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
Morgan Stanley California Tax-Free Income Fund
(Exact name of registrant as specified in charter)
1221 Avenue of the Americas, New York, New York 10020
(Address of principal executive offices) (Zip code)
Ronald E. Robison
1221 Avenue of the Americas, New York, New York 10020
(Name and address of agent for service)
Registrant's telephone number, including area code: 212-762-4000
Date of fiscal year end: December 31, 2006
Date of reporting period: June 30, 2006
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 semiannual 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 six months ended June 30, 2006
TOTAL RETURN FOR THE SIX MONTHS ENDED JUNE 30, 2006
<Table>
<Caption>
LEHMAN LIPPER
BROTHERS CALIFORNIA
CALIFORNIA MUNICIPAL
EXEMPT DEBT FUNDS
CLASS A CLASS B CLASS C CLASS D INDEX(1) INDEX(2)
0.11% 0.13% -0.12% 0.16% 0.36% 0.39%
</Table>
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 six months ended June 30, 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 pace of U.S. economic growth remained resilient during the first half of
2006 despite record oil prices and a slowdown in housing. Recently, the market
has focused on the change in leadership at the Federal Reserve Board (the "Fed")
and uncertainties created by inflationary pressures and forecasts of slower
growth.
As investors had anticipated, the Fed continued to raise the federal funds
target rate in 25 basis point increments at each of its four meetings in the
first six months of 2006, bringing the rate to 5.25 percent as of June 29. Since
June 2004, the Fed has raised the rate 17 consecutive times. Representative
yields on two-year AAA-rated municipal bonds generally followed the federal
funds target rate, rising 50 basis points, while yields on 30-year bonds rose
only 25 basis points from 4.40 to 4.65 percent during the first half of 2006.
Accordingly, the slope of the municipal yield curve continued to flatten as the
spread (the difference between yields on short-term and long-term interest
rates) narrowed.
Investors' quest for yield favored lower-quality bonds over high-grade issues
and continued to keep credit spreads relatively tight. Credit spreads measure
the incremental yield investors are willing to accept to assume additional
credit risk. When credit spreads tighten, lower-quality issues typically
outperform high-grade issues.
Reinvestment of an estimated $100 billion of bond maturities, calls and coupons
for June, July and August strengthened demand for municipal bonds. Although
municipal bond issuance picked up during the quarter, supply continued to lag
last year's record pace. New issue volume in the first six months of 2006
declined by nearly 15 percent. Rising interest rates discouraged municipalities
from refinancing debt and the pace of refunding activity slowed substantially.
Bond issues backed by insurance had close to a 50 percent market share.
2
Sustained demand and declining supply helped municipal bonds outperform U.S.
Treasuries with comparable maturities. As a result, the relative attractiveness
of tax-exempt bonds ebbed and the 30-year municipal-to-Treasury yield ratio
declined from 97 to 89 percent. The municipal-to-Treasury yield ratio measures
the relative attractiveness of the two sectors. The higher the ratio, the
greater the attractiveness of municipal yields relative to Treasury yields.
The State of California continued to lead the nation in municipal issuance.
Although new volume dipped during 2006, declines were not as steep as the
national average. California's municipal market benefited from the continued
strengthening of its credit fundamentals. The near-term credit outlook for the
state is stable. California's large and diverse economy continued to grow and
employment gains were in line with the national average. On the fiscal front, a
rebound in capital gain and stock option taxes contributed to higher revenues.
While his popularity has ebbed, Governor Schwarzenegger has nonetheless made
progress advancing a number of his municipal funding proposals. The state still
faces challenges, however, with budget deficits, pension funding litigation and
immigration issues among the most significant.
PERFORMANCE ANALYSIS
For the six-month period ended June 30, 2006, Morgan Stanley California Tax-Free
Income Fund underperformed the Lehman Brothers California Exempt Index and the
Lipper California Municipal Debt Funds Index, assuming no deduction of
applicable sales charges.
The Fund made ongoing adjustments to its portfolio to reduce volatility during
the year in anticipation of continued Fed tightening and generally higher
interest rates. For example, a U.S. Treasury futures hedge was used to reduce
the portfolio's duration.* At the end of June, the Fund's option-adjusted
duration was 7.3 years. This duration positioning helped total returns when
rates rose.
The Fund maintained its high-quality bias, with nearly 85 percent of the
portfolio rated A or better. However, exposure to investment grade bonds rated
BBB was modestly increased by purchases of tobacco securitization bonds in the
industrial development/ pollution control sector. This had a positive impact on
performance, as lower-rated issues outperformed. Reflecting a commitment to
diversification, the Fund's net assets of approximately $527 million were
invested among 13 long-term sectors and 68 credits.
