UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED
MANAGEMENT INVESTMENT COMPANIES
Investment Company Act file number | 811-04020 | |||||||
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Morgan Stanley California Tax-Free Income Fund | ||||||||
(Exact name of registrant as specified in charter) | ||||||||
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1221 Avenue of the Americas, New York, New York |
| 10020 | ||||||
(Address of principal executive offices) |
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Ronald E. Robison | ||||||||
(Name and address of agent for service) | ||||||||
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Registrant’s telephone number, including area code: | 212-762-4000 |
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Date of fiscal year end: | December 31, 2006 |
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Date of reporting period: | December 31, 2006 |
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Item 1 - Report to Shareholders
Welcome, Shareholder:
In this report, you'll learn about how your investment in Morgan Stanley California Tax-Free Income Fund performed during the annual period. We will provide an overview of the market conditions, and discuss some of the factors that affected performance during the reporting period. In addition, this report includes the Fund's financial statements and a list of Fund investments.
This material must be preceded or accompanied by a prospectus for the fund being offered.
Market forecasts provided in this report may not necessarily come to pass. There is no assurance that the Fund will achieve its investment objective. The Fund is subject to market risk, which is the possibility that market values of securities owned by the Fund will decline and, therefore, the value of the Fund's shares may be less than what you paid for them. Accordingly, you can lose money investing in this Fund. Please see the prospectus for more complete information on investment risks.
Fund Report
For the year ended December 31, 2006
Total Return for the 12 Months Ended December 31, 2006 | |||||||||||||||||||||||
Class A | Class B | Class C | Class D | Lehman Brothers California Exempt Index1 | Lipper California Municipal Debt Funds Index2 | ||||||||||||||||||
4.64 | % | 4.81 | % | 4.12 | % | 4.90 | % | 5.13 | % | 5.01 | % |
The performance of the Fund's four share classes varies because each has different expenses. The Fund's total returns assume the reinvestment of all distributions but do not reflect the deduction of any applicable sales charges. Such costs would lower performance. See Performance Summary for standardized performance and benchmark information.
Because Class B shares incurred lower expenses under the 12b-1 Plan than did Class A shares for the fiscal period ended December 31, 2006, the total operating expense ratio for Class B shares was lower and, as a result, the performance of Class B shares was higher than that of the Class A shares. There can be no assurance that this will continue to occur in the future as the maximum fees payable by Class B shares under the 12b-1 Plan are higher than those payable by Class A shares.
Market Conditions
The Federal Open Market Committee (the "Fed") responded to solid economic growth in the first half of 2006 by raising the federal funds target rate a total of 100 basis points in four separate moves, bringing it to 5.25 percent by the end of June. Slower economic growth in the second half of the year, due primarily to the contraction in the residential real estate sector, prompted the Fed to leave its target rate unchanged for the remainder of the period.
Long-term municipal bond yields rose modestly in the first half of the year, with representative yields on 30-year AAA-rated municipal bonds increasing from 4.40 percent in December 2005 to 4.65 percent in July. In the months that followed, the stabilization of Fed monetary policy led long-term municipal rates to reverse course, declining to a low of 3.90 percent in November before ending the year at 4.10 percent. In contrast, shorter-term municipal bond yields continued to reflect earlier Fed rate hikes. Representative yields on two-year AAA municipal bonds followed the Fed's lead during the first six months of the period, increasing from 3.20 percent to 3.50 percent, and remained basically unchanged for the rest of the year. Accordingly, the spread between long-term and short-term municipal yields, which had been in the 100-120 basis point range in the first half of the year, narrowed to 50-60 basis points, causing the slope o f the municipal yield curve to dramatically flatten. Many investors continued to favor the higher income of lower-rated issues, and quality spreads remained tight.
Although municipal bond issuance in 2006 lagged that of the previous year, declining interest rates in the fourth quarter of the year spurred a rebound in issuance. New issue volume in 2006 of $383 billion was one of the highest on record, and was only six percent below 2005's record pace. Bonds backed by insurance maintained a 50 percent market share. The State of California remained one of the country's largest municipal bond issuers, though overall new issue volume for the year was 16 percent lower than in 2005.
Despite low interest rates, institutional investors and non-traditional buyers such as hedge funds and arbitrage
2
accounts continued to purchase municipal bonds. The strong demand helped municipal bonds outperform Treasuries for the year. The 30-year municipal-to-Treasury yield ratio, which measures the relative attractiveness of these two sectors, declined from 97 to 85 percent during the year, indicating that municipals outperformed Treasuries while at the same time becoming richer (less attractive) on a relative basis. As a comparison, this yield ratio reached a high of 102 percent in 2005.
California's economic and fiscal recovery continued during the reporting period. Stronger-than-expected personal income tax receipts contributed to growth in revenues, some of which, however, was offset by softer-than-expected corporate tax and sales receipts. With the exception of the real estate sector, job growth, wages and business earnings in most California industries remained healthy and, as of year end, the state's unemployment rate stood at 4.6 percent, down from 5.1 percent one year earlier.
Performance Analysis
Morgan Stanley California Tax Free Income Fund underperformed the Lehman Brothers California Exempt Index and the Lipper California Municipal Debt Funds Index for the 12 months ended December 31, 2006, assuming no deduction of applicable sales charges.
During the year, the Fund's interest-rate posture continued to be influenced by the risk of higher interest rates. As such, the Fund's option-adjusted duration* was conservatively positioned and at year end, stood at 6.8 years. This duration strategy helped total returns at the beginning of the period, but tempered returns later in the year when rates declined. Purchases during the period favored bonds with maturities of 20 years or longer. The Fund benefited from this emphasis on the long end of the yield curve, as this segment of the market performed strongly.
The Fund maintained its high quality bias with nearly 90 percent of the portfolio rated A or better. However, exposure to investment grade bonds rated BBB was modestly increased, which had a positive impact on performance as lower-rated issues outperformed higher-quality bonds. Another boost to performance came from issues that appreciated when they were prerefunded. Reflecting a commitment to diversification, the Fund's net assets of approximately $509 million were invested among 12 long-term sectors and 59 credits. As of the close of the period, the Fund's largest allocations were to the water & sewer, transportation and health care sectors.
There is no guarantee that any sectors mentioned will continue to perform as discussed herein or that securities in such sectors will be held by the Fund in the future.
* A measure of the sensitivity of a bond's price to changes in interest rates, expressed in years. Each year of duration represents an expected 1 percent change in the price of a bond for every 1 percent change in interest rates. The longer a bond's duration, the greater the effect of interest-rate movements on its price. Typically, funds with shorter durations perform better in rising-interest-rate environments, while funds with longer durations perform better when rates decline.
3
TOP FIVE SECTORS | |||||||
Water & Sewer | 20.0 | % | |||||
Transportation Facilities | 15.8 | ||||||
Hospital | 15.7 | ||||||
General Obligation | 9.4 | ||||||
Educational Facilities | 7.8 | ||||||
LONG-TERM CREDIT ANALYSIS | |||||||
Aaa/AAA | 67.1 | % | |||||
Aa/AA | 4.5 | ||||||
A/A | 17.1 | ||||||
Baa/BBB | 10.8 | ||||||
NR | 0.5 |
Data as of December 31, 2006. Subject to change daily. All percentages for top five sectors are as a percentage of net assets and all percentages for long-term credit analysis are as a percentage of total long-term investments. These data are provided for informational purposes only and should not be deemed a recommendation to buy or sell the securities mentioned. Morgan Stanley is a full-service securities firm engaged in securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.
Investment Strategy
The Fund will normally invest at least 80 percent of its net assets in securities that pay interest exempt from federal and California state income taxes. The Fund's "Investment Adviser," Morgan Stanley Investment Advisors Inc., generally invests the Fund's assets in investment grade, California municipal obligations. Municipal obligations are bonds, notes or short-term commercial paper issued by state governments, local governments or their respective agencies.
For More Information About Portfolio Holdings
Each Morgan Stanley fund provides a complete schedule of portfolio holdings in its semiannual and annual reports within 60 days of the end of the fund's second and fourth fiscal quarters. The semiannual reports and the annual reports are filed electronically with the Securities and Exchange Commission (SEC) on Form N-CSRS and Form N-CSR, respectively. Morgan Stanley also delivers the semiannual and annual reports to fund shareholders and makes these reports available on its public web site, www.morganstanley.com. Each Morgan Stanley fund also files a complete schedule of portfolio holdings with the SEC for the fund's first and third fiscal quarters on Form N-Q. Morgan Stanley does not deliver the reports for the first and third fiscal quarters to shareholders, nor are the reports posted to the Morgan Stanley public web site. Y ou may, however, obtain the Form N-Q filings (as well as the Form N-CSR and N-CSRS filings) by accessing the SEC's web site, http://www.sec.gov. You may also review and copy them at the SEC's public reference room in Washington, DC. Information on the operation of the SEC's public reference room may be obtained by calling the SEC at (800) SEC-0330. You can also
4
request copies of these materials, upon payment of a duplicating fee, by electronic request at the SEC's e-mail address (publicinfo@sec.gov) or by writing the public reference section of the SEC, Washington, DC 20549-0102.
Householding Notice
To reduce printing and mailing costs, the Fund attempts to eliminate duplicate mailings to the same address. The Fund delivers a single copy of certain shareholder documents, including shareholder reports, prospectuses and proxy materials, to investors with the same last name who reside at the same address. Your participation in this program will continue for an unlimited period of time unless you instruct us otherwise. You can request multiple copies of these documents by calling (800) 350-6414, 8:00 a.m. to 8:00 p.m., ET. Once our Customer Service Center has received your instructions, we will begin sending individual copies for each account within 30 days.
5
Distribution by Maturity
(% of Long-Term Portfolio) As of December 31, 2006
Weighted Average Maturity: 17 Years(a)
(a) Where applicable maturities reflect mandatory tenders, puts and call dates.
Portfolio structure is subject to change.
6
Call and Cost (Book) Yield Structure
(Based on Long-Term Portfolio) As of December 31, 2006
Years Bonds Callable—Weighted Average Call Protection: 6 Years
Cost (Book) Yield(b)—Weighted Average Book Yield: 5.3%
(a) May include issues initially callable in previous years.
(b) Cost or "book" yield is the annual income earned on a portfolio investment based on its original purchase price before the Fund's operating expenses. For example, the Fund is earning a book yield of 5.6% on 4% of the long-term portfolio that is callable in 2007.
Portfolio structure is subject to change.
7
Performance Summary
Performance of $10,000 Investment—Class B
8
Average Annual Total Returns—Period Ended December 31, 2006 | |||||||||||||||||||||||||||||||||||
Symbol | Class A Shares* (since 07/28/97) CLFAX | Class B Shares** (since 07/11/84) CLFBX | Class C Shares† (since 07/28/97) CLFCX | Class D Shares†† (since 07/28/97) CLFDX | |||||||||||||||||||||||||||||||
1 Year | 4.64% 0.19 | 3 4 | 4.81% (0.19) | 3 4 | 4.12% 3.12 | 3 4 | 4.90% — | 3 | |||||||||||||||||||||||||||
5 Years | 4.99 4.08 | 3 4 | 5.02 4.70 | 3 4 | 4.41 4.41 | 3 4 | 5.19 — | 3 | |||||||||||||||||||||||||||
10 Years | — — | 4.94 4.94 | 3 4 | — — | — — | ||||||||||||||||||||||||||||||
Since Inception | 4.76 4.28 | 3 4 | 6.92 6.92 | 3 4 | 4.26 4.26 | 3 4 | 5.02 — | 3 |
Performance data quoted represents past performance, which is no guarantee of future results and current performance may be lower or higher than the figures shown. For most recent month-end performance figures, please visit www.morganstanley.com or speak with your Financial Advisor. Investment returns and principal value will fluctuate and fund shares, when redeemed, may be worth more or less than their original cost. The graph and table do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Performance for Class A, Class B, Class C, and Class D shares will vary due to differences in sales charges and expenses.
* The maximum front-end sales charge for Class A is 4.25%.
** The maximum contingent deferred sales charge (CDSC) for Class B is 5.0%. The CDSC declines to 0% after six years.
† The maximum contingent deferred sales charge for Class C is 1.0% for shares redeemed within one year of purchase.
†† Class D has no sales charge.
(1) The Lehman Brothers California Exempt Index tracks the performance of California issued municipal bonds rated at least Baa or BBB by Moody's Investors Service, Inc. or Standard & Poor's Corporation, respectively and with maturities of 2 years or greater. The index is unmanaged and its returns do not include any sales charges or fees. Such costs would lower performance. It is not possible to invest directly in an index.
(2) The Lipper California Municipal Debt Funds Index is an equally weighted performance index of the largest qualifying funds (based on net assets) in the Lipper California Municipal Debt Funds classification. The Index, which is adjusted for capital gains distributions and income dividends, is unmanaged and should not be considered an investment. There are currently 30 funds represented in this Index.
(3) Figure shown assumes reinvestment of all distributions and does not reflect the deduction of any sales charges.
(4) Figure shown assumes reinvestment of all distributions and the deduction of the maximum applicable sales charge. See the Fund's current prospectus for complete details on fees and sales charges.
‡ Ending value assuming a complete redemption on December 31, 2006.
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Expense Example
As a shareholder of the Fund, you incur two types of costs: (1) transaction costs, including sales charges (loads) on purchase payments and redemption fees; and (2) ongoing costs, including advisory fees; distribution and service (12b-1) fees; and other Fund expenses. This example is intended to help you understand your ongoing costs (in dollars) of investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds.
The example is based on an investment of $1,000 invested at the beginning of the period and held for the entire period 07/01/06 – 12/31/06.
Actual Expenses
The first line of the table below provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you invested, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading entitled "Expenses Paid During Period" to estimate the expenses you paid on your account during this period.
