest expense deduction incurred to carry State and local obligations, that's correct.

QUESTION: I thought that that's what the system was. It's exactly tracking what the Feds do.

But how do you treat State and municipal bonds, the same way?

MR. BARTEL: In repo transactions?

QUESTION: Yes.

MR. BARTEL: The Nebraska statute only exempts from State taxation interest earned from ownership of Nebraska-based obligations. It does not, on its face, exempt repo interest attributable to transactions involving Nebraska-based obligations, so it's our position in Nebraska, consistent with our taxation of repo income involving Federal obligations, that that, too, would be subject to Nebraska income tax. There is no discrimination, contrary to the argument that respondent has made.

QUESTION: So you're saying the treatment is the same.

MR. BARTEL: Yes.

QUESTION: Mr. Bartel, I have a problem with your urging us to look at the economic reality of the transaction. I mean, there are various levels of economic reality, I suppose. Certainly one reality is that as a result of this transaction the buyer owns the Treasury bills for, you know, for the period, and that is real. The buyer really owns them, right? Is not the buyer the owner during that period?

MR. BARTEL: We would take the position that it's ownership only in the most nominal sense, bare legal title, if you will. All the true indicia of ownership we don't believe go to the buyer.

If you look at the general repurchase agreement in this case --

QUESTION: Yes, well, you're raising exactly my point. We want to talk about this case. We're going to have to examine these repo agreements one by one to determine what -- you know, what the economic reality of this particular repurchase agreement is. Why isn't it much simpler, for purposes of the administration of the Federal tax law, to say whoever owns them gets the deduction, period, work it out?

MR. BARTEL: The Internal Revenue Code has by ruling adopted various criteria, or it looks at characteristics that can -- are used to determine whether secured loan characterization is appropriate to repurchase agreements involving State and local obligations. Those are referred to in our brief.

Economic substance is important, because we are dealing with a tax matter, and that is the general principle that's been long recognized.

In the context here, we think analyzing economic substance as a standard is appropriate. Now, that may lead to different results if you have different characteristics in other repos, but we're dealing here with a specific type of repo engaged in by the mutual funds. We think the Court can accept the economic substance principle, lay the ground rules, and that will allow parties to --

QUESTION: Lay the ground rules such as what, such as whether the agreement, as in this case, does not give full indicia of ownership?

MR. BARTEL: Yes.

QUESTION: Each case is a different inquiry.

MR. BARTEL: But if parties outside --

QUESTION: It's going to be a very narrow decision you're asking us to write, this just in the circumstances of this particular repo agreement.

MR. BARTEL: Because of the fact that repos can differ so much in nature, I think we'd be hard-pressed to ask for anything else.

QUESTION: To what extent does Nebraska copy, or is it guided by, how the Federal authorities treat repo arrangements? Do you look at these individual -- these different deals on your own, or is there some attempt at conformity?

MR. BARTEL: The revenue ruling at issue simply spoke in terms of repos being deemed secured lendings. It did not establish specific criteria for repos themselves. What rule may be adopted as a result of a decision would obviously depend on that decision.

QUESTION: Is there any interstate cooperation, since many States are your friends in this matter?

MR. BARTEL: In terms of the treatment, it seems that most States tax this income. That's the general consensus you derive from looking at the brief of the amicus State and Local Legal Center, as well as Investment Company Institute.

As to how they do it, whether it's by judicial decision, whether they do it by administrative ruling, there is even some inconsistency with some States saying that they can tax all dividends from mutual fund shareholders. We haven't attempted to do that. We're only looking at that portion which is derived from repurchase agreements.

So I don't know that other States have adopted exactly the same test, but I think they're all urging the Court, the amicus States, to look at economic substance as the test to be applied.

QUESTION: Very bravely I'm going to try this again, since I'm thinking that it seems quite important in my mind as to how the case comes out. The repoer receives the interest on the Treasury bill while the bills are repoed, is that right?

MR. BARTEL: That is correct.

QUESTION: The repoer pays some money to the holder of those bills. That's right?

MR. BARTEL: That is correct.