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
<Table>
<Caption>
TOP FIVE SECTORS
Water & Sewer 21.7%
Transportation 15.8
Hospital 14.9
General Obligation 10.7
Tax Allocation 7.8
</Table>
<Table>
<Caption>
LONG-TERM CREDIT ANALYSIS
Aaa/AAA 64.6%
Aa/AA 4.4
A/A 15.6
Baa/BBB 13.1
Ba/BB or Less 1.9
Not Rated 0.4
</Table>
Data as of June 30, 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. YOU 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 REQUEST COPIES OF THESE
4
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 June 30, 2006
WEIGHTED AVERAGE MATURITY: 17 YEARS(A)
<Table>
0-5 4
6-10 11
11-15 27
16-20 34
21-25 10
26-30 6
31+ Years 8
</Table>
(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 June 30, 2006
YEARS BONDS CALLABLE -- WEIGHTED AVERAGE CALL PROTECTION: 6 YEARS
<Table>
2006(a) 2
2007 7
2008 12
2009 5
2010 2
2011 18
2012 10
2013 11
2014 6
2015 15
2016+ 12
</Table>
COST (BOOK) YIELD(B) -- WEIGHTED AVERAGE BOOK YIELD: 5.3%
<Table>
2006(a) 5.9
2007 5.8
2008 5.4
2009 5.2
2010 6.0
2011 5.1
2012 5.0
2013 4.9
2014 5.5
2015 5.1
2016+ 5.6
</Table>
(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 5.9% on 2% of the
long-term portfolio that is callable in 2006.
Portfolio structure is subject to change.
7
PERFORMANCE SUMMARY
AVERAGE ANNUAL TOTAL RETURNS -- PERIOD ENDED JUNE 30, 2006
<Table>
<Caption>
CLASS A SHARES* CLASS B SHARES** CLASS C SHARES(+) CLASS D SHARES(++)
(since 07/28/97) (since 07/11/84) (since 07/28/97) (since 07/28/97)
SYMBOL CLFAX CLFBX CLFCX CLFDX
1 YEAR 0.68%(3) 0.87%(3) 0.20%(3) 0.94%(3)
(3.59)(4) (3.89)(4) (0.75)(4)
5 YEARS 4.72(3) 4.70(3) 4.12(3) 4.90(3)
3.81(4) 4.37(4) 4.12(4) --
10 YEARS -- 4.95(3) -- --
-- 4.95(4) -- --
SINCE INCEPTION 4.51(3) 6.87(3) 4.02(3) 4.77(3)
4.01(4) 6.87(4) 4.02(4) --
</Table>
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 table does 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. Indexes are unmanaged and their
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.
8
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 01/01/06 - 06/30/06.
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.
<Table>
<Caption>
BEGINNING ENDING EXPENSES PAID
ACCOUNT VALUE ACCOUNT VALUE DURING PERIOD *
------------- ------------- ---------------
01/01/06 -
01/01/06 06/30/06 06/30/06
------------- ------------- ---------------
CLASS A
Actual (0.11% return)....................................... $1,000.00 $1,001.10 $4.22
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,020.58 $4.26
CLASS B
Actual (0.13% return)....................................... $1,000.00 $1,001.30 $3.32
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,021.47 $3.36
CLASS C
Actual (-0.12% return)...................................... $1,000.00 $ 998.80 $6.69
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,018.10 $6.76
CLASS D
Actual (0.16% return)....................................... $1,000.00 $1,001.60 $2.98
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,021.82 $3.01
</Table>
- ------------------
* Expenses are equal to the Fund's annualized expense ratios of 0.85%, 0.67%,
1.35% and 0.60% for Class A, Class B, Class C and Class D shares,
respectively, multiplied by the average account value over the period,
multiplied by 181/365 (to reflect the one-half year period). If the Fund had
borne all of its expenses, the annualized expense ratios would have been
0.88%, 0.70%, 1.38% and 0.63% for Class A, Class B, Class C and Class D
shares, respectively.
Because Class B shares incurred lower expenses under the Rule 12b-1 Plan of
Distribution than did Class A shares for the six months ended June 30, 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 Rule 12b-1
Plan of Distribution are higher than those payable by Class A shares.
9
INVESTMENT ADVISORY AGREEMENT APPROVAL
NATURE, EXTENT AND QUALITY OF SERVICES
The Board reviewed and considered the nature and extent of the investment
advisory services provided by the Investment Adviser under the Advisory
Agreement, including portfolio management, investment research and fixed income
securities trading. The Board also reviewed and considered the nature and extent
of the non-advisory, administrative services provided by the Fund's
Administrator under the Administration Agreement, including accounting,
clerical, bookkeeping, compliance, business management and planning, and the
provision of supplies, office space and utilities at the Investment Adviser's
expense. (The Investment Adviser and the Administrator together are referred to
as the "Adviser" and the Advisory and Administration Agreements together are
referred to as the "Management Agreement.") The Board also compared the nature
of the services provided by the Adviser with similar services provided by
non-affiliated advisers as reported to the Board by Lipper Inc. ("Lipper").