Hypothetical Example for Comparison Purposes
The second line of the table below provides information about hypothetical expenses based on the Fund's actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund's actual return. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period. You may use this information to compare the ongoing cost of investing in the Fund and other funds. To do so, compare this 5% hypothetical example with the 5% hypothetical examples that appear in the shareholder reports of the other funds.
Please note that the expenses shown in the table are meant to highlight your ongoing costs only and do not reflect any transactional costs, such as sales charges (loads) and redemption fees. Therefore, the second line of the table is useful in comparing ongoing costs, and will not help you determine the relative total cost of owning different funds. In addition, if these transactional costs were included, your costs would have been higher.
Beginning Account Value | Ending Account Value | Expenses Paid During Period * | |||||||||||||
07/01/06 | 12/31/06 | 07/01/06 – 12/31/06 | |||||||||||||
Class A | |||||||||||||||
Actual (4.52% return) | $ | 1,000.00 | $ | 1,045.20 | $ | 4.48 | |||||||||
Hypothetical (5% annual return before expenses) | $ | 1,000.00 | $ | 1,020.82 | $ | 4.43 | |||||||||
Class B | |||||||||||||||
Actual (4.67% return) | $ | 1,000.00 | $ | 1,046.70 | $ | 3.71 | |||||||||
Hypothetical (5% annual return before expenses) | $ | 1,000.00 | $ | 1,021.58 | $ | 3.67 | |||||||||
Class C | |||||||||||||||
Actual (4.24% return) | $ | 1,000.00 | $ | 1,042.40 | $ | 7.05 | |||||||||
Hypothetical (5% annual return before expenses) | $ | 1,000.00 | $ | 1,018.30 | $ | 6.97 | |||||||||
Class D | |||||||||||||||
Actual (4.73% return) | $ | 1,000.00 | $ | 1,047.30 | $ | 3.20 | |||||||||
Hypothetical (5% annual return before expenses) | $ | 1,000.00 | $ | 1,022.08 | $ | 3.16 |
* Expenses are equal to the Fund's annualized expense ratios of 0.87%, 0.72%, 1.37% and 0.62% for Class A, Class B, Class C and Class D shares, respectively, multiplied by the average account value over the period, multiplied by 184/365 (to reflect the one-half year period). If the Fund had borne all of its expenses, the annualized expense ratios would have been 0.91%, 0.76%, 1.41% and 0.66%, for Class A, Class B, Class C and Class D shares, respectively.
Because Class B shares incurred lower expenses under the 12b-1 Plan than did Class A shares for the six months ended December 31, 2006, the total operating expense ratio for Class B shares was lower and, as a result the performance of Class B shares was higher than that of the Class A shares. There can be no assurance that this will continue to occur in the future as the maximum fees payable by Class B shares under the 12b-1 Plan are higher than those payable by Class A shares.
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Morgan Stanley California Tax-Free Income Fund
Portfolio of Investments n December 31, 2006
PRINCIPAL AMOUNT IN THOUSANDS | COUPON RATE | MATURITY DATE | VALUE | ||||||||||||||||
California Tax–Exempt Municipal Bonds (100.5%) | |||||||||||||||||||
General Obligation (9.4%) | |||||||||||||||||||
California, | |||||||||||||||||||
$ | 5,000 | Ser 1990 | 7.00 | % | 08/01/08 | $ | 5,258,050 | ||||||||||||
2,000 | Veterans Ser AT | 9.50 | 02/01/10 | 2,324,420 | |||||||||||||||
535 | Various Purpose Dtd 04/01/93 (FSA) | 5.50 | 04/01/19 | 537,434 | |||||||||||||||
5,000 | Various Purpose Dtd 04/01/02 | 6.00 | 04/01/19 | 5,958,300 | |||||||||||||||
3,210 | Ser 1996 (Ambac) | 5.25 | 06/01/21 | 3,247,043 | |||||||||||||||
5,000 | Various Purpose Dtd 12/01/05 | 5.00 | 03/01/27 | 5,295,750 | |||||||||||||||
3,000 | Huntington Beach Union High School District, Ser 2004 (FSA) | 5.00 | 08/01/27 | 3,175,470 | |||||||||||||||
5,000 | Los Angeles, Ser 2004 A (MBIA) | 5.00 | 09/01/24 | 5,315,400 | |||||||||||||||
5,000 | San Francisco City & County, Laguna Honda Hospital Ser 2005 I (FSA) ‡ | 5.00 | 06/15/30 | 5,435,000 | |||||||||||||||
Puerto Rico, | |||||||||||||||||||
8,000 | Public Impr Ser 1999 | 4.75 | 07/01/23 | 8,091,280 | |||||||||||||||
3,000 | Public Impr Ser 1999 (Secondary MBIA) | 4.875 | 07/01/23 | 3,071,550 | |||||||||||||||
44,745 | 47,709,697 | ||||||||||||||||||
Educational Facilities Revenue (7.8%) | |||||||||||||||||||
California Educational Facilities Authority, | |||||||||||||||||||
2,000 | California College of Arts Ser 2005 | 5.00 | 06/01/35 | 2,048,940 | |||||||||||||||
3,000 | Mills College Ser 2005 A | 5.00 | 09/01/29 | 3,133,920 | |||||||||||||||
2,000 | Pitzer College Ser 2005 A | 5.00 | 04/01/35 | 2,070,280 | |||||||||||||||
2,000 | University of Redlands Ser 2005 A | 5.00 | 10/01/35 | 2,078,180 | |||||||||||||||
5,000 | University of San Diego Ser 1998 (Ambac) | 5.00 | 10/01/22 | 5,145,750 | |||||||||||||||
California Infrastructure & Economic Development Bank, | |||||||||||||||||||
2,000 | California Science Center Foundation Phase II Ser 2006 B (FGIC) | 5.00 | 05/01/31 | 2,124,820 | |||||||||||||||
1,000 | California Municipal Finance Authority, American Heritage Educational Foundation Ser 2006 A | 5.25 | 06/01/26 | 1,048,820 | |||||||||||||||
2,000 | San Diego County, Burnham Institute for Medical Research Ser 2006 COPs | 5.00 | 09/01/34 | 2,079,940 | |||||||||||||||
University of California, | |||||||||||||||||||
10,400 | Ser 2007 J (FSA) (WI) ‡ | 4.50 | 05/15/31 | 10,439,182 | |||||||||||||||
9,600 | Ser 2007 J (FSA) (WI) ‡ | 4.50 | 05/15/35 | 9,636,168 | |||||||||||||||
39,000 | 39,806,000 | ||||||||||||||||||
Electric Revenue (6.6%) | |||||||||||||||||||
20,000 | Los Angeles Department of Water & Power, 2001 Ser A (FSA) | 5.25 | 07/01/22 | 21,156,600 |
See Notes to Financial Statements
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Morgan Stanley California Tax-Free Income Fund
Portfolio of Investments n December 31, 2006 continued
PRINCIPAL AMOUNT IN THOUSANDS | COUPON RATE | MATURITY DATE | VALUE | ||||||||||||||||
Southern California Public Power Authority, | |||||||||||||||||||
$ | 3,500 | Mead-Adelanto 1994 Ser A (Ambac) | 6.15 | †††% | 07/01/15 | $ | 4,200,035 | ||||||||||||
2,500 | Mead-Phoenix 1994 Ser A (Ambac) | 6.15 | ††† | 07/01/15 | 3,000,025 | ||||||||||||||
2,750 | Transmission Refg Ser 2002 A (FSA) | 5.25 | 07/01/18 | 2,959,853 | |||||||||||||||
2,000 | Puerto Rico Electric Power Authority, Power Ser II (MBIA) | 5.375 | 07/01/19 | 2,171,940 | |||||||||||||||
30,750 | 33,488,453 | ||||||||||||||||||
Hospital Revenue (15.7%) | |||||||||||||||||||
8,000 | Antelope Valley Healthcare District, Refg Ser 1997 A (FSA) | 5.20 | 01/01/20 | 8,266,000 | |||||||||||||||
California Health Facilities Financing Authority, | |||||||||||||||||||
4,000 | Cedars-Sinai Medical Center Ser 2005 | 5.00 | 11/15/27 | 4,182,080 | |||||||||||||||
5,000 | Cedars-Sinai Medical Center Ser 2005 | 5.00 | 11/15/34 | 5,201,850 | |||||||||||||||
2,000 | Kaiser Permanente Ser 2006 A | 5.25 | 04/01/39 | 2,126,080 | |||||||||||||||
2,500 | Sutter/CHS Ser 1996 A (MBIA) | 5.875 | 08/15/16 | 2,554,225 | |||||||||||||||
5,000 | California Infrastructure & Economic Development Bank, Kaiser Hospital Ser 2001 A | 5.55 | 08/01/31 | 5,316,350 | |||||||||||||||
California Statewide Communities Development Authority, | |||||||||||||||||||
5,000 | Adventist Healthwest 2005 Ser A | 5.00 | 03/01/30 | 5,184,650 | |||||||||||||||
1,440 | Cedars-Sinai Medical Center Ser 1992 COPs | 6.50 | 08/01/12 | 1,533,931 | |||||||||||||||
3,000 | Daughters of Charity Health Ser 2005 A | 5.25 | 07/01/30 | 3,160,800 | |||||||||||||||
1,630 | Huntington Memorial Hospital Ser 2005 | 5.00 | 07/01/27 | 1,705,241 | |||||||||||||||
14,000 | Duarte, City of Hope National Medical Center Ser 1999 A COPs | 5.25 | 04/01/19 | 14,422,940 | |||||||||||||||
5,000 | Loma Linda, Loma Linda University Medical Center Ser 2005 A | 5.00 | 12/01/20 | 5,209,850 | |||||||||||||||
7,500 | Madera County, Valley Children's Hospital Ser 1995 COPs (MBIA) | 6.50 | 03/15/15 | 8,658,225 | |||||||||||||||
4,000 | Rancho Mirage Joint Powers Financing Authority, Eisenhower Medical Center Ser 1997 A COPs (MBIA) | 5.25 | 07/01/17 | 4,108,800 | |||||||||||||||
7,890 | University California, UCLA Medical Center Ser 2004 A (Ambac) | 5.00 | 05/15/39 | 8,231,953 | |||||||||||||||
75,960 | 79,862,975 | ||||||||||||||||||
Industrial Development/Pollution Control Revenue (1.1%) | |||||||||||||||||||
5,000 | California Pollution Control Financing Authority, San Diego | ||||||||||||||||||
Gas & Electric Co 1996 Ser A | 5.90 | 06/01/14 | 5,575,800 | ||||||||||||||||
Mortgage Revenue - Multi-Family (0.4%) | |||||||||||||||||||
2,000 | Independent Cities Lease Financing Authority, San Juan | ||||||||||||||||||
Mobile Estates Ser 2006 A | 5.125 | 05/15/41 | 2,056,120 | ||||||||||||||||
Public Facilities Revenue (4.3%) | |||||||||||||||||||
4,000 | Anaheim Public Financing Authority, 1997 Ser C (FSA) | 6.00 | 09/01/16 | 4,659,240 |
See Notes to Financial Statements
12
Morgan Stanley California Tax-Free Income Fund
Portfolio of Investments n December 31, 2006 continued
PRINCIPAL AMOUNT IN THOUSANDS | COUPON RATE | MATURITY DATE | VALUE | ||||||||||||||||
California Public Works Board, | |||||||||||||||||||
$ | 2,000 | Butterfield State Office 2005 Ser A | 5.25 | % | 06/01/30 | $ | 2,142,480 | ||||||||||||
10,000 | Department of Corrections Refg 1993 Ser A (Ambac) | 5.00 | 12/01/19 | 10,929,200 | |||||||||||||||
5,000 | Puerto Rico Public Buildings Authority, 2002 Ser D (Ambac) | 0.00 | †† | 07/01/31 | 4,199,400 | ||||||||||||||
21,000 | 21,930,320 | ||||||||||||||||||
Tax Allocation Revenue (5.7%) | |||||||||||||||||||
1,500 | Fontana Public Finance Authority, Ser 2003 A (Ambac) | 5.375 | 09/01/25 | 1,613,430 | |||||||||||||||
20,000 | Long Beach Financing Authority, Ser 1992 (Ambac) | 6.00 | 11/01/17 | 23,036,000 | |||||||||||||||
4,000 | Rancho Mirage Redevelopment Agency, Ser 2003 A (MBIA) | 5.00 | 04/01/33 | 4,173,080 | |||||||||||||||
25,500 | 28,822,510 | ||||||||||||||||||
Transportation Facilities Revenue (15.8%) | |||||||||||||||||||
10,000 | Alameda Corridor Transportation Authority, Sr Lien Ser 1999 A (MBIA) | 5.25 | 10/01/21 | 10,496,400 | |||||||||||||||
4,000 | Bay Area Toll Authority, San Francisco Bay Area Toll Bridge 2001 Ser D | 5.00 | 04/01/18 | 4,197,160 | |||||||||||||||
Foothill/Eastern Transportation Corridor Agency, | |||||||||||||||||||
5,000 | Toll Road Ser 1999 (MBIA) | 5.125 | 01/15/19 | 5,242,850 | |||||||||||||||
14,000 | Toll Road Ser 1999 | 0.00 | †† | 01/15/23 | 12,971,840 | ||||||||||||||
Port of Oakland, | |||||||||||||||||||
5,200 | Ser 2002 M (FGIC) | 5.25 | 11/01/19 | 5,618,080 | |||||||||||||||
2,000 | Ser 2002 M (FGIC) | 5.25 | 11/01/20 | 2,156,440 | |||||||||||||||
5,000 | San Francisco Airports Commission, San Francisco Int'l Airport Second Ser Refg Issue 27B (FGIC) | 5.125 | 05/01/26 | 5,238,000 | |||||||||||||||
9,500 | San Francisco Bay Area Rapid Transit District, Sales Tax Ser 1998 (Ambac) | 4.75 | 07/01/23 | 9,692,565 | |||||||||||||||
San Joaquin Hills Transportation Corridor Agency, | |||||||||||||||||||
6,000 | Toll Road Refg Ser 1997 A (MBIA) | 0.00 | 01/15/15 | 4,390,260 | |||||||||||||||
10,000 | Toll Road Senior Lien Ser 1993 | 5.00 | 01/01/33 | 9,919,400 | |||||||||||||||
10,000 | San Jose, Airport Ser 2001 A (FGIC) | 5.00 | 03/01/25 | 10,343,300 | |||||||||||||||
80,700 | 80,266,295 | ||||||||||||||||||
Water & Sewer Revenue (20.0%) | |||||||||||||||||||
20,000 | California Department of Water Resources, Center Valley Ser Y (FGIC) | 5.00 | 12/01/25 | 21,180,400 | |||||||||||||||
4,000 | Corona Public Financing Authority, Water Ser 1998 (FGIC) | 4.75 | 09/01/23 | 4,108,200 | |||||||||||||||
10,000 | East Bay Municipal Utility District, Water Ser 2001 (MBIA) | 5.00 | 06/01/26 | 10,430,200 | |||||||||||||||