QUESTION: And you're saying the money he pays is his own payment of interest. It's an expense.

MR. BARTEL: That is correct.

QUESTION: When Nebraska then gets its tax return, you say -- suppose it was $5,000 in interest. He would say $5,000 in interest was tax-free. That's what he'd put at the top.

MR. BARTEL: Yes.

QUESTION: Then he has to -- he then looks at the statue and says, but I paid $4,000. I paid $4,000 to the holder of the bills when they were repoed. Does he have to, in effect, subtract the $4,000 from the $5,000 so he only has $1,000, or does he not?

MR. BARTEL: Again, based on my understanding of the statute, that would be the application, assuming it was a Nebraska --

QUESTION: So the answer to my question is yes, he does have to subtract the $4,000 from the $5,000, as you read the Nebraska statute.

MR. BARTEL: Yes.

QUESTION: And we should assume that's so for purposes of deciding this case?

MR. BARTEL: I don't know that I can say that, I guess, but I'm - - my understanding --

QUESTION: Well, it's important because if the answer is yes, which is the answer you've given, that diminishes the exemption, doesn't it?

MR. BARTEL: No more so than does any State statute which has an add-back like Nebraska's if this were a direct borrowing to obtain the obligation.

In other words, that would require a reading of section 3124 that we think is well beyond what is -- is required by First National Bank of Atlanta. The pro rata deduction --

QUESTION: The question is not whether it's legal to diminish it. The question is, does it diminish it, and the answer is --

MR. BARTEL: Only in an economic sense, is my answer to that, and it's not constitutionally required, and the statute doesn't require that the exemption be handled any differently.

QUESTION: What you are saying is you are essentially treating this like a secured loan? The parties are concerned that you're treating this as though it were a borrowing to finance the purchase of these bills.

MR. BARTEL: Yes. That is in substance what it is. That's how it's --

QUESTION: It would seem to me that the economic sense of it is that if the person who has the cash derived from the collateralized loan, if that's what you want to call it, uses that cash to earn money from, say, a General Motors instrument, or something like that, that that is outside nonexempt income, and that the cost of that is outside expenses that are offset against the outside income, but it doesn't seem to me that your statute does that.

MR. BARTEL: Well --

QUESTION: And if that is so, then it seems to me that the respondents may have a point.

MR. BARTEL: The key, though, is if you look at the exemption statute itself, what is a State precluded from doing? It may not tax -- impose a tax on a Federal obligation, or interest on a Federal obligation, that considers that in its computation. Our --

QUESTION: Yes, but you're asking us to recharacterize the transaction that the parties have -- have engaged in here in an economic sense, so we are simply asking you in an economic sense whether or not the full exemption is being accorded to one or both of the parties under your accounting system, and it seems to me that you're saying well, maybe not.

MR. BARTEL: In an economic --

QUESTION: And that, it seems to me, bears upon the wisdom or the prudence of our allowing you to recharacterize the transaction in the way that you seek to do.

MR. BARTEL: Even if the transaction were characterized as a sale and repurchase, if the funds were the actual owner, then that raises another question. Then is not, if they are the owner and they are reselling the obligation, wouldn't that in essence be gain on sale, which the States have, I think, the authority to tax a gain on sale of a Federal obligation.

So if they are -- it's clear from the agreements that what they're bargaining for is not the interest from the Federal Government, and if it is a real sale, then in actuality what they are getting is gain on sale of that Federal obligation.

If there are no further questions, I would like to reserve any remaining time for rebuttal.

QUESTION: Very well, Mr. Bartel.

Mr. Wittler, we'll hear from you.

ORAL ARGUMENT OF TERRY R. WITTLER

MR. WITTLER: Mr. Chief Justice, may it please the Court:

Since 1862, Federal obligations have been, by statute, exempt from taxation by the States. Nebraska statutes begin by recognizing this exemption by providing a deduction from a Federal adjusted gross income. However, the Nebraska Department of Revenue has adopted an administrative ruling that essentially takes away that exemption in the case of repurchase agreements. That revenue ruling violates the applicable Federal statute and the Supremacy Clause, and the Nebraska supreme court reached the correct ruling when it invalidated that revenue ruling.