The Board reviewed and considered the qualifications of the portfolio managers,
the senior administrative managers and other key personnel of the Adviser who
provide the advisory and administrative services to the Fund. The Board
determined that the Adviser's portfolio managers and key personnel are well
qualified by education and/or training and experience to perform the services in
an efficient and professional manner. The Board concluded that the nature and
extent of the advisory and administrative services provided were necessary and
appropriate for the conduct of the business and investment activities of the
Fund. The Board also concluded that the overall quality of the advisory and
administrative services was satisfactory.
PERFORMANCE RELATIVE TO COMPARABLE FUNDS MANAGED BY OTHER ADVISERS
On a regular basis, the Board reviews the performance of all funds in the Morgan
Stanley Fund Complex, including the Fund, compared to their peers, paying
specific attention to the underperforming funds. In addition, the Board
specifically reviewed the Fund's performance for the one-, three- and five-year
periods ended November 30, 2005, as shown in a report provided by Lipper (the
"Lipper Report"), compared to the performance of comparable funds selected by
Lipper (the "performance peer group"). The Board considered the impact on
performance of the Fund's principal investment strategy and defensive investment
strategy. The Board discussed with the Adviser the performance goals and the
actual results achieved in managing the Fund and concluded that the Fund's
performance was acceptable.
FEES RELATIVE TO OTHER PROPRIETARY FUNDS MANAGED BY THE ADVISER WITH COMPARABLE
INVESTMENT STRATEGIES
The Board noted that the Adviser did not manage any other proprietary funds with
investment strategies comparable to those of the Fund.
10
FEES AND EXPENSES RELATIVE TO COMPARABLE FUNDS MANAGED BY OTHER ADVISERS
The Board reviewed the advisory and administrative fee (together, the
"management fee") rate and total expense ratio of the Fund as compared to the
average management fee rate and average total expense ratio for funds, selected
by Lipper (the "expense peer group"), managed by other advisers with investment
strategies comparable to those of the Fund, as shown in the Lipper Report. The
Board concluded that the Fund's management fee rate and total expense ratio were
competitive with those of its expense peer group.
BREAKPOINTS AND ECONOMIES OF SCALE
The Board reviewed the structure of the Fund's management fee schedule under the
Management Agreement and noted that it includes breakpoints. The Board also
reviewed the level of the Fund's management fee and noted that the fee, as a
percentage of the Fund's net assets, would decrease as net assets increase
because the management fee includes breakpoints. The Board concluded that the
Fund's management fee would reflect economies of scale as assets increase.
PROFITABILITY OF THE ADVISER AND AFFILIATES
The Board considered information concerning the costs incurred and profits
realized by the Adviser and affiliates during the last year from their
relationship with the Fund and during the last two years from their relationship
with the Morgan Stanley Fund Complex and reviewed with the Adviser the cost
allocation methodology used to determine the profitability of the Adviser and
affiliates. Based on its review of the information it received, the Board
concluded that the profits earned by the Adviser and affiliates were not
excessive in light of the advisory, administrative and other services provided
to the Fund.
FALL-OUT BENEFITS
The Board considered so-called "fall-out benefits" derived by the Adviser and
affiliates from their relationship with the Fund and the Morgan Stanley Fund
Complex, such as sales charges on sales of Class A shares and "float" benefits
derived from handling of checks for purchases and sales of Fund shares, through
a broker-dealer affiliate of the Adviser. The Board also considered that a
broker-dealer affiliate of the Adviser receives from the Fund 12b-1 fees for
distribution and shareholder services. The Board concluded that the float
benefits were relatively small and the sales charges and 12b-1 fees were
competitive with those of other broker-dealers.
11
SOFT DOLLAR BENEFITS
The Board considered whether the Adviser realizes any benefits from commissions
paid to brokers who execute securities transactions for the Fund ("soft
dollars"). The Board noted that the Fund invests only in fixed income
securities, which do not generate soft dollars.
ADVISER FINANCIALLY SOUND AND FINANCIALLY CAPABLE OF MEETING THE FUND'S NEEDS
The Board considered whether the Adviser is financially sound and has the
resources necessary to perform its obligations under the Management Agreement.
The Board noted that the Adviser's operations remain profitable, although
increased expenses in recent years have reduced the Adviser's profitability. The
Board concluded that the Adviser has the financial resources necessary to
fulfill its obligations under the Management Agreement.
HISTORICAL RELATIONSHIP BETWEEN THE FUND AND THE ADVISER
The Board also reviewed and considered the historical relationship between the
Fund and the Adviser, including the organizational structure of the Adviser, the
policies and procedures formulated and adopted by the Adviser for managing the
Fund's operations and the Board's confidence in the competence and integrity of
the senior managers and key personnel of the Adviser. The Board concluded that
it is beneficial for the Fund to continue its relationship with the Adviser.