8,000 | Eastern Municipal Water District, Water & Sewer Refg Ser 1998 A COPs (FGIC) | 4.75 | 07/01/23 | 8,135,520 |
See Notes to Financial Statements
13
Morgan Stanley California Tax-Free Income Fund
Portfolio of Investments n December 31, 2006 continued
PRINCIPAL AMOUNT IN THOUSANDS | COUPON RATE | MATURITY DATE | VALUE | ||||||||||||||||
Los Angeles Department of Water & Power, | |||||||||||||||||||
$ | 5,000 | Water 2001 Ser A | 5.125 | % | 07/01/41 | $ | 5,175,800 | ||||||||||||
5,000 | Water 2003 Ser A (FGIC) | 5.00 | 07/01/43 | 5,239,850 | |||||||||||||||
20,000 | Los Angeles Wastewater, Refg Ser 2003 B (FSA) | 5.00 | 06/01/22 | 21,203,600 | |||||||||||||||
5,000 | San Diego County Water Authority, Ser 2004 A COPs (FSA) | 5.00 | 05/01/29 | 5,287,700 | |||||||||||||||
10,000 | San Diego Public Facilities Authority, Sewer Ser 1993 A | 5.25 | 05/15/20 | 10,007,600 | |||||||||||||||
5,650 | San Francisco Public Utilities Commission, Water 2002 Ser A (MBIA) | 5.00 | 11/01/20 | 6,021,544 | |||||||||||||||
5,000 | West Basin Municipal Water District, Refg Ser 2003 A COPs (MBIA) | 5.00 | 08/01/30 | 5,244,100 | |||||||||||||||
97,650 | 102,034,514 | ||||||||||||||||||
Other Revenue (6.2%) | |||||||||||||||||||
California County Tobacco Securitization Agency, | |||||||||||||||||||
5,000 | Los Angeles County Securitization Corporation Ser 2006 | 0.00 | †† | 06/01/28 | 4,319,800 | ||||||||||||||
3,000 | Sonoma County Securitization Corporation Ser 2005 | 5.125 | 06/01/38 | 3,080,370 | |||||||||||||||
10,000 | California Economic Recovery, Ser 2004 A | 5.00 | 07/01/16 | 10,586,000 | |||||||||||||||
Golden State Tobacco Securitization Corporation, | |||||||||||||||||||
1,000 | Enhanced Asset Backed Ser 2005 A (Ambac) | 5.00 | 06/01/21 | 1,048,190 | |||||||||||||||
3,000 | Enhanced Asset Backed Ser 2005 A | 5.00 | 06/01/45 | 3,117,930 | |||||||||||||||
Tobacco Securitization Authority of Northern California, Sacramento County Tobacco Securitization Corporation | |||||||||||||||||||
4,000 | Ser 2006 A-1 | 5.00 | 06/01/37 | 4,065,520 | |||||||||||||||
5,000 | Ser 2005 A-1 | 5.50 | 06/01/45 | 5,277,150 | |||||||||||||||
31,000 | 31,494,960 | ||||||||||||||||||
Refunded (7.5%) | |||||||||||||||||||
10,000 | California Department of Water Resources, Power Supply Ser 2002 A | 5.375 | 05/01/12† | 10,970,500 | |||||||||||||||
San Jose Redevelopment Agency, | |||||||||||||||||||
8,000 | Ser 1999 (Ambac) | 4.75 | 08/01/08† | 8,236,880 | |||||||||||||||
3,000 | Merged Area Ser 2002 (MBIA) | 5.00 | 08/01/10† | 3,177,450 | |||||||||||||||
10,000 | Sacramento Financing Authority, Water & Capital Improvement 2001 Ser A (Ambac) | 5.00 | 06/01/11† | 10,577,800 | |||||||||||||||
5,000 | University California, Ser 2003 Q (FSA) | 5.00 | 09/01/11† | 5,355,150 | |||||||||||||||
36,000 | 38,317,780 | ||||||||||||||||||
489,305 | Total California Tax-Exempt Municipal Bonds (Cost $481,055,594) | 511,365,424 |
See Notes to Financial Statements
14
Morgan Stanley California Tax-Free Income Fund
Portfolio of Investments n December 31, 2006 continued
PRINCIPAL AMOUNT IN THOUSANDS | COUPON RATE | MATURITY DATE | VALUE | ||||||||||||||||
Short-Term California Tax-Exempt Municipal Obligations (3.2%) | |||||||||||||||||||
$ | 9,000 | Adelanto Public Utility Authority, Ser 2005 A (Ambac) (Demand 01/02/07) | 3.85 | *% | 11/01/34 | $ | 9,000,000 | ||||||||||||
300 | Orange County Sanitation District, Ser 2000 B COPs (Demand 01/02/07) | 3.83 | * | 08/01/30 | 300,000 | ||||||||||||||
6,000 | California Infrastructure & Economic Development Bank, San Francisco Ballet Assn Ser 2006 (FGIC) (Demand 01/02/07) | 3.90 | * | 07/01/36 | 6,000,000 | ||||||||||||||
1,200 | California Educational Facilities Authority, Stanford University Ser 2004 S-4 (Demand 01/02/07) | 3.88 | * | 11/01/50 | 1,200,000 | ||||||||||||||
16,500 | Total Short-Term California Tax-Exempt Municipal Obligations (Cost $16,500,000) | 16,500,000 | |||||||||||||||||
505,805 | Total Investments (Cost $497,555,594) (a) (b) | 527,865,424 | |||||||||||||||||
(18,000 | ) | Floating Rate Note Obligations Related to Securities Held (-3.5%) | |||||||||||||||||
Notes with interest rates ranging from 3.48% to 3.92% at December 31, 2006 and contractual maturities of collateral ranging from 06/15/30 to 05/15/35 (see Note 1D) ‡‡ (Cost $(18,000,000)) | (18,000,000 | ) | |||||||||||||||||
$ | 487,805 | Total Net Investments (Cost $479,555,594) | 100.2 | % | 509,865,424 | ||||||||||||||
Liabilities in Excess of Other Assets | (0.2 | ) | (1,015,444 | ) | |||||||||||||||
Net Assets | 100.0 | % | $ | 508,849,980 |
COPs Certificates of Participation.
WI Security purchased on a when-issued basis.
* Current coupon of variable rate demand obligation.
‡ Underlying security related to inverse floaters entered into by the Fund (See Note 1D).
‡‡ Floating rate note obligations related to securities held. The interest rates shown reflect the rates in effect at December 31, 2006.
† Prerefunded to call date shown.
†† Security is a "step-up" bond where the coupon increases on a predetermined date.
††† Current coupon rate for inverse floating rate municipal obligations (See Note 7). This rate resets periodically as the auction rate on the related security changes. Positions in inverse floating rate municipal obligations have a total value of $7,200,060, which represents 1.4% of net assets.
(a) Securities have been designated as collateral in an amount equal to $5,082,950 in connection with security purchased on a when-issued basis.
(b) The aggregate cost for federal income tax purposes is $479,265,599. The aggregate gross unrealized appreciation is $30,607,425 and the aggregate gross unrealized depreciation is $7,600, resulting in net unrealized appreciation of $30,599,825.
Bond Insurance:
Ambac Ambac Assurance Corporation.
FGIC Financial Guaranty Insurance Company.
FSA Financial Security Assurance Inc.
MBIA Municipal Bond Investors Assurance Corporation.
See Notes to Financial Statements
15
Morgan Stanley California Tax-Free Income Fund
Financial Statements
Statement of Assets and Liabilities
December 31, 2006
Assets: | |||||||
Investments in securities, at value (cost $497,555,594) | $ | 527,865,424 | |||||
Cash | 77,039 | ||||||
Receivable for: | |||||||
Interest | 6,395,021 | ||||||
Shares of beneficial interest sold | 211,142 | ||||||
Receivable from Distributor | 136,446 | ||||||
Prepaid expenses and other assets | 25,361 | ||||||
Total Assets | 534,710,433 | ||||||
Liabilities: | |||||||
Floating rate note obligations | 18,000,000 | ||||||
Payable for: | |||||||
Investments purchased | 5,082,950 | ||||||
Dividends and distributions to shareholders | 1,753,365 | ||||||
Shares of beneficial interest redeemed | 483,984 | ||||||
Investment advisory fee | 201,893 | ||||||
Distribution fee | 164,340 | ||||||
Administration fee | 34,877 | ||||||
Transfer agent fee | 9,628 | ||||||
Accrued expenses and other payables | 129,416 | ||||||
Total Liabilities | 25,860,453 | ||||||
Net Assets | $ | 508,849,980 | |||||
Composition of Net Assets: | |||||||
Paid-in-capital | $ | 477,383,623 | |||||
Net unrealized appreciation | 30,309,830 | ||||||
Accumulated undistributed net investment income | 439,040 | ||||||
Accumulated undistributed net realized gain | 717,487 | ||||||
Net Assets | $ | 508,849,980 | |||||
Class A Shares: | |||||||
Net Assets | $ | 299,413,562 | |||||
Shares Outstanding (unlimited authorized, $.01 par value) | 24,618,404 | ||||||
Net Asset Value Per Share | $ | 12.16 | |||||
Maximum Offering Price Per Share, (net asset value plus 4.44% of net asset value) | $ | 12.70 | |||||
Class B Shares: | |||||||
Net Assets | $ | 132,162,458 | |||||
Shares Outstanding (unlimited authorized, $.01 par value) | 10,797,387 | ||||||
Net Asset Value Per Share | $ | 12.24 | |||||
Class C Shares: | |||||||
Net Assets | $ | 23,319,625 | |||||
Shares Outstanding (unlimited authorized, $.01 par value) | 1,906,330 | ||||||
Net Asset Value Per Share | $ | 12.23 | |||||
Class D Shares: | |||||||
Net Assets | $ | 53,954,335 | |||||
Shares Outstanding (unlimited authorized, $.01 par value) | 4,422,997 | ||||||
Net Asset Value Per Share | $ | 12.20 |
See Notes to Financial Statements
16
Morgan Stanley California Tax-Free Income Fund
Financial Statements continued
Statement of Operations
For the year ended December 31, 2006
Net Investment Income: | |||||||
Interest Income | $ | 26,370,261 | |||||
Expenses | |||||||
Investment advisory fee | 2,509,111 | ||||||
Distribution fee (Class A shares) | 786,332 | ||||||
Distribution fee (Class B shares) | 112,417 | ||||||
Distribution fee (Class C shares) | 186,879 | ||||||
Administration fee | 428,604 | ||||||
Transfer agent fees and expenses | 180,792 | ||||||
Shareholder reports and notices | 105,942 | ||||||
Professional fees | 86,382 | ||||||
Interest and residual trust expenses | 44,094 | ||||||
Custodian fees | 25,030 | ||||||
Trustees' fees and expenses | 14,568 | ||||||
Other | 66,997 | ||||||
Total Expenses | 4,547,148 | ||||||
Less: amounts waived/reimbursed | (178,027 | ) | |||||
Less: expense offset | (24,868 | ) | |||||
Net Expenses | 4,344,253 | ||||||
Net Investment Income | 22,026,008 | ||||||
Net Realized and Unrealized Gain (Loss): Net Realized Gain on: | |||||||
Investments | 2,870,702 | ||||||
Futures contracts | 275,469 | ||||||
Net Realized Gain | 3,146,171 | ||||||
Net Change in Unrealized Appreciation/Depreciation on: | |||||||
Investments | (1,106,280 | ) | |||||
Futures contracts | 87,934 | ||||||
Net Depreciation | (1,018,346 | ) | |||||
Net Gain | 2,127,825 | ||||||
Net Increase | $ | 24,153,833 |
See Notes to Financial Statements
17
Morgan Stanley California Tax-Free Income Fund
Financial Statements continued
Statements of Changes in Net Assets
FOR THE YEAR ENDED DECEMBER 31, 2006 | FOR THE YEAR ENDED DECEMBER 31, 2005 | ||||||||||
Increase (Decrease) in Net Assets: Operations: | |||||||||||
Net investment income | $ | 22,026,008 | $ | 25,348,818 | |||||||
Net realized gain | 3,146,171 | 9,687,312 | |||||||||
Net change in unrealized appreciation | (1,018,346 | ) | (13,777,338 | ) | |||||||
Net Increase | 24,153,833 | 21,258,792 | |||||||||
Dividends and Distributions to Shareholders from: | |||||||||||
Net investment income | |||||||||||
Class A shares | (12,766,269 | ) | (9,719,215 | ) | |||||||
Class B shares | (5,999,996 | ) | (12,140,918 | ) | |||||||
Class C shares | (883,715 | ) | (968,237 | ) | |||||||
Class D shares | (2,272,801 | ) | (2,455,372 | ) | |||||||
Net realized gain | |||||||||||
Class A shares | (1,481,325 | ) | (5,480,668 | ) | |||||||
Class B shares | (650,009 | ) | (2,674,136 | ) | |||||||
Class C shares | (114,574 | ) | (436,485 | ) | |||||||
Class D shares | (265,713 | ) | (895,913 | ) | |||||||
Total Dividends and Distributions | (24,434,402 | ) | (34,770,944 | ) | |||||||
Net decrease from transactions in shares of beneficial interest | (60,270,569 | ) | (48,234,063 | ) | |||||||
Net Decrease | (60,551,138 | ) | (61,746,215 | ) | |||||||
Net Assets: | |||||||||||
Beginning of period | 569,401,118 | 631,147,333 | |||||||||
End of Period | |||||||||||
(Including accumulated undistributed net investment income of $439,040 and $479,770, respectively) | $ | 508,849,980 | $ | 569,401,118 |
See Notes to Financial Statements
18
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006
1. Organization and Accounting Policies
Morgan Stanley California Tax-Free Income Fund (the "Fund") is registered under the Investment Company Act of 1940, as amended (the "Act"), as a diversified, open-end management investment company. The Fund's investment objective is to provide a high level of current income exempt from federal and California income tax, consistent with the preservation of capital. The Fund was organized as a Massachusetts business trust on April 9, 1984 and commenced operations on July 11, 1984. On July 28, 1997, the Fund converted to a multiple class share structure.