The results -- to reach that result, the Revenue Department says that you should disregard the way in which the parties structure their transaction and restructure it to fit their interpretation. The Revenue Department's ruling does not comply with this Court's decision in Frank Lyons, which sets out basically a three-part test for determining whether or not the structure the parties have chosen should be respected.

First of all, that case requires that it be a genuine multiparty transaction with economic substance, secondly, the form of the transaction must be based on business and economic realities, and thirdly, it must be based on tax-independent considerations. It may not have been structured that way solely to avoid tax.

The transactions in this situation, these repurchase agreements, meet each of those three test under Frank Lyons, and accordingly the Government should be required to respect the form in which the parties have chosen to structure their transaction.

QUESTION: Well, do you think the Frank Lyon opinion, Mr. Wittler, was intended as the be-all and end- all for what anybody might do with respect to restructuring a tax transaction to show the economic reality of it?

MR. WITTLER: No, Mr. Chief Justice, I do not think that Frank Lyon was the be-all and end-all. I think, though, that any -- the form that you choose is not determinative in this case.

The way in which you read Frank Lyon, or the way in which you might adjust the holding of Frank Lyon is really not determinative, because the State's position is, we don't look at any of those aspects. We look solely at the so-called economic substance, and that's the only test we apply, and we apply it as we see fit, and we reach the result that we choose.

QUESTION: Well, do you agree that the estimation of the economic substance in this case is a correct one?

MR. WITTLER: Yes, Your Honor, but I think that begs the question, and let me explain why. Economics strives to be value-free. It tries to be value-neutral. The law, on the other hand, is value- driven, it's value-laden, and let me give you some examples of why I think that begs the question. If I have a widget factory, and I hire 12-year- old children, or I hire adults, to an economist, he or she would say, the economic substance of those two transactions is the same. But the law says no, a very different result comes about.

If I hire a salesperson to sell my widgets, and I pay him or her commission, the law says it's deductible. If I pay a bribe to someone to purchase my widgets, the law says that's unlawful. An economist says those two payments are exactly the same for economic substance. The law says, we don't care, we treat them dramatically different.

If I borrow $100,000 for a vacation home, my interest is tax- deductible. If I borrow $100,000, buy an RV to go to exactly the same place for a vacation, it's not tax-deductible.

That's why -- that's the basic fallacy of the State's approach, is to look solely at economic substance.

QUESTION: Well, I'm not sure it is, because if one or the other theories, and I'm not sure which one it is, operates to deprive securities of their economic- exempt status, then the purpose of the statute -- then the purpose of the statute is contravened, and we interpret the law according to the purpose of the statute.

So we do begin by asking what is the economic effect on the market for Federal securities, on the grant or the denial of the full exemption to which the securities are entitled, and we're asking that, and it seems to me the structure of the transaction has a great deal to do with that.

MR. WITTLER: It does, Your Honor, but that -- and that structure is chosen by the parties for reasons independent of the tax considerations, and I think we mentioned in our brief that a significant part of this market, participants in this market, are municipalities, school districts, agencies that pay no tax. They enter into repurchase agreements not for tax reasons, but because of business and regulatory concerns that they have to meet.

And I want to go back just one moment to what I feel is the basic fallacy of the economic analysis. If I loan $10,000 to General Motors, and I loan $10,000 to the United States Treasury, the economic substance of those two transactions is identical.

But Congress has said the $500 that I earn on one is fully taxable, and the $500 on the other is not taxable by the State, and that's what we're here to talk about.

QUESTION: How do you distinguish the situation of the municipal bond and the Federal taxation? Municipal bonds are also exempt, but if we were talking about municipal bonds and the taxing authority is the Federal Government, then I believe that the position of the Government is that the interest -- that the interest to the reserver would be taxable.

But you say -- so explain -- the same kinds of transactions, but on the one hand T-bills and the State taxing authority, and the other hand, municipal bonds and the Federal taxing authority.

MR. WITTLER: Justice --

QUESTION: Why can't Nebraska say, we want to do the same thing that the Feds are doing?