OTHER FACTORS AND CURRENT TRENDS
The Board considered the controls and procedures adopted and implemented by the
Adviser and monitored by the Fund's Chief Compliance Officer and concluded that
the conduct of business by the Adviser indicates a good faith effort on its part
to adhere to high ethical standards in the conduct of the Fund's business.
GENERAL CONCLUSION
After considering and weighing all of the above factors, the Board concluded
that it would be in the best interest of the Fund and its shareholders to
approve renewal of the Management Agreement for another year.
12
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED)
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
California Tax-Exempt Municipal Bonds (96.5%)
General Obligation (10.7%)
California,
$ 5,000 Ser 1990................................................ 7.00 % 08/01/07 $ 5,167,650
5,000 Ser 1990................................................ 7.00 08/01/08 5,310,000
3,210 Ser 1996 (Ambac)........................................ 5.25 06/01/21 3,258,182
535 Various Purpose Dtd 04/01/93 (FSA)...................... 5.50 04/01/19 537,076
5,000 Various Purpose Dtd 04/01/02............................ 6.00 04/01/19 5,708,300
5,000 Various Purpose Dtd 12/01/05............................ 5.00 03/01/27 5,093,750
2,000 Veterans Ser AT......................................... 9.50 02/01/10 2,348,480
2,400 Veterans Ser BH (AMT) (FSA)............................. 5.40 12/01/16 2,476,104
3,000 Huntington Beach Union High School District, Ser 2004
(FSA)................................................... 5.00 08/01/27 3,075,060
5,000 Los Angeles, Ser 2004 A (MBIA)............................ 5.00 09/01/24 5,150,050
5,000 Los Angeles Unified School District, 2003 Ser A (FSA)..... 5.25 07/01/20 5,292,650
2,000 San Francisco City & County, Laguna Honda Hospital RITES
PA 1387 (FSA)........................................... 7.504+++ 06/15/30 2,149,680
Puerto Rico,
8,000 Public Impr Ser 1999.................................... 4.75 07/01/23 7,759,360
3,000 Public Impr Ser 1999 (Secondary MBIA)................... 4.875 07/01/23 3,042,990
------------
- --------
56,369,332
54,145
------------
- --------
Educational Facilities Revenue (4.2%)
California Educational Facilities Authority,
2,000 California College of the Arts Ser 2005................. 5.00 06/01/35 1,956,520
3,000 Mills College Ser 2005 A................................ 5.00 09/01/29 3,012,510
2,000 Pitzer College Ser 2005 A............................... 5.00 04/01/35 1,983,260
2,000 University of Redlands Ser 2005 A....................... 5.00 10/01/35 1,992,220
5,000 University of San Diego Ser 1998 (Ambac)................ 5.00 10/01/22 5,131,400
1,000 California Municipal Finance Authority, American Heritage
Educational Foundation Ser 2006 A....................... 5.25 06/01/26 1,007,260
2,000 San Diego County, Burnham Institute for Medical Research
Ser 2006 COPs........................................... 5.00 09/01/34 1,965,140
5,000 University California, Ser 2003 Q (FSA)................... 5.00 09/01/24 5,140,650
------------
- --------
22,188,960
22,000
------------
- --------
Electric Revenue (7.2%)
25,000 Los Angeles Department of Water & Power, 2001 Ser A
(FSA)................................................... 5.25 07/01/22 26,173,250
Southern California Public Power Authority,
3,500 Mead-Adelanto 1994 Ser A (Ambac)........................ 6.67+++ 07/01/15 3,991,540
2,500 Mead-Phoenix 1994 Ser A (Ambac)......................... 6.59+++ 07/01/15 2,851,100
</Table>
See Notes to Financial Statements
13
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
$ 2,750 Transmission Refg Ser 2002 A (FSA)...................... 5.25 % 07/01/18 $ 2,910,023
2,000 Puerto Rico Electric Power Authority, Power Ser II
(MBIA).................................................. 5.375 07/01/19 2,137,820
------------
- --------
38,063,733
35,750
------------
- --------
Hospital Revenue (14.9%)
8,000 Antelope Valley Healthcare District, Refg Ser 1997 A
(FSA)................................................... 5.20 01/01/20 8,270,960
California Health Facilities Financing Authority,
4,000 Cedars-Sinai Medical Center Ser 2005.................... 5.00 11/15/27 4,028,040
5,000 Cedars-Sinai Medical Center Ser 2005.................... 5.00 11/15/34 5,005,650
2,000 Kaiser Permanente Ser 2006 A............................ 5.25 04/01/39 2,043,480
2,500 Sutter/CHS Ser 1996 A (MBIA)............................ 5.875 08/15/16 2,555,600
5,000 California Infrastructure & Economic Development Bank,
Kaiser Hospital Ser 2001 A.............................. 5.55 08/01/31 5,201,750
California Statewide Communities Development Authority,
5,000 Adventist Healthwest 2005 Ser A......................... 5.00 03/01/30 5,001,400
1,595 Cedars-Sinai Medical Center Ser 1992 COPs............... 6.50 08/01/12 1,695,581
3,000 Daughters of Charity Health Ser 2005 A.................. 5.25 07/01/30 3,041,880