The Fund offers Class A shares, Class B shares, Class C shares and Class D shares. The four classes are substantially the same except that most Class A shares are subject to a sales charge imposed at the time of purchase and some Class A shares, and most Class B shares and Class C shares are subject to a contingent deferred sales charge imposed on shares redeemed within eighteen months, six years and one year, respectively. Class D shares are not subject to a sales charge. Additionally, Class A shares, Class B shares and Class C shares incur distribution expenses.
The Fund will assess a 2% redemption fee, on Class A shares, Class B shares, Class C shares, and Class D shares, which is paid directly to the Fund, for shares redeemed within seven days of purchase, subject to certain exceptions. The redemption fee is designed to protect the Fund and its remaining shareholders from the effects of short-term trading.
The following is a summary of significant accounting policies:
A. Valuation of Investments — (1) portfolio securities are valued by an outside independent pricing service approved by the Trustees. The pricing service uses both a computerized grid matrix of tax-exempt securities and evaluations by its staff, in each case based on information concerning market transactions and quotations from dealers which reflect the mean between the last reported bid and asked price. The portfolio securities are thus valued by reference to a combination of transactions and quotations for the same or other securities believed to be comparable in quality, coupon, maturity, type of issue, call provisions, trading characteristics and other features deemed to be relevant. The Trustees believe that timely and reliable market quotations are generally not readily available for purposes of valuing tax-exempt securities and that the valuations supplied by the pricing service are more likely to approximate the fa ir value of such securities; (2) futures are valued at the latest sale price on the commodities exchange on which they trade unless it is determined that such price does not reflect their market value, in which case they will be valued at their fair value as determined in good faith under procedures established by and under the supervision of the Trustees; and (3) short-term debt securities having a maturity date of more than sixty days at time of purchase are valued on a mark-to-market basis until sixty days prior to maturity and thereafter at amortized cost based on their value on the 61st day. Short-term debt securities having a maturity date of sixty days or less at the time of purchase are valued at amortized cost.
19
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
B. Accounting for Investments — Security transactions are accounted for on the trade date (date the order to buy or sell is executed). Realized gains and losses on security transactions are determined by the identified cost method. Discounts are accreted and premiums are amortized over the life of the respective securities. Interest income is accrued daily.
C. Multiple Class Allocations — Investment income, expenses (other than distribution fees), and realized and unrealized gains and losses are allocated to each class of shares based upon the relative net asset value on the date such items are recognized. Distribution fees are charged directly to the respective class.
D. Floating Rate Note Obligations Related to Securities Held — The Fund enters into transactions in which it transfers to Dealer Trusts ("Dealer Trusts"), fixed rate bonds in exchange for cash and residual interests in the Dealer Trusts' assets and cash flows, which are in the form of inverse floating rate investments. The Dealer Trusts fund the purchases of the fixed rate bonds by issuing floating rate notes to third parties and allowing the Fund to retain residual interest in the bonds. The Fund enters into shortfall agreements with the Dealer Trusts which commit the Fund to pay the Dealer Trusts, in certain circumstances, the difference between the liquidation value of the fixed rate bonds held by the Dealer Trusts and the liquidation value of the floating rate notes held by third parties, as well as any shortfalls in interest cash flows. The residual interests held by the Fund (inverse floating rate investments) include the right of the Fund (1) to cause the holders of the floating rate notes to tender their notes at par at the next interest rate reset date, and (2) to transfer the municipal bond from the Dealer Trusts to the Fund, thereby collapsing the Dealer Trusts. The Fund accounts for the transfer of bonds to the Dealer Trusts as secured borrowings, with the securities transferred remaining in the Fund's investment assets, and the related floating rate notes reflected as Fund liabilities under the caption "floating rate note obligations" on the "Statement of Assets and Liabilities." The Fund records the interest income from the fixed rate bonds under the caption "Interest Income" and records the expenses related to floating rate note obligations and any administrative expenses of the dealer trusts under the caption "Interest and residual trust expenses" in the Fund's "Statement of Operations." The notes issued by the Dealer Trusts have interest rates that reset weekly and the floating rate note holders have the optio n to tender their notes to the Dealer Trusts for redemption at par at each reset date. At December 31, 2006, Fund investments with a value of $25,510,350 are held by the Dealer Trusts and serve as collateral for the $18,000,000 in floating rate note obligations outstanding at that date. Contractual maturities of the floating rate note obligations and interest rates in effect at December 31, 2006 are presented in the "Portfolio of Investments."
E. Futures Contracts — A futures contract is an agreement between two parties to buy and sell financial instruments or contracts based on financial indices at a set price on a future date. Upon entering into such a contract, the Fund is required to pledge to the broker cash, U.S. Government securities or other liquid portfolio securities equal to the minimum initial margin requirements of the
20
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
applicable futures exchange. Pursuant to the contract, the Fund agrees to receive from or pay to the broker an amount of cash equal to the daily fluctuation in the value of the contract. Such receipts or payments known as variation margin are recorded by the Fund as unrealized gains and losses. Upon closing of the contract, the Fund realizes a gain or loss equal to the difference between the value of the contract at the time it was opened and the value at the time it was closed.
F. Federal Income Tax Policy — It is the Fund's policy to comply with the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute substantially all of its taxable and nontaxable income to its shareholders. Accordingly, no federal income tax provision is required.
G. Dividends and Distributions to Shareholders — Dividends and distributions to shareholders are recorded on the ex-dividend date.
H. Use of Estimates — The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts and disclosures. Actual results could differ from those estimates.
2. Investment Advisory/Administration Agreements
Pursuant to an Investment Advisory Agreement with Morgan Stanley Investment Advisors Inc. (the "Investment Adviser") the Fund pays the Investment Adviser an advisory fee, accrued daily and payable monthly, by applying the following annual rates to the Fund's net assets determined as of the close of each business day: 0.47% to the portion of the daily net assets not exceeding $500 million; 0.445% to the portion of the daily net assets exceeding $500 million but not exceeding $750 million; 0.42% to the portion of the daily net assets exceeding $750 million but not exceeding $1 billion; 0.395% to the portion of the daily net assets exceeding $1 billion but not exceeding $1.25 billion; and 0.37% to the portion of the daily net assets in excess of $1.25 billion.
Pursuant to an Administration Agreement with Morgan Stanley Services Company Inc. (the "Administrator"), an affiliate of the Investment Adviser, the Fund pays an administration fee, accrued daily and payable monthly, by applying the annual rate of 0.08% to the Fund's daily net assets.
The Investment Adviser has agreed to cap the Fund's operating expenses (except for brokerage and 12b-1 fees) by assuming the Fund's "other expenses" and/or waiving the Fund's advisory fees, and the Administrator has agreed to waive the Fund's administrative fees, to the extent such operating expenses exceed 0.60% of the average daily net assets of the Fund on an annualized basis. These voluntary assumptions/waivers may be discontinued at any time.
21
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
3. Plan of Distribution
Shares of the Fund are distributed by Morgan Stanley Distributors Inc. (the "Distributor"), an affiliate of the Investment Adviser and Administrator. The Fund has adopted a Plan of Distribution (the "Plan") pursuant to Rule 12b-1 under the Act. The Plan provides that the Fund will pay the Distributor a fee which is accrued daily and paid monthly at the following annual rates: (i) Class A — up to 0.25% of the average daily net assets of Class A; (ii) Class B — up to 0.75% of the lesser of: (a) the average daily aggregate gross sales of the Class B shares since the inception of the Fund (not including reinvestment of dividend or capital gain distributions) less the average daily aggregate net asset value of the Class B shares redeemed since the Fund's inception upon which a contingent deferred sales charge has been imposed or waived; or (b) the average daily net assets of Class B; and (iii) Class C — up to 0.75% of the average daily net assets of Class C.
In the case of Class B shares, provided that the Plan continues in effect, any cumulative expenses incurred by the Distributor but not yet recovered may be recovered through the payment of future distribution fees from the Fund pursuant to the Plan and contingent deferred sales charges paid by investors upon redemption of Class B shares. Although there is no legal obligation for the Fund to pay expenses incurred in excess of payments made to the Distributor under the Plan and the proceeds of contingent deferred sales charges paid by investors upon redemption of shares, if for any reason the Plan is terminated, the Trustees will consider at that time the manner in which to treat such expenses. The Distributor has advised the Fund that there were no excess expenses as of December 31, 2006.
For the year ended December 31, 2006, the distributor fee was accrued for Class B shares at the annual rate of 0.08%. At December 31, 2006, included in the Statement of Assets and Liabilities, is a receivable from the Fund's Distributor which represents payments due to be reimbursed to the Fund under the Plan. Because the Plan is what is referred to as a "reimbursement plan," the Distributor reimburses to the Fund any 12b-1 fees collected in excess of the actual distribution expenses incurred. This receivable represents this excess amount as of December 31, 2006.
In the case of Class A shares and Class C shares, expenses incurred pursuant to the Plan in any calendar year in excess of 0.25% or 0.75% of the average daily net assets of Class A or Class C, respectively, will not be reimbursed by the Fund through payments in any subsequent year, except that expenses representing a gross sales credit to Morgan Stanley Financial Advisors and other authorized financial representatives at the time of sale may be reimbursed in the subsequent calendar year. For the year ended December 31, 2006, the distribution fee was accrued for Class A shares and Class C shares at the annual rate of 0.25% and 0.75%, respectively.
The Distributor has informed the Fund that for the year ended December 31, 2006, it received contingent deferred sales charges from certain redemptions of the Fund's Class B shares and Class C shares of $183,764 and $452, respectively and received $95,796 in front-end sales charges from
22
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
sales of the Fund's Class A shares. The respective shareholders pay such charges which are not an expense of the Fund.
4. Security Transactions and Transactions with Affiliates
The cost of purchases and proceeds from sales of portfolio securities, excluding short-term investments, for the year ended December 31, 2006 aggregated $27,005,190 and $88,737,342, respectively. Included in the aforementioned transactions are sales of $8,374,797 with other Morgan Stanley funds including net realized gains of $313,216.
Morgan Stanley Trust, an affiliate of the Investment Adviser, Administrator and Distributor, is the Fund's transfer agent.
The Fund has an unfunded noncontributory defined benefit pension plan covering certain independent Trustees of the Fund who will have served as independent Trustees for at least five years at the time of retirement. Benefits under this plan are based on factors which include years of service and compensation. The Trustees voted to close the plan to new participants and eliminate the future benefits growth due to increases to compensation after July 31, 2003. Aggregate pension costs for the year ended December 31, 2006 included in Trustees' fees and expenses in the Statement of Operations amounted to $5,162. At December 31, 2006, the Fund had an accrued pension liability of $62,665 which is included in accrued expenses in the Statement of Assets and Liabilities.
The Fund has an unfunded Deferred Compensation Plan (the "Compensation Plan") which allows each independent Trustee to defer payment of all, or a portion, of the fees he or she receives for serving on the Board of Trustees. Each eligible Trustee generally may elect to have the deferred amounts credited with a return equal to the total return on one or more of the Morgan Stanley funds that are offered as investment options under the Compensation Plan. Appreciation/depreciation and distributions received from these investments are recorded with an offsetting increase/decrease in the deferred compensation obligation and do not affect the net asset value of the Fund.
5. Expense Offset
The expense offset represents a reduction of the fees and expenses for interest earned on cash balances maintained by the Fund with the custodian and transfer agent.