MR. WITTLER: Because Nebraska doesn't have a Supremacy Clause, and the U.S. Congress does, and in the recent case involving South Carolina v. Baker, this Court held that the exemption of municipal bonds interest is statutorily based. It's granted by Congress. It has no constitutional features.

QUESTION: Oh, so you're resting not just -- it's not just what 3124 means, but you're saying the Constitution requires that, so even if Congress was explicit in 3124, and says, and we don't mean that the interest paid to the reverser is not income, that would be unconstitutional?

MR. WITTLER: That's not what I mean to say, Your Honor. If Congress -- if 3124 was repealed tomorrow, we'd still have a problem with the Nebraska approach, because it singles out Federal obligations and doesn't mention State obligations, so it discriminates. But no, our basic position is it's based on the statute.

QUESTION: So you're rejecting what we were just told, that -- we were just told that Nebraska treat State, its obligations the same way, and you're saying it doesn't?

MR. WITTLER: I disagree with that, Your Honor. There is nothing in the record, number 1, to answer that question. I don't know for a fact how they treat them. What I know is that the Department of Revenue apparently thought it necessary to adopt this regulation to reach Federal repo income, and it has not seen fit to adopt a similar regulation to allow it to meet State of Nebraska repo income, so all I know is that there's a ruling that addresses Federal, none that addresses State, and I believe under those circumstances it discriminates.

QUESTION: There has been, so far as I know, no voice from the U.S. side, the Treasury side, in all of this, and you are not exactly in the position of McCulloch in this case.

With all the friends that are appearing, is there any reason why we have not had any position for the United States? If the idea is that 3124 means that you can't have this add-back for the -- why have we heard nothing but silence from the Federal Government?

MR. WITTLER: I can give you a theory, Your Honor. The United States may have an interest on the one hand in seeing that the exemption is preserved, because that reduces costs, borrowing costs to the Treasury, in which case they would side with us, and there may be persons within the United States who are concerned about maintaining the validity of union planners in that line of cases and going after revenue arising from municipal bonds who would be, their interest being with the Nebraska, State of Nebraska.

QUESTION: Could a third possibility be that under either theory the full exemption is allowed and therefore the market is unaffected?

MR. WITTLER: I don't believe so, Your Honor. I think that the way Nebraska has structured its approach, which is a very curious way to do it, it starts with the Federal -- your Federal adjusted gross income, which includes revenue from the United States, because it's taxable at the Federal level.

And then it says, okay, now you can back out your interest on Federal obligations, unless you borrowed some money to help hold those obligations. If you borrowed some money from General Motors or from anybody else, you don't get to back it all out, you just get to back out the part that is offset by a deduction, and that's where we lose the parity with the Federal approach, because the Federal approach --

QUESTION: But that seems to me quite a plausible theory if they deprive you of any of the exemption, because then it works out, and that's the problem I have with your footnote at page 29. It seems to me that you're comparing apples and oranges, or nectarines and peaches, whatever we're using here today. (Laughter.)

MR. WITTLER: No, Your Honor, I don't believe I am, because the statute says, their position is, even though I've loaned -- I've sold these to somebody else, I really own them. If I really own them, I must -- but yet I'm paying interest to somebody, I must be paying that interest to carry the obligations.

In other words, I own the obligations. I'm carrying them, even though I've loaned them out, and that is what 2716(1)(e) says. If you've paid that interest to carry those obligations, we're going to take away your Federal exemption, we're going to narrow it down, chew it down, and that's where the loss comes in.

QUESTION: Well, if you disregard Nebraska's add-back to the borrower's interest expense deduction, does the borrower otherwise get the full benefit?

MR. WITTLER: Yes. If you disregard the statute that says you don't get the full benefit, you do get the full benefit, that's absolutely true, and the reasons go back to an earlier question --

QUESTION: Then why should Loewenstein or the mutual funds prevail in any event? Why isn't the flaw, if there be a flaw, that the add-back -- if -- your theory about what 3124 requires doesn't mean that Loewenstein has to be the one to get the tax benefit. It could be the repoer by not charging him with the add-back.