1,630 Huntington Memorial Hospital Ser 2005................... 5.00 07/01/27 1,648,843
14,000 Duarte, City of Hope National Medical Center Ser 1999 A
COPs.................................................... 5.25 04/01/19 14,257,880
5,000 Loma Linda, Loma Linda University Medical Center Ser 2005
A....................................................... 5.00 12/01/20 5,017,300
7,500 Madera County, Valley Children's Hospital
Ser 1995 COPs (MBIA).................................... 6.50 03/15/15 8,532,600
4,000 Rancho Mirage Joint Powers Financing Authority, Eisenhower
Medical Center Ser 1997 A COPs (MBIA)................... 5.25 07/01/17 4,126,160
7,890 University California, UCLA Medical Center Ser 2004 A
(Ambac)................................................. 5.00 05/15/39 7,990,282
------------
- --------
78,417,406
76,115
------------
- --------
Industrial Development/Pollution Control Revenue (4.4%)
California County Tobacco Securitization Agency,
5,000 Los Angeles County Securitization Corporation, Ser
2006.................................................... 0.00++ 06/01/28 3,924,200
1,000 Merced County Tobacco Funding Corporation, Ser 2005 A... 5.25 06/01/45 984,460
3,000 Sonoma County Securitization Corporation, Ser 2005...... 5.125 06/01/38 2,930,760
1,000 Sonoma County Securitization Corporation, Ser 2005...... 5.25 06/01/45 984,460
5,000 California Pollution Control Financing Authority, San
Diego
Gas & Electric Co 1996 Ser A............................ 5.90 06/01/14 5,516,100
Tobacco Securitization Authority of Northern California,
Sacramento County Tobacco Securitization Corporation
4,000 Ser 2006 A-1............................................ 5.00 06/01/37 3,821,240
5,000 Ser 2005 A-1............................................ 5.50 06/01/45 5,043,600
------------
- --------
23,204,820
24,000
------------
- --------
</Table>
See Notes to Financial Statements
14
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
Mortgage Revenue -- Multi-Family (0.4%)
$ 350 California Housing Finance Agency, Rental II 1992 Ser B... 6.70 % 08/01/15 $ 350,640
2,000 Independent Cities Lease Financing Authority, San Juan
Mobile Estates Ser 2006 A............................... 5.125 05/15/41 1,990,220
------------
- --------
2,340,860
2,350
------------
- --------
Mortgage Revenue -- Single Family (0.2%)
630 California Housing Finance Agency, 1995 Ser B-2 (AMT)..... 6.30.. 08/01/24 631,203
California Rural Home Financing Authority,
125 1997 Ser A-2 (AMT)...................................... 7.00 09/01/29 127,350
100 Home 1998 Ser A (AMT)................................... 6.35 12/01/29 101,301
------------
- --------
859,854
855
------------
- --------
Public Facilities Revenue (4.2%)
4,000 Anaheim Public Financing Authority, 1997 Ser C (FSA)...... 6.00 09/01/16 4,501,720
California Public Works Board,
2,000 Butterfield State Office 2005 Ser A..................... 5.25 06/01/30 2,063,860
10,000 Department of Corrections Refg 1993 Ser A (Ambac)....... 5.00 12/01/19 10,443,800
1,010 Sacramento City Financing Authority, 2002 Ser A (FSA)..... 5.25 12/01/17 1,069,974
5,000 Puerto Rico Public Buildings Authority, 2002 Ser D
(Ambac)................................................. 0.00++ 07/01/31 3,888,450
------------
- --------
21,967,804
22,010
------------
- --------
Tax Allocation Revenue (7.8%)
1,500 Fontana Public Finance Authority, Ser 2003 A (Ambac)...... 5.375 09/01/25 1,580,085
Long Beach Bond Finance Authority,
1,030 Downtown North Long Beach 2002 A (Ambac)................ 5.375 08/01/19 1,098,639
755 Downtown North Long Beach 2002 Ser A (Ambac)............ 5.375 08/01/20 805,313
20,000 Long Beach Financing Authority, Ser 1992 (Ambac).......... 6.00 11/01/17 22,444,800
4,000 Rancho Mirage Redevelopment Agency, Ser 2003 A (MBIA)..... 5.00 04/01/33 4,053,440
San Jose Redevelopment Agency,
8,000 Ser 1999 (Ambac)........................................ 4.75 08/01/23 8,016,720
3,000 Merged Area Ser 2002 (MBIA)............................. 5.00 08/01/32 3,040,860
------------
- --------
41,039,857
38,285
------------
- --------
Transportation Facilities Revenue (15.8%)
10,000 Alameda Corridor Transportation Authority, Sr Lien Ser
1999 A (MBIA)........................................... 5.25 10/01/21 10,437,000
4,000 Bay Area Toll Authority, San Francisco Bay Area Toll
Bridge
2001 Ser D.............................................. 5.00 04/01/18 4,138,080
Foothill/Eastern Transportation Corridor Agency,
5,000 Toll Road Ser 1999 (MBIA)............................... 5.125 01/15/19 5,207,900
14,000 Toll Road Ser 1999...................................... 0.00++ 01/15/23 12,246,640
5,000 Orange County, Airport Refg Ser 1997 (AMT) (MBIA)......... 5.50 07/01/11 5,160,100
</Table>
See Notes to Financial Statements
15
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
Port of Oakland,
$ 5,200 Ser 2002 M (FGIC)....................................... 5.25 % 11/01/19 $ 5,516,992