23
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
6. Shares of Beneficial Interest
Transactions in shares of beneficial interest were as follows:
FOR THE YEAR ENDED DECEMBER 31, 2006 | FOR THE YEAR ENDED DECEMBER 31, 2005 | ||||||||||||||||||
SHARES | AMOUNT | SHARES | AMOUNT | ||||||||||||||||
CLASS A SHARES | |||||||||||||||||||
Sold | 561,176 | $ | 6,820,180 | 510,370 | $ | 6,347,742 | |||||||||||||
Conversion from Class B | 894,934 | 10,791,004 | 26,881,166 | 333,835,771 | |||||||||||||||
Reinvestment of dividends and distributions | 644,718 | 7,811,064 | 709,137 | 8,718,752 | |||||||||||||||
Redeemed | (4,607,144 | ) | (55,839,391 | ) | (2,517,480 | ) | (31,217,088 | ) | |||||||||||
Net increase (decrease) — Class A | (2,506,316 | ) | (30,417,143 | ) | 25,583,193 | 317,685,177 | |||||||||||||
CLASS B SHARES | |||||||||||||||||||
Sold | 297,066 | 3,625,123 | 636,974 | 7,964,926 | |||||||||||||||
Conversion to Class A | (889,299 | ) | (10,791,004 | ) | (26,729,720 | ) | (333,835,771 | ) | |||||||||||
Reinvestment of dividends and distributions | 236,268 | 2,880,749 | 545,578 | 6,775,281 | |||||||||||||||
Redeemed | (1,854,198 | ) | (22,605,127 | ) | (3,444,670 | ) | (43,042,005 | ) | |||||||||||
Net decrease — Class B | (2,210,163 | ) | (26,890,259 | ) | (28,991,838 | ) | (362,137,569 | ) | |||||||||||
CLASS C SHARES | |||||||||||||||||||
Sold | 102,257 | 1,250,054 | 223,514 | 2,798,084 | |||||||||||||||
Reinvestment of dividends and distributions | 49,863 | 607,734 | 73,982 | 915,630 | |||||||||||||||
Redeemed | (402,316 | ) | (4,912,822 | ) | (338,227 | ) | (4,230,339 | ) | |||||||||||
Net decrease — Class C | (250,196 | ) | (3,055,034 | ) | (40,731 | ) | (516,625 | ) | |||||||||||
CLASS D SHARES | |||||||||||||||||||
Sold | 481,825 | 5,825,582 | 211,330 | 2,634,719 | |||||||||||||||
Reinvestment of dividends and distributions | 119,003 | 1,446,629 | 154,996 | 1,915,329 | |||||||||||||||
Redeemed | (592,150 | ) | (7,180,344 | ) | (628,321 | ) | (7,815,094 | ) | |||||||||||
Net increase (decrease) — Class D | 8,678 | 91,867 | (261,995 | ) | (3,265,046 | ) | |||||||||||||
Net decrease in Fund | (4,957,997 | ) | $ | (60,270,569 | ) | (3,711,371 | ) | $ | (48,234,063 | ) |
7. Purposes of and Risks Relating to Certain Financial Instruments
The Fund may invest a portion of its assets in inverse floating rate instruments, either through outright purchases of inverse floating rate securities or through the transfer of bonds to a Dealer Trust in exchange for cash and residual interests in the Dealer Trust. These investments are typically used by the Fund in seeking to enhance the yield of the portfolio. These instruments typically involve greater risks than a fixed rate municipal bond. In particular, these instruments are acquired through leverage or may have leverage embedded in them and therefore involve many of the risks associated with leverage. Leverage is a speculative technique that may expose the Fund to greater risk and increased costs. Leverage may cause the Fund's net asset value to be more volatile than if it had not been leveraged
24
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
because leverage tends to magnify the effect of any increases or decreases in the value of the Fund's portfolio securities. The use of leverage may also cause the Fund to liquidate portfolio positions when it may not be advantageous to do so in order to satisfy its obligations with respect to inverse floating rate instruments.
To hedge against adverse interest rate changes, the Fund may invest in financial futures contracts or municipal bond index futures contracts ("futures contracts"). These futures contracts involve elements of market risk in excess of the amount reflected in the Statement of Assets and Liabilities. The Fund bears the risk of an unfavorable change in the value of the underlying securities. Risks may also arise upon entering into these contracts from the potential inability of the counterparties to meet the terms of their contracts.
8. Legal Matters
The Investment Adviser, certain affiliates of the Investment Adviser, certain officers of such affiliates and certain investment companies advised by the Investment Adviser or its affiliates, including the Fund, were named as defendants in a consolidated class action. This consolidated action also named as defendants certain individual Trustees and Directors of the Morgan Stanley funds. The consolidated amended complaint, filed in the United States District Court for the Southern District of New York on April 16, 2004, generally alleged that defendants, including the Fund, violated their statutory disclosure obligations and fiduciary duties by failing properly to disclose (i) that the Investment Adviser and certain affiliates of the Investment Adviser allegedly offered economic incentives to brokers and others to recommend the funds advised by the Investment Adviser or its affiliates to investors rather than funds managed by oth er companies, and (ii) that the funds advised by the Investment Adviser or its affiliates, including the Fund, allegedly paid excessive commissions to brokers in return for their alleged efforts to recommend these funds to investors. The complaint sought, among other things, unspecified compensatory damages, rescissionary damages, fees and costs. On July 2, 2004, defendants moved to dismiss the action. On March 9, 2005, plaintiffs filed a Motion for Leave to File a Supplemental Pleading that would, among other things, expand the allegations and alleged class. On April 14, 2006, the Court granted defendants' motion to dismiss in its entirety, with prejudice. Additionally, plaintiffs' Motion for Leave to File a Supplemental Pleading was denied. The time for plaintiffs to appeal the orders granting defendants' motion to dismiss and denying plaintiffs' motion for supplemental pleading has expired. This case is now concluded.
9. Federal Income Tax Status
The amount of dividends and distributions from net investment income and net realized capital gains are determined in accordance with federal income tax regulations which may differ from generally
25
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
accepted accounting principles. These "book/tax" differences are either considered temporary or permanent in nature. To the extent these differences are permanent in nature, such amounts are reclassified within the capital accounts based on their federal tax-basis treatment; temporary differences do not require reclassification. Dividends and distributions which exceed net investment income and net realized capital gains for tax purposes are reported as distributions of paid-in-capital.
The tax character of distributions paid was as follows:
FOR THE YEAR ENDED DECEMBER 31, 2006 | FOR THE YEAR ENDED DECEMBER 31, 2005 | ||||||||||
Tax-exempt income | $ | 21,922,781 | $ | 25,232,039 | |||||||
Ordinary income | — | 51,809 | |||||||||
Long-term capital gains | 2,511,621 | 9,487,096 | |||||||||
Total distributions | $ | 24,434,402 | $ | 34,770,944 | |||||||
As of December 31, 2006, the tax-basis components of accumulated earnings were as follows: | |||||||||||
Undistributed tax-exempt income | $ | 213,238 | |||||||||
Undistributed long-term gains | 717,667 | ||||||||||
Net accumulated earnings | 930,905 | ||||||||||
Temporary differences | (64,373 | ) | |||||||||
Net unrealized appreciation | 30,599,825 | ||||||||||
Total accumulated earnings | $ | 31,466,357 |
As of December 31, 2006, the Fund had temporary book/tax differences primarily attributable to book amortization of discounts on debt securities.
Permanent differences, due to tax adjustments on debt securities sold by the Fund, resulted in the following reclassifications among the Fund's components of net assets at December 31, 2006:
ACCUMULATED UNDISTRIBUTED NET INVESTMENT INCOME | ACCUMULATED UNDISTRIBUTED NET REALIZED GAIN | PAID-IN-CAPITAL | |||||||||
$ | (143,957 | ) | $ | 143,957 | — |
10. New Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement 109 (FIN 48). FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position must
26
Morgan Stanley California Tax-Free Income Fund
Notes to Financial Statements n December 31, 2006 continued
meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is to be applied to all open tax years as of the effective date. Recent SEC guidance allows implementing FIN 48 in the fund NAV calculations on the fund's last NAV calculation in the first required financial statement period. As a result, the Fund will incorporate FIN 48 in its semiannual report on June 30, 2007. The impact to the Fund's financial statements, if any, is currently being assessed.
In addition, in September 2006, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), was issued and is effective for fiscal years beginning after November 15, 2007. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Management is currently evaluating the impact the adoption of SFAS 157 will have on the Fund's financial statement disclosures.
27
Morgan Stanley California Tax-Free Income Fund
Financial Highlights
Selected ratios and per share data for a share of beneficial interest outstanding throughout each period:
FOR THE YEAR ENDED DECEMBER 31, | |||||||||||||||||||||||
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||
Class A Shares | |||||||||||||||||||||||
Selected Per Share Data: | |||||||||||||||||||||||
Net asset value, beginning of period | $ | 12.16 | $ | 12.46 | $ | 12.58 | $ | 12.68 | $ | 12.34 | |||||||||||||
Income (loss) from investment operations: | |||||||||||||||||||||||
Net investment income | 0.49 | 0.52 | 0.54 | 0.55 | 0.57 | ||||||||||||||||||
Net realized and unrealized gain (loss) | 0.06 | (0.10 | ) | (0.02 | ) | (0.01 | ) | 0.44 | |||||||||||||||
Total income from investment operations | 0.55 | 0.42 | 0.52 | 0.54 | 1.01 | ||||||||||||||||||
Less dividends and distributions from: | |||||||||||||||||||||||
Net investment income | (0.49 | ) | (0.51 | ) | (0.53 | ) | (0.55 | ) | (0.57 | ) | |||||||||||||
Net realized gain | (0.06 | ) | (0.21 | ) | (0.11 | ) | (0.09 | ) | (0.10 | ) | |||||||||||||
Total dividends and distributions | (0.55 | ) | (0.72 | ) | (0.64 | ) | (0.64 | ) | (0.67 | ) | |||||||||||||
Net asset value, end of period | $ | 12.16 | $ | 12.16 | $ | 12.46 | $ | 12.58 | $ | 12.68 | |||||||||||||
Total Return† | 4.64 | % | 3.44 | % | 4.26 | % | 4.31 | % | 8.37 | % | |||||||||||||
Ratios To Average Net Assets(1) : | |||||||||||||||||||||||
Total expenses (before expense offset) | 0.86 | % | 0.86 | % | 0.81 | % | 0.78 | % | 0.80 | % | |||||||||||||
Total expenses (before expense offset, exclusive of interest and residual trust expenses) | 0.85 | %(2) | 0.86 | %(2) | 0.81 | % | 0.78 | % | 0.80 | % | |||||||||||||
Net investment income | 4.06 | %(2) | 4.11 | %(2) | 4.29 | % | 4.34 | % | 4.53 | % | |||||||||||||
Supplemental Data: | |||||||||||||||||||||||
Net assets, end of period, in thousands | $ | 299,414 | $ | 329,938 | $ | 19,203 | $ | 17,422 | $ | 20,775 | |||||||||||||
Portfolio turnover rate | 5 | % | 23 | % | 10 | % | 11 | % | 12 | % |
† Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period.
(1) Reflects overall Fund ratios for investment income and non-class specific expenses.
(2) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset (exclusive of interest and residual trust expenses), would have been as follows:
PERIOD ENDED | EXPENSE RATIO | NET INVESTMENT INCOME RATIO | |||||||||
December 31, 2006 | 0.89 | % | 4.02 | % | |||||||
December 31, 2005 | 0.87 | 4.10 |
See Note to Financial Statements
28
Morgan Stanley California Tax-Free Income Fund
Financial Highlights continued
FOR THE YEAR ENDED DECEMBER 31, | |||||||||||||||||||||||
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||
Class B Shares | |||||||||||||||||||||||
Selected Per Share Data: | |||||||||||||||||||||||
Net asset value, beginning of period | $ | 12.24 | $ | 12.52 | $ | 12.65 | $ | 12.75 | $ | 12.42 | |||||||||||||
Income (loss) from investment operations: | |||||||||||||||||||||||
Net investment income | 0.52 | 0.54 | 0.54 | 0.55 | 0.56 | ||||||||||||||||||
Net realized and unrealized gain (loss) | 0.05 | (0.08 | ) | (0.02 | ) | (0.02 | ) | 0.42 | |||||||||||||||
Total income from investment operations | 0.57 | 0.46 | 0.52 | 0.53 | 0.98 | ||||||||||||||||||
Less dividends and distributions from: | |||||||||||||||||||||||
Net investment income | (0.51 | ) | (0.53 | ) | (0.54 | ) | (0.54 | ) | (0.55 | ) | |||||||||||||
Net realized gain | (0.06 | ) | (0.21 | ) | (0.11 | ) | (0.09 | ) | (0.10 | ) | |||||||||||||
Total dividends and distributions | (0.57 | ) | (0.74 | ) | (0.65 | ) | (0.63 | ) | (0.65 | ) | |||||||||||||
Net asset value, end of period | $ | 12.24 | $ | 12.24 | $ | 12.52 | $ | 12.65 | $ | 12.75 | |||||||||||||
Total Return† | 4.81 | % | 3.74 | % | 4.22 | % | 4.27 | % | 8.13 | % | |||||||||||||
Ratios To Average Net Assets(1): | |||||||||||||||||||||||
Total expenses (before expense offset) | 0.69 | % | 0.68 | % | 0.78 | %(2) | 0.83 | %(2) | 0.93 | %(2) | |||||||||||||
Total expenses (before expense offset, exclusive of interest and residual trust expenses) | 0.68 | %(3) | 0.68 | %(3) | 0.78 | %(2) | 0.83 | %(2) | 0.93 | %(2) | |||||||||||||
Net investment income | 4.23 | %(3) | 4.29 | %(3) | 4.32 | %(2) | 4.29 | %(2) | 4.40 | %(2) | |||||||||||||
Supplemental Data: | |||||||||||||||||||||||
Net assets, end of period, in thousands | $ | 132,162 | $ | 159,221 | $ | 526,026 | $ | 599,737 | $ | 682,046 | |||||||||||||
Portfolio turnover rate | 5 | % | 23 | % | 10 | % | 11 | % | 12 | % |
† Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period.
(1) Reflects overall Fund ratios for investment income and non-class specific expenses.