MR. WITTLER: I agree that at a Federal level, in terms of the statutory scheme, you're right, and as long as somebody gets it, the statute's complied with. The problem, and the reason why you have to be careful how you draft a statute to achieve that result, goes back to this Court's holding in Denman v. Slayton back in 1930.

If you allow people to simply pass the obligation back and forth by borrowing to buy exempt obligations, then you face a situation where I've got $10,000 in salary income, and I decide I'm going to go out to my local bond dealer, borrow $10,000 worth of securities, or borrow $100,000 worth of securities, pay them $10,000 in interest, receive $10,000 from the Government, offset the two, bingo, I pay no tax. Not only do I not pay tax on the interest-free income, but I've got a nice deduction for interest that I can offset against my salary, and I wash my hands. I pay no interest.

That's why the scheme of 265 was developed, and that's why you've got to have an offset one place and add back another. It makes a difference from a tax equity point of view.

QUESTION: You know, Mr. Wittler, it seems to me that we dealt with an aspect of this argument in the Bartow County Board of Tax Assessors case, where the Court said that the tax exemption required by the Constitution and section 3124 is not a tax shelter, and Federal obligations may be acquired in part by liabilities, and when they are, a pro rata method of allocating a fair share to the liabilities doesn't infringe on the immunity. And it seems to me your argument runs somewhat counter to what the Court said in Bartow --

MR. WITTLER: Justice --

QUESTION: -- that you don't have to have out there somewhere the full exemption, that if there -- if you borrow money, and you have to offset the cost of that to engage in the purchase of the Federal obligations, you lose some of the exemption. I thought that's what this Court said.

MR. WITTLER: Bartow County dealt with a net worth tax, and a net worth, the net worth is an abstraction. It's not a tax of your assets. It's not a tax against your liabilities.

What the taxpayer wanted to do in Bartow County was say, I've got these nontaxable assets, I've got these liabilities, they cancel each other out, and what I have left is tax exempt. What the taxing authority wanted to do was just reverse it and say, no, we're going to offset your liabilities against your exempt obligations, and everything you've got that's left is fully taxable, and the compromise was, realistically, was to say no, we have to offset them. We have to have them be pro rata, and the tax exempt can bear their fair share of the burden.

Here, the State is saying no, not only are you not going to get a double benefit, you're not going to get any benefit. We're going to treat you just like if you'd gone out and bought a fully taxable obligation for General Motors or anybody else.

That's realistically the only reason that the State Department of Revenue adopts a ruling like this, is to earn some money for the State, and if you run through the arithmetic, they will increase their revenues by exactly the amount of repurchase revenue they recapture, and to take my example of the total of $500 in interest that the Federal Treasury writes a check for, it slowly disappears, the more and more people down the road who have repurchase obligations, and that's why it's basically a violation of the statutes.

QUESTION: That's -- I want to go back, if I can, to Justice Kennedy's -- it's the same question I think many of us have. It starts with your footnote, and it -- I'm thinking of the $1 million in Treasury bills. Say they issue for $985,000, as there's $15,000 you might call an original issue discount. That's the interest. And suppose you start with the proposition that that $15,000 is the amount the State shouldn't tax --

MR. WITTLER: Right.

QUESTION: -- forgetting how you characterize it. They can have any kind of system they want, within limits, as long as they don't get at that $15,000. Now, you've continuously said, and you do that in your footnote, that it's that statute we've been talking about that requires an add-back of some kind. You know what I'm thinking.

MR. WITTLER: Yes, I do.

QUESTION: But as I read that statute, it doesn't. As I read that statute, it only requires an add back of costs incurred to carry the bonds.

MR. WITTLER: That's right.

QUESTION: Well, you're not carrying the bonds when you've repoed the bonds out to General Motors. General Motors is carrying the bonds. Rather, you've got $1 million --

MR. WITTLER: I agree --

QUESTION: -- and you're going to use -- you've got $1 million because they have your bonds for a day and you have their million for the day, and so the money that you're paying to General Motors for the 1-day's loan of the Treasury bills, so you get the million, is not a cost of the Treasury's bills. It's a cost of whatever income you use that million in your hands to get.