2,000 Ser 2002 M (FGIC)....................................... 5.25 11/01/20 2,110,080
5,000 San Francisco Airports Commission, San Francisco Int'l
Airport Second Ser Refg Issue 27B (FGIC)................ 5.125 05/01/26 5,138,550
9,500 San Francisco Bay Area Rapid Transit District, Sales Tax
Ser 1998 (Ambac)........................................ 4.75 07/01/23 9,558,425
San Joaquin Hills Transportation Corridor Agency,
6,000 Toll Road Refg Ser 1997 A (MBIA)........................ 0.00 01/15/15 4,085,580
10,000 Toll Road Senior Lien Ser 1993.......................... 5.00 01/01/33 9,394,200
10,000 San Jose, Airport Ser 2001 A (FGIC)....................... 5.00 03/01/25 10,146,800
------------
- --------
83,140,347
85,700
------------
- --------
Water & Sewer Revenue (21.7%)
20,000 California Department of Water Resources, Center Valley
Ser Y (FGIC)............................................ 5.00 12/01/25 20,516,400
4,000 Corona Public Financing Authority, Water Ser 1998
(FGIC).................................................. 4.75 09/01/23 4,025,320
10,000 East Bay Municipal Utility District, Water Ser 2001
(MBIA).................................................. 5.00 06/01/26 10,173,900
8,000 Eastern Municipal Water District, Water & Sewer Refg Ser
1998 A COPs (FGIC)...................................... 4.75 07/01/23 8,012,960
Los Angeles Department of Water & Power,
5,000 Water 2001 Ser A........................................ 5.125 07/01/41 5,063,550
5,000 Water 2003 Ser A (FGIC)................................. 5.00 07/01/43 5,057,350
20,000 Los Angeles Wastewater, Refg Ser 2003 B (FSA)............. 5.00 06/01/22 20,588,200
5,000 San Diego County Water Authority, Ser 2004 A COPs (FSA)... 5.00 05/01/29 5,098,050
10,000 San Diego Public Facilities Authority, Sewer Ser 1993 A... 5.25 05/15/20 10,003,500
10,000 Sacramento Financing Authority, Water & Capital
Improvement 2001 Ser A (Ambac).......................... 5.00 12/01/26 10,173,900
San Francisco Public Utilities Commission,
5,650 Water 2002 Ser A (MBIA)................................. 5.00 11/01/20 5,830,630
4,525 Water 1996 Ser A........................................ 5.00 11/01/21 4,560,883
5,000 West Basin Municipal Water District, Refg Ser 2003 A COPs
(MBIA).................................................. 5.00 08/01/30 5,084,800
------------
- --------
114,189,443
112,175
------------
- --------
Other Revenue (2.9%)
10,000 California Economic Recovery, Ser 2004 A.................. 5.00 07/01/16 10,467,800
Golden State Tobacco Securitization Corporation,
1,000 Enhanced Asset Backed Ser 2005 A (Ambac)................ 5.00 06/01/21 1,037,710
4,000 Enhanced Asset Backed Ser 2005 A........................ 5.00 06/01/45 3,989,600
------------
- --------
15,495,110
15,000
------------
- --------
</Table>
See Notes to Financial Statements
16
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
Refunded (2.1%)
$ 10,000 California Department of Water Resources, Power Supply Ser
- -------- 2002 A**................................................ 5.375% 05/01/12+ $ 10,854,500
------------
498,385 Total California Tax-Exempt Municipal Bonds (Cost $489,452,454).............. 508,132,026
------------
- --------
Short-Term California Tax-Exempt Municipal Obligations (2.3%)
900 California Department of Water Resources, Power Supply Ser
2002 B (Demand 07/03/06)................................ 3.90* 05/01/22 900,000
1,500 California Health Facilities Financing Authority,
Adventist Health/ West 1998 Ser B (MBIA) (Demand
07/03/06)............................................... 3.93* 09/01/28 1,500,000
35 California Rural Home Financing Authority, Home 1997 Ser
D-CL 5 (AMT) (Called for redemption 08/01/06)........... 6.70 05/01/29 35,561
4,900 Metropolitan Water District of Southern California, Water
2000 Ser B-1 (Demand 07/03/06).......................... 3.91* 07/01/35 4,900,000
1,750 Newport Beach, Hoag Memorial Hospital Presbyterian 1992
Ser (Demand 07/03/06)................................... 3.88* 10/01/22 1,750,000
3,000 Pittsburg Redevelopment Agency, Los Medanos, 2004 Ser A
(Ambac) (Demand 07/03/06)............................... 3.99* 09/01/35 3,000,000
------------
- --------
12,085 Total Short-Term California Tax-Exempt Municipal Obligations (Cost
$12,087,835)................................................................. 12,085,561
------------
- --------
$510,470 Total Investments (Cost $501,540,289) (a) (b)...................... 98.8% 520,217,587
========
Other Assets in Excess of Liabilities.............................. 1.2 6,375,175
----- ------------
Net Assets......................................................... 100.0% $526,592,762
===== ============
</Table>
See Notes to Financial Statements
17
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2006 (UNAUDITED) continued
- ---------------------
<Table>
AMT Alternative Minimum Tax.