(2) If the Fund had borne all of its expenses that were reimbursed by the Distributor, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
PERIOD ENDED | EXPENSE RATIO | NET INVESTMENT INCOME RATIO | |||||||||
December 31, 2004 | 1.03 | % | 4.07 | % | |||||||
December 31, 2003 | 1.35 | 3.77 | |||||||||
December 31, 2002 | 1.35 | 3.98 |
(3) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset (exclusive of interest and residual trust expenses), would have been as follows:
PERIOD ENDED | EXPENSE RATIO | NET INVESTMENT INCOME RATIO | |||||||||
December 31, 2006 | 0.72 | % | 4.19 | % | |||||||
December 31, 2005 | 0.69 | 4.28 |
See Note to Financial Statements
29
Morgan Stanley California Tax-Free Income Fund
Financial Highlights continued
FOR THE YEAR ENDED DECEMBER 31, | |||||||||||||||||||||||
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||
Class C Shares | |||||||||||||||||||||||
Selected Per Share Data: | |||||||||||||||||||||||
Net asset value, beginning of period | $ | 12.23 | $ | 12.52 | $ | 12.65 | $ | 12.74 | $ | 12.42 | |||||||||||||
Income (loss) from investment operations: | |||||||||||||||||||||||
Net investment income | 0.43 | 0.45 | 0.47 | 0.48 | 0.50 | ||||||||||||||||||
Net realized and unrealized gain (loss) | 0.06 | (0.08 | ) | (0.02 | ) | 0.00 | 0.42 | ||||||||||||||||
Total income from investment operations | 0.49 | 0.37 | 0.45 | 0.48 | 0.92 | ||||||||||||||||||
Less dividends and distributions from: | |||||||||||||||||||||||
Net investment income | (0.43 | ) | (0.45 | ) | (0.47 | ) | (0.48 | ) | (0.50 | ) | |||||||||||||
Net realized gain | (0.06 | ) | (0.21 | ) | (0.11 | ) | (0.09 | ) | (0.10 | ) | |||||||||||||
Total dividends and distributions | (0.49 | ) | (0.66 | ) | (0.58 | ) | (0.57 | ) | (0.60 | ) | |||||||||||||
Net asset value, end of period | $ | 12.23 | $ | 12.23 | $ | 12.52 | $ | 12.65 | $ | 12.74 | |||||||||||||
Total Return† | 4.12 | % | 2.97 | % | 3.61 | % | 3.80 | % | 7.59 | % | |||||||||||||
Ratios To Average Net Assets(1): | |||||||||||||||||||||||
Total expenses (before expense offset) | 1.36 | % | 1.36 | % | 1.36 | % | 1.35 | % | 1.35 | % | |||||||||||||
Total expenses (before expense offset, exclusive of interest and residual trust expenses) | 1.35 | %(2) | 1.36 | %(2) | 1.36 | % | 1.35 | % | 1.35 | % | |||||||||||||
Net investment income | 3.56 | %(2) | 3.61 | %(2) | 3.74 | % | 3.77 | % | 3.98 | % | |||||||||||||
Supplemental Data: | |||||||||||||||||||||||
Net assets, end of period, in thousands | $ | 23,320 | $ | 26,385 | $ | 27,519 | $ | 26,435 | $ | 25,825 | |||||||||||||
Portfolio turnover rate | 5 | % | 23 | % | 10 | % | 11 | % | 12 | % |
† Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period.
(1) Reflects overall Fund ratios for investment income and non-class specific expenses.
(2) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset (exclusive of interest and residual trust expenses), would have been as follows:
PERIOD ENDED | EXPENSE RATIO | NET INVESTMENT INCOME RATIO | |||||||||
December 31, 2006 | 1.39 | % | 3.52 | % | |||||||
December 31, 2005 | 1.37 | 3.60 |
See Note to Financial Statements
30
Morgan Stanley California Tax-Free Income Fund
Financial Highlights continued
FOR THE YEAR ENDED DECEMBER 31, | |||||||||||||||||||||||
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||
Class D Shares | |||||||||||||||||||||||
Selected Per Share Data: | |||||||||||||||||||||||
Net asset value, beginning of period | $ | 12.20 | $ | 12.49 | $ | 12.61 | $ | 12.71 | $ | 12.39 | |||||||||||||
Income (loss) from investment operations: | |||||||||||||||||||||||
Net investment income | 0.53 | 0.54 | 0.56 | 0.57 | 0.60 | ||||||||||||||||||
Net realized and unrealized gain (loss) | 0.05 | (0.08 | ) | (0.01 | ) | (0.01 | ) | 0.41 | |||||||||||||||
Total income from investment operations | 0.58 | 0.46 | 0.55 | 0.56 | 1.01 | ||||||||||||||||||
Less dividends and distributions from: | |||||||||||||||||||||||
Net investment income | (0.52 | ) | (0.54 | ) | (0.56 | ) | (0.57 | ) | (0.59 | ) | |||||||||||||
Net realized gain | (0.06 | ) | (0.21 | ) | (0.11 | ) | (0.09 | ) | (0.10 | ) | |||||||||||||
Total dividends and distributions | (0.58 | ) | (0.75 | ) | (0.67 | ) | (0.66 | ) | (0.69 | ) | |||||||||||||
Net asset value, end of period | $ | 12.20 | $ | 12.20 | $ | 12.49 | $ | 12.61 | $ | 12.71 | |||||||||||||
Total Return† | 4.90 | % | 3.74 | % | 4.48 | % | 4.50 | % | 8.41 | % | |||||||||||||
Ratios To Average Net Assets(1): | |||||||||||||||||||||||
Total expenses (before expense offset) | 0.61 | % | 0.61 | % | 0.61 | % | 0.60 | % | 0.60 | % | |||||||||||||
Total expenses (before expense offset, exclusive of interest and residual trust expenses) | 0.60 | %(2) | 0.61 | %(2) | 0.61 | % | 0.60 | % | 0.60 | % | |||||||||||||
Net investment income | 4.31 | %(2) | 4.36 | %(2) | 4.49 | % | 4.52 | % | 4.73 | % | |||||||||||||
Supplemental Data: | |||||||||||||||||||||||
Net assets, end of period, in thousands | $ | 53,954 | $ | 53,857 | $ | 58,399 | $ | 66,143 | $ | 75,332 | |||||||||||||
Portfolio turnover rate | 5 | % | 23 | % | 10 | % | 11 | % | 12 | % |
† Calculated based on the net asset value as of the last business day of the period.
(1) Reflects overall Fund ratios for investment income and non-class specific expenses.
(2) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset (exclusive of interest and residual trust expenses), would have been as follows:
PERIOD ENDED | EXPENSE RATIO | NET INVESTMENT INCOME RATIO | |||||||||
December 31, 2006 | 0.64 | % | 4.27 | % | |||||||
December 31, 2005 | 0.62 | 4.35 |
See Note to Financial Statements
31
Morgan Stanley California Tax-Free Income Fund
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Trustees of
Morgan Stanley California Tax-Free Income Fund:
We have audited the accompanying statement of assets and liabilities of Morgan Stanley California Tax-Free Income Fund (the "Fund"), including the portfolio of investments, as of December 31, 2006, and the related statements of operations for the year then ended and changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund's management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. The Fund is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2006, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Morgan Stanley California Tax-Free Income Fund as of December 31, 2006, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP
New York, New York
February 23, 2007
32
Morgan Stanley California Tax-Free Income Fund
Results of Special Shareholder Meeting (unaudited)
On August 1, 2006, a Special Meeting of Shareholders of the Fund was scheduled in order to vote on the proposals set forth below. The meeting was held on August 1, 2006 and the voting results with respect to these proposals were as follows:
(1) Election of Trustees:
For | Withhold | Abstain | BNV* | ||||||||||||||||
Frank L. Bowman | 23,575,017 | 773,816 | 0 | 0 | |||||||||||||||
Kathleen A. Dennis | 23,589,097 | 759,736 | 0 | 0 | |||||||||||||||
James F. Higgins | 23,562,470 | 786,363 | 0 | 0 | |||||||||||||||
Joseph J. Kearns | 23,568,931 | 779,902 | 0 | 0 | |||||||||||||||
Michael F. Klein | 23,574,044 | 774,789 | 0 | 0 | |||||||||||||||
W. Allen Reed | 23,549,099 | 799,734 | 0 | 0 | |||||||||||||||
Fergus Reid | 23,550,107 | 798,726 | 0 | 0 |
The following Trustees were not standing for reelection at this meeting: Michael Bozic, Dr. Manuel H. Johnson and Michael E. Nugent.
(2) Elimination of certain fundamental investment restrictions:
For | Against | Abstain | BNV* | ||||||||||||||||
Elimination of the fundamental policy restricting the Fund's ability to pledge assets | 22,596,538 | 652,614 | 1,099,681 | 0 | |||||||||||||||
Elimination of the fundamental policy restricting purchases of securities on margin | 22,515,293 | 794,454 | 1,039,086 | 0 | |||||||||||||||
Elimination of the fundamental policy prohibiting investments in oil, gas, and other types of minerals or mineral leases | 22,602,234 | 707,089 | 1,039,510 | 0 | |||||||||||||||
Elimination of the fundamental policy prohibiting or restricting the purchase of securities of issuers in which Trustees or Officers have an interest | 22,678,111 | 713,241 | 957,481 | 0 | |||||||||||||||
Elimination of the fundamental policy prohibiting investments for purposes of exercising control | 22,745,664 | 637,804 | 965,365 | 0 | |||||||||||||||
Elimination of the fundamental policy prohibiting the purchase of common stocks and other instruments | 22,825,511 | 564,226 | 959,096 | 0 |
33
Morgan Stanley California Tax-Free Income Fund
Results of Special Shareholder Meeting (unaudited) continued
(3) Modify certain fundamental investment restrictions:
For | Against | Abstain | BNV* | ||||||||||||||||
Modify fundamental policy regarding diversification | 22,864,733 | 500,086 | 984,014 | 0 | |||||||||||||||
Modify fundamental policy regarding borrowing money | 22,674,326 | 725,865 | 948,642 | 0 | |||||||||||||||
Modify fundamental policy regarding loans | 22,707,619 | 670,985 | 970,229 | 0 | |||||||||||||||
Modify fundamental policy regarding investment in commodities, commodity contracts and futures contracts | 22,379,454 | 673,092 | 1,296,287 | 0 | |||||||||||||||
Modify fundamental policy regarding issuance of senior securities | 22,787,214 | 540,348 | 1,021,271 | 0 |
(4) Reclassify certain fundamental policies as non-fundamental policies:
For | Against | Abstain | BNV* | ||||||||||||||||
Reclassification as non-fundamental the fundamental policy regarding the short sale of securities | 22,670,642 | 666,984 | 1,011,207 | 0 | |||||||||||||||
Reclassification as non-fundamental the fundamental policy prohibiting investments in other investment companies | 22,789,689 | 617,385 | 941,759 | 0 | |||||||||||||||
Reclassification as non-fundamental the fundamental policy on the purchase or sale of puts, calls, and combinations thereof | 22,734,868 | 621,731 | 992,234 | 0 |
* Broker "non-votes" are shares held in street name for which the broker indicates that instructions have not been received from the beneficial owners or other persons entitled to vote and for which the broker does not have discretionary voting authority.