So that's why I read the statute, as I read it according to its language, as not infringing on the $15,000, but I have to admit you've told me it infringes on the $15,000, and they seem to concede the point, and there doesn't seem to be a finding by the Nebraska supreme court on the matter, and therefore I don't know what to do.

That's my question. (Laughter.)

MR. WITTLER: Well, you can affirm the Nebraska supreme court. But --

QUESTION: Thank you. (Laughter.)

MR. WITTLER: Your Honor, if you adopt their position that we --

QUESTION: No, I'm -- what I'm interested in is that narrow statute that talks about adding back the expenses of carrying the Treasury bills. If I take it literally -- I don't want to just repeat myself, but if I take it literally, you wouldn't add it back, because it isn't a cost of carrying the Treasury bills, which during the repo are in the hands of the person to whom you have repoed them. Rather, it is a cost of whatever income you use the money you "borrowed" to earn.

MR. WITTLER: But Your Honor, this language --

QUESTION: So you wouldn't add it back.

MR. WITTLER: -- tracks section 265, and there is extensive litigation history about how you decide whether you add it back in or not, and the cases consistently take the position that with repos you add it back in.

QUESTION: All right. Then you're right. If that's what happens, you add it back in, and if in fact you had a 90-day bill, and what you did was, you gave it to 90 different people for a day, you would discover there was virtually no interest that wasn't taxed.

MR. WITTLER: That's right.

QUESTION: That's what your point is.

MR. WITTLER: That's our position.

QUESTION: Yes. All right, got it.

QUESTION: But then this entire case, this entire controversy comes up because -- because of the requirement of the add-back. In other words, if Nebraska didn't have that requirement, you would have no case, Loewenstein would have no case, is that right? Nevada --

MR. WITTLER: No, Your Honor. The -- it's a two-step add-back. We start at the Federal level, where the income is included, because Federal law says --

QUESTION: Let's just --

MR. WITTLER: Yes.

QUESTION: -- focus on this part about the add- back that the repoer has to do under Nebraska law. If Nebraska didn't require that, you'd have no case, is that correct?

MR. WITTLER: Well, I'd have no case, but I'd also owe no tax. I would have gotten an exemption.

QUESTION: How would you have gotten the exemption? Isn't it -- if Nebraska -- you, I thought, are arguing for Loewenstein --

MR. WITTLER: Yes, ma'am.

QUESTION: -- not the repoer.

MR. WITTLER: That's right.

QUESTION: Okay. The repoer doesn't get all the interest, and doesn't have to add back any -- any offsetting cost of borrowing for whatever the borrowing is for --

MR. WITTLER: All right. I'm sorry.

QUESTION: -- so every dollar is accounted for, but the repoer gets it all.

MR. WITTLER: Right.

QUESTION: And the reverser gets interest income.

MR. WITTLER: Right.

QUESTION: If that's the position that Nebraska took, there would be no argument under 3124, and Loewenstein would lose, is that --

MR. WITTLER: That's right, but Loewenstein would know that he was going to lose, and he would say to the repoer, I'm not going to cut the deal that I cut with you last year, because now I know I'm going to have to pay tax on it, so now I want more money, because I'm going to have to pay tax.

QUESTION: If I'm right about Nebraska having a choice, if what they're doing is not permissible, then they have a choice.

MR. WITTLER: Yes.

QUESTION: And why should a court, a Federal court, make that choice for them?

MR. WITTLER: Because the -- they have a choice only in the sense they have to do it the constitutional way.

QUESTION: Yes, but you told me the Constitution doesn't care about whether the repoer or the reverser gets the benefit.

MR. WITTLER: I'm saying somebody has to get it. They've said nobody gets it. If --

QUESTION: But if they -- even if -- even if that -- even if you would prevail on that point, somebody gets it, what authority does this Court have to say which somebody it should be?

MR. WITTLER: It hasn't. I think no authority. I think all it can do is interpret 3124, that says, somebody gets it, and Nebraska says nobody gets it.