COPs Certificates of Participation.
RITES Residual Interest Tax-Exempt Security. (Illiquid security).
* Current coupon of variable rate demand obligation.
** A portion of this security has been physically segregated in
connection with open futures contracts in the amount of
$145,000.
+ 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. 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
$8,992,320 which represents 1.7% of net assets.
(a) Securities have been designated as collateral in an amount
equal to $31,158,126 in connection with open futures
contracts.
(b) The aggregate cost for federal income tax purposes
approximates the aggregate cost for book purposes. The
aggregate gross unrealized appreciation is $20,521,305 and
the aggregate gross unrealized depreciation is $1,460,210,
resulting in net unrealized appreciation of $19,061,095.
Bond Insurance:
- ---------------
Ambac Ambac Assurance Corporation.
FGIC Financial Guaranty Insurance Company.
FSA Financial Security Assurance Inc.
MBIA Municipal Bond Investors Assurance Corporation.
</Table>
FUTURES CONTRACTS OPEN AT JUNE 30, 2006:
<Table>
<Caption>
NUMBER OF DESCRIPTION, DELIVERY UNDERLYING FACE UNREALIZED
CONTRACTS LONG/SHORT MONTH AND YEAR AMOUNT AT VALUE APPRECIATION
- -------------------------------------------------------------------------------------
100 Short U.S. Treasury Notes 10 Year
September 2006 $(10,485,938) $ 37,224
200 Short U.S. Treasury Notes 5 Year
September 2006 (20,681,250) 97,889
--------
Total Unrealized Appreciation............................ $135,113
========
</Table>
See Notes to Financial Statements
18
Morgan Stanley California Tax-Free Income Fund
FINANCIAL STATEMENTS
Statement of Assets and Liabilities
June 30, 2006 (unaudited)
<Table>
Assets:
Investments in securities, at value
(cost $501,540,289)..................... $520,217,587
Cash..................................... 2,348,040
Receivable for:
Interest............................. 6,978,425
Shares of beneficial interest sold... 50,512
Investments sold..................... 30,827
Receivable from affiliate................ 81,698
Prepaid expenses and other assets........ 25,655
------------
Total Assets......................... 529,732,744
------------
Liabilities:
Payable for:
Investments purchased................ 2,256,534
Investment advisory fee.............. 195,293
Shares of beneficial interest
redeemed............................ 167,524
Distribution fee..................... 166,762
Dividends to shareholders............ 122,356
Variation margin..................... 92,187
Administration fee................... 35,017
Transfer agent fee................... 8,488
Accrued expenses and other payables...... 95,821
------------
Total Liabilities.................... 3,139,982
------------
Net Assets........................... $526,592,762
============
Composition of Net Assets:
Paid-in-capital.......................... $505,434,995
Net unrealized appreciation.............. 18,812,411
Accumulated undistributed net investment
income.................................. 446,898
Accumulated undistributed net realized
gain.................................... 1,898,458
------------
Net Assets........................... $526,592,762
============
Class A Shares:
Net Assets............................... $314,265,480
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 26,345,793
Net Asset Value Per Share............ $11.93
============
Maximum Offering Price Per Share,
(net asset value plus 4.44% of net
asset value)......................... $12.46
============
Class B Shares:
Net Assets............................... $137,462,637
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 11,451,132
Net Asset Value Per Share............ $12.00
============
Class C Shares:
Net Assets............................... $24,369,559
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 2,031,083
Net Asset Value Per Share............ $12.00
============
Class D Shares:
Net Assets............................... $50,495,086
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 4,220,451
Net Asset Value Per Share............ $11.96
============
</Table>
Statement of Operations
For the six months ended June 30, 2006 (unaudited)
<Table>
Net Investment Income:
Interest Income.......................... $ 13,514,631
------------
Expenses
Investment advisory fee.................. 1,275,325
Distribution fee (Class A shares)........ 397,220
Distribution fee (Class B shares)........ 47,141
Distribution fee (Class C shares)........ 94,948
Administration fee....................... 218,128
Transfer agent fees and expenses......... 96,343
Shareholder reports and notices.......... 41,298
Professional fees........................ 30,360
Custodian fees........................... 12,640
Trustees' fees and expenses.............. 7,303
Registration fees........................ 3,314
Other.................................... 31,410
------------
Total Expenses....................... 2,255,430
Less: amounts waived/reimbursed.......... (67,830)
Less: expense offset..................... (12,328)
------------
Net Expenses......................... 2,175,272
------------
Net Investment Income................ 11,339,359
------------
Net Realized and Unrealized Gain (Loss):
Net Realized Gain on:
Investments.............................. 1,280,746
Futures contracts........................ 678,732
------------