34
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited)
Independent Trustees:
Name, Age and Address of Independent Trustee | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | Number of Portfolios in Fund Complex Overseen by Independent Trustee** | Other Directorships Held by Independent Trustee | ||||||||||||||||||
Frank L. Bowman (62) c/o Kramer Levin Naftalis & Frankel LLP Counsel to the Independent Trustees 1177 Avenue of the Americas New York, NY 10036 | Trustee | Since August 2006 | President and Chief Executive Officer of the Nuclear Energy Institute (policy organization) (since February 2005); Director or Trustee of various Retail Funds and Institutional Funds (since August 2006); formerly variously, Admiral in the U.S. Navy, Director of Naval Nuclear Propulsion Program and Deputy Administrator – Naval Reactors in the National Nuclear Security Administration at the U.S. Department of Energy (1996-2004). Honorary Knight Commander of the Most Excellent Order of the British Empire. | 171 | Director of the National Energy Foundation, the U.S. Energy Association, the American Council for Capital Formation and the Armed Services YMCA of the USA. | ||||||||||||||||||
Michael Bozic (65) c/o Kramer Levin Naftalis & Frankel LLP Counsel to the Independent Trustees 1177 Avenue of the Americas New York, NY 10036 | Trustee | Since April 1994 | Private investor; Chairperson of the Valuation, Insurance and Compliance Committee (since October 2006); Director or Trustee of the Retail Funds (since April 1994) and the Institutional Funds (since July 2003); formerly Chairperson of the Insurance Committee (July 2006-September 2006); Vice Chairman of Kmart Corporation (December 1998-October 2000), Chairman and Chief Executive Officer of Levitz Furniture Corporation (November 1995-November 1998) and President and Chief Executive Officer of Hills Department Stores (May 1991-July 1995); variously Chairman, Chief Executive Officer, President and Chief Operating Officer (1987-1991) of the Sears Merchandise Group of Sears, Roebuck & Co. | 173 | Director of various business organizations. | ||||||||||||||||||
35
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Name, Age and Address of Independent Trustee | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | Number of Portfolios in Fund Complex Overseen by Independent Trustee** | Other Directorships Held by Independent Trustee | ||||||||||||||||||
Kathleen A. Dennis (53) c/o Kramer Levin Naftalis & Frankel LLP Counsel to the Independent Trustees 1177 Avenue of the Americas New York, NY 10036 | Trustee | Since August 2006 | President, Cedarwood Associates (mutual fund consulting) (since July 2006); Chairperson of the Money Market and Alternatives Sub-Committee of the Investment Committee (since October 2006) and Director or Trustee of various Retail Funds and Institutional Funds (since August 2006); formerly, Senior Managing Director of Victory Capital Management (1993-2006). | 171 | None. | ||||||||||||||||||
Dr. Manuel H. Johnson (57) c/o Johnson Smick Group, Inc. 888 16th Street, N.W. Suite 740 Washington, D.C. 20006 | Trustee | Since July 1991 | Senior Partner, Johnson Smick International, Inc., (consulting firm); Chairperson of the Investment Committee (since October 2006) and Director or Trustee of the Retail Funds (since July 1991) and the Institutional Funds (since July 2003); Co-Chairman and a founder of the Group of Seven Council (G7C), (international economic commission); formerly Chairperson of the Audit Committee (July 1991-September 2006); Vice Chairman of the Board of Governors of the Federal Reserve System and Assistant Secretary of the U.S. Treasury. | 173 | Director of NVR, Inc. (home construction); Director of KFX Energy; Director of RBS Greenwich Capital Holdings (financial holding company). | ||||||||||||||||||
Joseph J. Kearns (64) c/o Kearns & Associates LLC PMB754 23852 Pacific Coast Highway Malibu, CA 90265 | Trustee | Since August 1994 | President, Kearns & Associates LLC (investment consulting); Chairperson of the Audit Committee (since October 2006) and Director or Trustee of the Retail Funds (since July 2003) and the Institutional Funds (since August 1994); formerly Deputy Chairperson of the Audit Committee (July 2003-September 2006) and Chairperson of the Audit Committee of the Institutional Funds (October 2001-July 2003); formerly CFO of the J. Paul Getty Trust. | 174 | Director of Electro Rent Corporation (equipment leasing), The Ford Family Foundation, and the UCLA Foundation. | ||||||||||||||||||
36
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Name, Age and Address of Independent Trustee | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | Number of Portfolios in Fund Complex Overseen by Independent Trustee** | Other Directorships Held by Independent Trustee | ||||||||||||||||||
Michael F. Klein (48) c/o Kramer Levin Naftalis & Frankel LLP Counsel to the Independent Trustees 1177 Avenue of the Americas New York, NY 10036 | Trustee | Since August 2006 | Chief Operating Officer and Managing Director, Aetos Capital, LLC (since March 2000); Chairperson of the Fixed-Income Sub-Committee of the Investment Committee (since October 2006) and Director or Trustee of various Retail Funds and Institutional Funds (since August 2006); formerly Managing Director, Morgan Stanley & Co. Inc. and Morgan Stanley Dean Witter Investment Management, President, Morgan Stanley Institutional Funds (June 1998-March 2000) and Principal, Morgan Stanley & Co. Inc. and Morgan Stanley Dean Witter Investment Management (August 1997-December 1999). | 171 | Director of certain investment funds managed or sponsored by Aetos Capital, LLC. | ||||||||||||||||||
Michael E. Nugent (70) c/o Triumph Capital, L.P. 445 Park Avenue New York, NY 10022 | Chairman of the Board and Trustee | Chairman of the Boards since July 2006 and Trustee since July 1991 | General Partner of Triumph Capital, L.P., (private investment partnership); Chairman of the Boards of the Retail Funds and Institutional Funds (since July 2006) and Director or Trustee of the Retail Funds (since July 1991) and the Institutional Funds (since July 2001); formerly Chairperson of the Insurance Committee (until July 2006); Vice President, Bankers Trust Company and BT Capital Corporation (1984-1988). | 173 | None. | ||||||||||||||||||
37
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Name, Age and Address of Independent Trustee | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | Number of Portfolios in Fund Complex Overseen by Independent Trustee** | Other Directorships Held by Independent Trustee | ||||||||||||||||||
W. Allen Reed (59) c/o Kramer Levin Naftalis & Frankel LLP Counsel to the Independent Trustees 1177 Avenue of the Americas New York, NY 10036 | Trustee | Since August 2006 | Chairperson of the Equity Sub-Commitee of the Investment Committee (since October 2006) and Director or Trustee of various Retail Funds and Institutional Funds (since August 2006). President and CEO of General Motors Asset Management; formerly, Chairman and Chief Executive Officer of the GM Trust Bank and Corporate Vice President of General Motors Corporation (August 1994-December 2005). | 171 | Director of GMAC (financial services), and Temple-Inland Industries (packaging, banking and forest products); member of the Board of Executives of the Morgan Stanley Capital International Editorial Board; Director of Legg Mason and Director of various investment fund advisory boards. | ||||||||||||||||||
Fergus Reid (74) c/o Lumelite Plastics Corporation 85 Charles Colman Blvd. Pawling, NY 12564 | Trustee | Since June 1992 | Chairman of Lumelite Plastics Corporation; Chairperson of the Governance Committee and Director or Trustee of the Retail Funds (since July 2003) and the Institutional Funds (since June 1992). | 174 | Trustee and Director of certain investment companies in the JPMorgan Funds complex managed by J.P. Morgan Investment Management Inc. | ||||||||||||||||||
38
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Interested Trustee:
Name, Age and Address of Interested Trustee | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | Number of Portfolios in Fund Complex Overseen by Interested Trustee** | Other Directorships Held by Interested Trustee | ||||||||||||||||||
James F. Higgins (58) c/o Morgan Stanley Trust Harborside Financial Center Plaza Two Jersey City, NJ 07311 | Trustee | Since June 2000 | Director or Trustee of the Retail Funds (since June 2000) and the Institutional Funds (since July 2003); Senior Advisor of Morgan Stanley (since August 2000). | 173 | Director of AXA Financial, Inc. and The Equitable Life Assurance Society of the United States (financial services). | ||||||||||||||||||
* This is the earliest date the Trustee began serving the funds advised by Morgan Stanley Investment Advisors Inc. (the "Investment Adviser") (the "Retail Funds") or the funds advised by Morgan Stanley Investment Management Inc. and Morgan Stanley AIP GP LP (the "Institutional Funds").
** The Fund Complex includes all open-end and closed-end funds (including all of their portfolios) advised by the Investment Adviser and any funds that have an investment adviser that is an affiliated person of the Investment Adviser (including, but not limited to, Morgan Stanley Investment Management Inc.) as of December 31, 2006.
39
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Executive Officers:
Name, Age and Address of Executive Officer | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | ||||||||||||
Ronald E. Robison (67) 1221 Avenue of the Americas New York, NY 10020 | President and Principal Executive Officer | President since September 2005 and Principal Executive Officer since May 2003 | President (since September 2005) and Principal Executive Officer (since May 2003) of funds in the Fund Complex; President (since September 2005) and Principal Executive Officer (since May 2003) of the Van Kampen Funds; Managing Director, Director and/or Officer of the Investment Adviser and various entities affiliated with the Investment Adviser; Director of Morgan Stanley SICAV (since May 2004). Formerly, Executive Vice President (July 2003 to September 2005) of funds in the Fund Complex and the Van Kampen Funds; President and Director of the Institutional Funds (March 2001 to July 2003); Chief Administrative Officer of the Investment Adviser; Chief Administrative Officer of Morgan Stanley Services Company Inc. | ||||||||||||
J. David Germany (52) Morgan Stanley Investment Management Limited 25 Cabot Square Canary Wharf, London United Kingdom E144QA | Vice President | Since February 2006 | Managing Director and (since December 2005) Chief Investment Officer – Global Fixed Income of Morgan Stanley Investment Management; Managing Director and Director of Morgan Stanley Investment Management Limited; Vice President of the Retail and Institutional Funds (since February 2006). | ||||||||||||
Dennis F. Shea (53) 1221 Avenue of the Americas New York, NY 10020 | Vice President | Since February 2006 | Managing Director and (since February 2006) Chief Investment Officer – Global Equity of Morgan Stanley Investment Management; Vice President of the Retail and Institutional Funds (since February 2006). Formerly, Managing Director and Director of Global Equity Research at Morgan Stanley. | ||||||||||||
Barry Fink (51) 1221 Avenue of the Americas New York, NY 10020 | Vice President | Since February 1997 | Managing Director of Morgan Stanley Investment Management; Managing Director of the Investment Adviser and various entities affiliated with the Investment Adviser; Vice President of the Retail Funds and (since July 2003) the Institutional Funds. Formerly, Secretary, General Counsel and/or Director of the Investment Adviser and various entities affiliated with the Investment Adviser; Secretary and General Counsel of the Retail Funds. | ||||||||||||
Amy R. Doberman (44) 1221 Avenue of the Americas New York, NY 10020 | Vice President | Since July 2004 | Managing Director and General Counsel, U.S. Investment Management of Morgan Stanley Investment Management (since July 2004); Vice President of the Retail Funds and the Institutional Funds (since July 2004); Vice President of the Van Kampen Funds (since August 2004); Secretary (since February 2006) and Managing Director (since July 2004) of the Investment Adviser and various entities affiliated with the Investment Adviser. Formerly, Managing Director and General Counsel – Americas, UBS Global Asset Management (July 2000 to July 2004). | ||||||||||||
Carsten Otto (43) 1221 Avenue of the Americas New York, NY 10020 | Chief Compliance Officer | Since October 2004 | Managing Director and U.S. Director of Compliance for Morgan Stanley Investment Management (since October 2004); Managing Director and Chief Compliance Officer of Morgan Stanley Investment Management. Formerly, Assistant Secretary and Assistant General Counsel of the Retail Funds. | ||||||||||||
40
Morgan Stanley California Tax-Free Income Fund
Trustee and Officer Information (unaudited) continued
Name, Age and Address of Executive Officer | Position(s) Held with Registrant | Term of Office and Length of Time Served* | Principal Occupation(s) During Past 5 Years | ||||||||||||
Stefanie V. Chang Yu (40) 1221 Avenue of the Americas New York, NY 10020 | Vice President | Since December1997 | Executive Director of the Investment Adviser and various entities affiliated with the Investment Adviser; Vice President of the Retail Funds (since July 2002) and the Institutional Funds (since December 1997). Formerly, Secretary of various entities affiliated with the Investment Adviser. | ||||||||||||
Francis J. Smith (41) c/o Morgan Stanley Trust Harborside Financial Center Plaza Two Jersey City, NJ 07311 | Treasurer and Chief Financial Officer | Treasurer since July 2003 and Chief Financial Officer since September 2002 | Executive Director of the Investment Adviser and various entities affiliated with the Investment Adviser; Treasurer and Chief Financial Officer of the Retail Funds (since July 2003). Formerly, Vice President of the Retail Funds (September 2002 to July 2003). | ||||||||||||
Mary E. Mullin (39) 1221 Avenue of the Americas New York, NY 10020 | Secretary | Since June 1999 | Executive Director of the Investment Adviser and various entities affiliated with the Investment Adviser; Secretary of the Retail Funds (since July 2003) and the Institutional Funds (since June 1999). | ||||||||||||
* This is the earliest date the Officer began serving the Retail Funds or the Institutional Funds.
2006 Federal Tax Notice (unaudited)
During the year ended December 31, 2006, the Fund paid to its shareholders the following per share amounts from the sources indicated below:
Class A | Class B | Class C | Class D | ||||||||||||||||
Tax-Exempt Income | 0.49 | 0.51 | 0.43 | 0.52 | |||||||||||||||
Long-Term Capital Gains | 0.06 | 0.06 | 0.06 | 0.06 |
41
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Trustees
Frank L. Bowman
Michael Bozic
Kathleen A. Dennis
James F. Higgins
Dr. Manuel H. Johnson
Joseph J. Kearns
Michael F. Klein
Michael E. Nugent
W. Allen Reed
Fergus Reid
Officers
Michael E. Nugent
Chairman of the Board
Ronald E. Robison
President and Principal Executive Officer
J. David Germany
Vice President
Dennis F. Shea
Vice President
Barry Fink
Vice President
Amy R. Doberman
Vice President
Carsten Otto
Chief Compliance Officer
Stefanie V. Chang Yu
Vice President
Francis J. Smith
Treasurer and Chief Financial Officer
Mary E. Mullin
Secretary
Transfer Agent
Morgan Stanley Trust
Harborside Financial Center, Plaza Two
Jersey City, New Jersey 07311
Independent Registered Public Accounting Firm
Deloitte & Touche LLP
Two World Financial Center
New York, New York 10281
Investment Adviser
Morgan Stanley Investment Advisors Inc.
1221 Avenue of the Americas
New York, New York 10020
This report is submitted for the general information of the shareholders of the Fund. For more detailed information about the Fund, its fees and expenses and other pertinent information, please read its Prospectus. The Fund's Statement of Additional Information contains additional information about the Fund, including its trustees. It is available, without charge, by calling (800) 869-NEWS.
This report is not authorized for distribution to prospective investors in the Fund unless preceded or accompanied by an effective Prospectus. Read the Prospectus carefully before investing.
Morgan Stanley Distributors Inc., member NASD.
© 2006 Morgan Stanley
MORGAN STANLEY FUNDS
Morgan Stanley
California Tax-Free
Income Fund
Annual Report
December 31, 2006
CLFANR-RA07-00152P-Y12/06
Item 2. Code of Ethics.
(a) The Fund has adopted a code of ethics (the “Code of Ethics”) that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the Fund or a third party.
(b) No information need be disclosed pursuant to this paragraph.
(c) Not applicable.
(d) Not applicable.
(e) Not applicable.
(f)
(1) The Fund’s Code of Ethics is attached hereto as Exhibit 12 A.
(2) Not applicable.
(3) Not applicable.
Item 3. Audit Committee Financial Expert.
The Fund’s Board of Trustees has determined that Joseph J. Kearns, an “independent” Trustee, is an “audit committee financial expert” serving on its audit committee. Under applicable securities laws, a person who is determined to be an audit committee financial expert will not be deemed an “expert” for any purpose, including without limitation for the purposes of Section 11 of the Securities Act of 1933, as a result of being designated or identified as an audit committee financial expert. The designation or identification of a person as an audit committee financial expert does not impose on such person any duties, obligations, or liabilities that are greater than the duties, obligations, and liabilities imposed on such person as a member of the audit committee and Board of Trustees in the absence of such designation or identification
Item 4. Principal Accountant Fees and Services.