QUESTION: But it seems to me --

MR. WITTLER: And that violates the Supremacy Clause.

QUESTION: But it seems to me quite plausible for Nebraska to say that you don't get it, because by your contract, you pay all of the Federal interest back. Loewenstein pays all of the Federal interest back to the original holder.

MR. WITTLER: But as --

QUESTION: And if --

MR. WITTLER: -- I pointed out, money is fungible. That doesn't make any difference. We could redraft the contract tomorrow to say it's cut the other way, and the net effect is the same.

QUESTION: Well, that might make a difference.

QUESTION: Well, suppose -- think about it in terms of a zero coupon bond, and there's just one coupon that's clipped at the end of the line, and that's the person that gets the interest, and in the meantime there's a repo transaction, and -- and the dealer transfers the Federal obligation to the repoer, and the repoer has to pay -- pays the money over and receives interest for that, which is not the interest on the Federal obligation.

I mean, why cannot the State tax that interest quite properly, and then at the end of the line, whoever owns, presumably the dealer by that time, the bond with the coupon will clip the coupon, get the interest, and get the deduction?

MR. WITTLER: First of all, Your Honor, Nebraska law incorporates by reference that tax law. Even if it didn't, 31 U.S.C. 3124(b) says, in determining the tax status of interest, we look at Federal law. Federal law has made a policy decision that we're going to prorate that zero coupon interest over a period of time, and I don't know, but I presume the reason is because otherwise people could wait till the day before that comes due, run out, buy it, say, "Even though I've only earned this 30-year bond 1 day, all of the interest in this last payment is mine," and that leads to the sort of tax manipulation that the Court found unacceptable in the Frank Lyon case.

But here, the basic principle is that somebody has to get tax exempt interest income according to the statute, and under the law of the State of Nebraska, they have tried to take away at least a portion of that exemption.

QUESTION: Well, but -- this is just repeating Justice Ginsburg's question, but I still don't understand your answer to it.

Granted what you've just said, that they've taken away the interest income, somebody's entitled to get it, don't you have more of a case to make than that?

Don't you have to show that your client is entitled to get it, and all we can say is, somebody's entitled to get it? Why does that mean that you win? I mean, you're claiming --

MR. WITTLER: Because --

QUESTION: You're claiming that Nebraska has to give it to your client, not to the repoer. Why is that? Whereas all you come before us and say is, Nebraska has to give it to either my client or the repoer.

MR. WITTLER: Because Nebraska has said, in a separate statute, Mr. Repoer, you clearly don't get it. We're not going to give it to you because you've entered into a repurchase arrangement, and you've been paying out interest over time. We're not going to let you get the deduction. They've taken that position. If that's their position, then I say somebody's got to get it, and my guy was the one who should have got it, and you can work through the arithmetic in the statute to show why he should have.

QUESTION: So we just decided, in effect, on the hypothetical, we assume that the repoer doesn't get it, and therefore you're left.

MR. WITTLER: Your Honor, with all due respect, I don't think it's a hypothetical. It's simply, the literal language of the statute says --

QUESTION: Is it clear under the statute that the repoer doesn't get it?

MR. WITTLER: I believe it's clear, yes, Your Honor.

QUESTION: Is it clear under the statute that your client doesn't get it?

MR. WITTLER: It's clear under the revenue rule that my client doesn't get it. The statute does not address that.

QUESTION: Whereas the statute does address the repoer? I mean, it seems to me the uncertainty stems from revenue rulings under both, doesn't it?

MR. WITTLER: No, sir. There's a statute that talks about taking interest deductions, and there's a statute that talks about excluding Federal obligations.

QUESTION: Yes, but isn't it true that although the -- let's assume there's $600 of Federal interest, and $500 of interest paid to the buyer-lender. Now, the $500 doesn't reduce the amount of the Government interest that's exempt from tax, but is it not available as an ordinary deduction for interest payments in connection with what the person wanted to use the money for? He does get the benefit from it in a different form, does he not?

MR. WITTLER: He gets the same benefit, Your Honor, that he would have gotten if he bought a fully taxable obligation.

QUESTION: Right.

MR. WITTLER: He gets an interest deduction.

QUESTION: But he does therefore get the benefit of the deduction.

MR. WITTLER: Yes, but that has nothing to do with the fact that it was a taxable or nontaxable --

QUESTION: Instead of treating it as $600 of tax-free income, he treats it as $100 of tax-free income and a $500 deduction from your gross income, which brings you out to the same figure.

MR. WITTLER: But where did the -- where did the other $500 go? That's the question.

QUESTION: Well, the other $500 is income to the person who lent the money. The $500 is interest to the buyer-lender.

MR. WITTLER: But then we have two people who have gotten $500, Your Honor.

QUESTION: No. One of them's a deduction, one of them's income. It's true that -- I understand what you're saying about changing the character of it. It's not Federal income exempt from taxation under the statute, but the $500 is a business expense, I should think, because it's the cost of borrowing that money.

MR. WITTLER: It's a business expense, and it goes against the tax-exempt income, except --

QUESTION: Well, but it brings you down to the same amount of taxable income, it seems to me. Maybe I'm missing something.

MR. WITTLER: No, Your Honor. I agree, for one party to the transaction, he gets a deduction-free interest payment, just like he'd get whether he's dealing in taxable or tax-exempt obligations, and he gets a little, tiny exemption for what's left over, the difference between the $500 and $600. He gets $100. But no -- the remainder paid by the Federal Government goes to somebody else who now becomes fully taxable, and that's the evil in the approach the State of Nebraska takes.

QUESTION: So could we do this, could we say, suppose you said, look, the States have to respect $15,000 of the original issue discount, and they have a lot of leeway as to how they do it, but they have to respect it. One way they could do it here is, they could say, the repoer gets the $15,000, gets the whole thing, and doesn't deduct this as a cost. Another way they could do it is give it to their -- your client. We don't know how Nebraska does it. We send it back to the Nebraska supreme court and tell them to decide Nebraska law and how it works out consistent with the principle. Could we do that?

MR. WITTLER: You certainly could do that, Your Honor, but the Federal law says --

QUESTION: *

MR. WITTLER: -- it will be governed by the Internal Revenue Code, and the Internal Revenue Code explains how we allocate these payments that occur over time, so -- and Nebraska law then incorporates by reference the Federal Internal Revenue Code, so it wouldn't advance us a great deal.

QUESTION: Yes, but if you're going by the Code you'd say, fine, you allocate the original issue discount day by day, but I don't know that the Federal Code would require giving days 3 to the repoer, or to the person who's holding the security, say, Ford Motor, or General Motors. I don't see anything in the Code that tells you the answer to that question.

The natural thing, if it's --

MR. WITTLER: Thank you.

QUESTION: Thank you, Mr. Wittler.

Mr. Bartel, you have 3 minutes remaining.

REBUTTAL ARGUMENT OF L. JAY BARTEL

MR. BARTEL: Again, may it please the Court: It seems that the issue in respondent's argument is focused on the validity of the add- back provision which Nebraska and apparently other States have.

We believe the validity of the add-back provision was established by the Court's decision in First National Bank of Atlanta v. Bartow County, and if that is the only argument that they have to present, we think that the Court can certainly reverse the decision of the court below.

QUESTION: I have just one question about why Nebraska is not taking the position that California and some other States have taken that all of this is beside the point, because what Loewenstein receives is simply a taxable dividend from the mutual fund.

MR. BARTEL: Of course, that's largely a policy question. Our Department of Revenue simply, in looking at the cases, I suppose, from the other States, saw that the trend was to allow the pass- through of interest income earned by direct ownership of Federal obligations.

We have not raised the issue, but I assume it's based on the trend in those decisions, but, of course, our position isn't binding on what other States may attempt.

There's been no decision, obviously, by this Court on that question.

CHIEF JUSTICE REHNQUIST: Thank you, Mr. Bartel. The case is submitted.

(Whereupon, at 12:04 p.m., the case in the above-entitled matter was submitted.)