(a)(b)(c)(d) and (g). Based on fees billed for the periods shown:
2006
| Registrant |
| Covered Entities(1) |
| |||
Audit Fees |
| $ | 31,200 |
| N/A |
| |
|
|
|
|
|
| ||
Non-Audit Fees |
|
|
|
|
| ||
Audit-Related Fees |
| $ | 531 | (2) | $ | 5,162,000 | (2) |
Tax Fees. |
| $ | 4,600 | (3) | $ | 1,389,000 | (4) |
All Other Fees |
| $ | — |
| $ | — |
|
Total Non-Audit Fees. |
| $ | 5,131 |
| $ | 6,551,000 |
|
|
|
|
|
|
| ||
Total |
| $ | 36,331 |
| $ | 6,551,000 |
|
2005
| Registrant |
| Covered Entities(1) |
| |||
Audit Fees |
| $ | 30,447 |
| N/A |
| |
|
|
|
|
|
| ||
Non-Audit Fees |
|
|
|
|
| ||
Audit-Related Fees |
| $ | 540 | (2) | $ | 3,215,745 | (2) |
Tax Fees |
| $ | 4,699 | (3) | $ | 24,000 | (4) |
All Other Fees |
| $ | — |
| $ | — |
|
Total Non-Audit Fees |
| $ | 5,239 |
| $ | 3,239,745 |
|
|
|
|
|
|
| ||
Total |
| $ | 35,686 |
| $ | 3,239,745 |
|
N/A- Not applicable, as not required by Item 4.
(1) Covered Entities include the Adviser (excluding sub-advisors) and any entity controlling, controlled by or under common control with the Adviser that provides ongoing services to the Registrant.
(2) Audit-Related Fees represent assurance and related services provided that are reasonably related to the performance of the audit of the financial statements of the Covered Entities’ and funds advised by the Adviser or its affiliates, specifically data verification and agreed-upon procedures related to asset securitizations and agreed-upon procedures engagements.
(3) Tax Fees represent tax compliance, tax planning and tax advice services provided in connection with the preparation and review of the Registrant’s tax returns.
(4) Tax Fees represent tax compliance, tax planning and tax advice services provided in connection with the review of Covered Entities’ tax returns.
(e)(1) The audit committee’s pre-approval policies and procedures are as follows:
APPENDIX A
AUDIT COMMITTEE
AUDIT AND NON-AUDIT SERVICES
PRE-APPROVAL POLICY AND PROCEDURES
OF THE
MORGAN STANLEY RETAIL AND INSTITUTIONAL FUNDS
AS ADOPTED AND AMENDED JULY 23, 2004,(1)
1. Statement of Principles
The Audit Committee of the Board is required to review and, in its sole discretion, pre-approve all Covered Services to be provided by the Independent Auditors to the Fund and Covered Entities in order to assure that services performed by the Independent Auditors do not impair the auditor’s independence from the Fund.
The SEC has issued rules specifying the types of services that an independent auditor may not provide to its audit client, as well as the audit committee’s administration of the engagement of the independent auditor. The SEC’s rules establish two different approaches to pre-approving services, which the SEC considers to be equally valid. Proposed services either: may be pre-approved without consideration of specific case-by-case services by the Audit Committee (“general pre-approval”); or require the specific pre-approval of the Audit Committee or its delegate (“specific pre-approval”). The Audit Committee believes that the combination of these two approaches in this Policy will result in an effective and efficient procedure to pre-approve services performed by the Independent Auditors. As set forth in this Policy, unless a type of service has received general pre-approval, it will require specific pre-approval by the Audit Committee (or by any member of the Audit Committee to which pre-approval authority has been delegated) if it is to be provided by the Independent Auditors. Any proposed services exceeding pre-approved cost levels or budgeted amounts will also require specific pre-approval by the Audit Committee.
The appendices to this Policy describe the Audit, Audit-related, Tax and All Other services that have the general pre-approval of the Audit Committee. The term of any general pre-approval is 12 months from the date of pre-approval, unless the Audit Committee considers and provides a different period and states otherwise. The Audit Committee will annually review and pre-approve the services that may be provided by the Independent Auditors without obtaining specific pre-approval from the Audit Committee. The Audit Committee will add to or subtract from the list of general pre-approved services from time to time, based on subsequent determinations.
(1) This Audit Committee Audit and Non-Audit Services Pre-Approval Policy and Procedures (the “Policy”), adopted as of the date above, supersedes and replaces all prior versions that may have been adopted from time to time.
The purpose of this Policy is to set forth the policy and procedures by which the Audit Committee intends to fulfill its responsibilities. It does not delegate the Audit Committee’s responsibilities to pre-approve services performed by the Independent Auditors to management.
The Fund’s Independent Auditors have reviewed this Policy and believes that implementation of the Policy will not adversely affect the Independent Auditors’ independence.
2. Delegation
As provided in the Act and the SEC’s rules, the Audit Committee may delegate either type of pre-approval authority to one or more of its members. The member to whom such authority is delegated must report, for informational purposes only, any pre-approval decisions to the Audit Committee at its next scheduled meeting.
3. Audit Services
The annual Audit services engagement terms and fees are subject to the specific pre-approval of the Audit Committee. Audit services include the annual financial statement audit and other procedures required to be performed by the Independent Auditors to be able to form an opinion on the Fund’s financial statements. These other procedures include information systems and procedural reviews and testing performed in order to understand and place reliance on the systems of internal control, and consultations relating to the audit. The Audit Committee will approve, if necessary, any changes in terms, conditions and fees resulting from changes in audit scope, Fund structure or other items.
In addition to the annual Audit services engagement approved by the Audit Committee, the Audit Committee may grant general pre-approval to other Audit services, which are those services that only the Independent Auditors reasonably can provide. Other Audit services may include statutory audits and services associated with SEC registration statements (on Forms N-1A, N-2, N-3, N-4, etc.), periodic reports and other documents filed with the SEC or other documents issued in connection with securities offerings.
The Audit Committee has pre-approved the Audit services in Appendix B.1. All other Audit services not listed in Appendix B.1 must be specifically pre-approved by the Audit Committee (or by any member of the Audit Committee to which pre-approval has been delegated).
4. Audit-related Services
Audit-related services are assurance and related services that are reasonably related to the performance of the audit or review of the Fund’s financial statements and, to the extent they are Covered Services, the Covered Entities or that are traditionally performed by the Independent Auditors. Because the Audit Committee believes that the provision of Audit-related services does not impair the independence of the auditor and is consistent with the SEC’s rules on auditor independence, the Audit Committee may grant general pre-approval to Audit-related services. Audit-related services include, among others, accounting consultations related to accounting, financial reporting or disclosure matters
not classified as “Audit services”; assistance with understanding and implementing new accounting and financial reporting guidance from rulemaking authorities; agreed-upon or expanded audit procedures related to accounting and/or billing records required to respond to or comply with financial, accounting or regulatory reporting matters; and assistance with internal control reporting requirements under Forms N-SAR and/or N-CSR.
The Audit Committee has pre-approved the Audit-related services in Appendix B.2. All other Audit-related services not listed in Appendix B.2 must be specifically pre-approved by the Audit Committee (or by any member of the Audit Committee to which pre-approval has been delegated).
5. Tax Services
The Audit Committee believes that the Independent Auditors can provide Tax services to the Fund and, to the extent they are Covered Services, the Covered Entities, such as tax compliance, tax planning and tax advice without impairing the auditor’s independence, and the SEC has stated that the Independent Auditors may provide such services.
Pursuant to the preceding paragraph, the Audit Committee has pre-approved the Tax Services in Appendix B.3. All Tax services in Appendix B.3 must be specifically pre-approved by the Audit Committee (or by any member of the Audit Committee to which pre-approval has been delegated).
6. All Other Services
The Audit Committee believes, based on the SEC’s rules prohibiting the Independent Auditors from providing specific non-audit services, that other types of non-audit services are permitted. Accordingly, the Audit Committee believes it may grant general pre-approval to those permissible non-audit services classified as All Other services that it believes are routine and recurring services, would not impair the independence of the auditor and are consistent with the SEC’s rules on auditor independence.
The Audit Committee has pre-approved the All Other services in Appendix B.4. Permissible All Other services not listed in Appendix B.4 must be specifically pre-approved by the Audit Committee (or by any member of the Audit Committee to which pre-approval has been delegated).
7. Pre-Approval Fee Levels or Budgeted Amounts
Pre-approval fee levels or budgeted amounts for all services to be provided by the Independent Auditors will be established annually by the Audit Committee. Any proposed services exceeding these levels or amounts will require specific pre-approval by the Audit Committee. The Audit Committee is mindful of the overall relationship of fees for audit and non-audit services in determining whether to pre-approve any such services.
8. Procedures
All requests or applications for services to be provided by the Independent Auditors that do not require specific approval by the Audit Committee will be submitted to the Fund’s Chief Financial Officer and must include a detailed description of the services to be
rendered. The Fund’s Chief Financial Officer will determine whether such services are included within the list of services that have received the general pre-approval of the Audit Committee. The Audit Committee will be informed on a timely basis of any such services rendered by the Independent Auditors. Requests or applications to provide services that require specific approval by the Audit Committee will be submitted to the Audit Committee by both the Independent Auditors and the Fund’s Chief Financial Officer, and must include a joint statement as to whether, in their view, the request or application is consistent with the SEC’s rules on auditor independence.
The Audit Committee has designated the Fund’s Chief Financial Officer to monitor the performance of all services provided by the Independent Auditors and to determine whether such services are in compliance with this Policy. The Fund’s Chief Financial Officer will report to the Audit Committee on a periodic basis on the results of its monitoring. Both the Fund’s Chief Financial Officer and management will immediately report to the chairman of the Audit Committee any breach of this Policy that comes to the attention of the Fund’s Chief Financial Officer or any member of management.
9. Additional Requirements
The Audit Committee has determined to take additional measures on an annual basis to meet its responsibility to oversee the work of the Independent Auditors and to assure the auditor’s independence from the Fund, such as reviewing a formal written statement from the Independent Auditors delineating all relationships between the Independent Auditors and the Fund, consistent with Independence Standards Board No. 1, and discussing with the Independent Auditors its methods and procedures for ensuring independence.
10. Covered Entities
Covered Entities include the Fund’s investment adviser(s) and any entity controlling, controlled by or under common control with the Fund’s investment adviser(s) that provides ongoing services to the Fund(s). Beginning with non-audit service contracts entered into on or after May 6, 2003, the Fund’s audit committee must pre-approve non-audit services provided not only to the Fund but also to the Covered Entities if the engagements relate directly to the operations and financial reporting of the Fund. This list of Covered Entities would include:
Morgan Stanley Retail Funds
Morgan Stanley Investment Advisors Inc.
Morgan Stanley & Co. Incorporated
Morgan Stanley DW Inc.
Morgan Stanley Investment Management Inc.
Morgan Stanley Investment Management Limited
Morgan Stanley Investment Management Private Limited
Morgan Stanley Asset & Investment Trust Management Co., Limited
Morgan Stanley Investment Management Company
Van Kampen Asset Management
Morgan Stanley Services Company, Inc.
Morgan Stanley Distributors Inc.
Morgan Stanley Trust FSB
Morgan Stanley Institutional Funds
Morgan Stanley Investment Management Inc.
Morgan Stanley Investment Advisors Inc.
Morgan Stanley Investment Management Limited
Morgan Stanley Investment Management Private Limited
Morgan Stanley Asset & Investment Trust Management Co., Limited
Morgan Stanley Investment Management Company
Morgan Stanley & Co. Incorporated
Morgan Stanley Distribution, Inc.
Morgan Stanley AIP GP LP
Morgan Stanley Alternative Investment Partners LP
(e)(2) Beginning with non-audit service contracts entered into on or after May 6, 2003, the audit committee also is required to pre-approve services to Covered Entities to the extent that the services are determined to have a direct impact on the operations or financial reporting of the Registrant. 100% of such services were pre-approved by the audit committee pursuant to the Audit Committee’s pre-approval policies and procedures (attached hereto).
(f) Not applicable.
(g) See table above.
(h) The audit committee of the Board of Trustees has considered whether the provision of services other than audit services performed by the auditors to the Registrant and Covered Entities is compatible with maintaining the auditors’ independence in performing audit services.
Item 5. Audit Committee of Listed Registrants.
(a) The Fund has a separately-designated standing audit committee established in accordance with Section 3(a)(58)(A) of the Exchange Act whose members are: Frank Bowman, Joseph Kearns, Michael Nugent and Allen Reed.
(b) Not applicable.
Item 6. Schedule of Investments
Refer to Item 1.
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
Applicable only to reports filed by closed-end funds.
Item 8. Portfolio Managers of Closed-End Management Investment Companies
Applicable only to reports filed by closed-end funds.
Item 9. Closed-End Fund Repurchases
Applicable only to reports filed by closed-end funds.
Item 10. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 11. Controls and Procedures
(a) The Fund’s principal executive officer and principal financial officer have concluded that the Fund’s disclosure controls and procedures are sufficient to ensure that information required to be disclosed by the Fund in this Form N-CSR was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, based upon such officers’ evaluation of these controls and procedures as of a date within 90 days of the filing date of the report.
(b) There were no changes in the registrant’s internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.
Item 12. Exhibits
(a) The Code of Ethics for Principal Executive and Senior Financial Officers is attached hereto.
(b) A separate certification for each principal executive officer and principal financial officer of the registrant are attached hereto as part of EX-99.CERT.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Morgan Stanley California Tax-Free Income Fund
/s/ Ronald E. Robison |
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Ronald E. Robison | |
Principal Executive Officer | |
February 9, 2007 |
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Ronald E. Robison |
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Ronald E. Robison |
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Principal Executive Officer |
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February 9, 2007 |
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/s/ Francis Smith |
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Francis Smith |
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Principal Financial Officer |
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February 9, 2007 |
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