Net Realized Gain.................... 1,959,478
------------
Net Change in Unrealized Appreciation/
Depreciation on:
Investments.............................. (12,738,812)
Futures contracts........................ 223,047
------------
Net Depreciation..................... (12,515,765)
------------
Net Loss............................. (10,556,287)
------------
Net Increase............................. $ 783,072
============
</Table>
See Notes to Financial Statements
19
Morgan Stanley California Tax-Free Income Fund
FINANCIAL STATEMENTS continued
Statements of Changes in Net Assets
<Table>
<Caption>
FOR THE SIX FOR THE YEAR
MONTHS ENDED ENDED
JUNE 30, 2006 DECEMBER 31, 2005
------------- -----------------
(unaudited)
Increase (Decrease) in Net Assets:
Operations:
Net investment income....................................... $ 11,339,359 $ 25,348,818
Net realized gain........................................... 1,959,478 9,687,312
Net change in unrealized appreciation/depreciation.......... (12,515,765) (13,777,338)
------------ ------------
Net Increase............................................ 783,072 21,258,792
------------ ------------
Dividends and Distributions to Shareholders from:
Net investment income
Class A shares.......................................... (6,586,886) (9,719,215)
Class B shares.......................................... (3,187,092) (12,140,918)
Class C shares.......................................... (457,864) (968,237)
Class D shares.......................................... (1,140,389) (2,455,372)
Net realized gain
Class A shares.......................................... -- (5,480,668)
Class B shares.......................................... -- (2,674,136)
Class C shares.......................................... -- (436,485)
Class D shares.......................................... -- (895,913)
------------ ------------
Total Dividends and Distributions....................... (11,372,231) (34,770,944)
------------ ------------
Net decrease from transactions in shares of beneficial
interest.................................................. (32,219,197) (48,234,063)
------------ ------------
Net Decrease............................................ (42,808,356) (61,746,215)
Net Assets:
Beginning of period......................................... 569,401,118 631,147,333
------------ ------------
End of Period
(Including accumulated undistributed net investment income
of $446,898 and $479,770, respectively)..................... $526,592,762 $569,401,118
============ ============
</Table>
See Notes to Financial Statements
20
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED)
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 which is 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
fair 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
21
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
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.
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. 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 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.
E. 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.
F. Dividends and Distributions to Shareholders -- Dividends and distributions to
shareholders are recorded on the ex-dividend date.
G. 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
22
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
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.
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 expenses as of June 30,
2006.
23
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
For the six months ended June 30, 2006, the distribution fee was accrued for
Class B shares at the annual rate of 0.07%. At June 30, 2006, included in the
Statement of Assets and Liabilities, is a receivable from affiliate, which
represents payments due from the Distributor to the Fund.
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 or other selected
broker-dealer representatives may be reimbursed in the subsequent calendar year.
For the six months ended June 30, 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 six months ended June 30,
2006, it received contingent deferred sales charges from certain redemptions of
the Fund's Class B shares and Class C shares of $98,210 and $284, respectively
and received $57,739 in front-end sales charges from 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 six months ended June 30, 2006 aggregated
$19,128,340 and $55,183,882, respectively.
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 six months ended June 30, 2006 included in Trustees' fees
and expenses in the Statement of Operations amounted to $3,662. At June 30,
2006, the Fund had an accrued pension liability of $62,639 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 receives for serving on the Board of Trustees. Each eligible Trustee
generally may elect to have the deferred amounts credited
24
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
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. Shares of Beneficial Interest
Transactions in shares of beneficial interest were as follows:
<Table>
<Caption>
FOR THE SIX FOR THE YEAR
MONTHS ENDED ENDED
JUNE 30, 2006 DECEMBER 31, 2005
------------------------- --------------------------
(unaudited)
SHARES AMOUNT SHARES AMOUNT
---------- ------------ ----------- ------------
CLASS A SHARES
Sold............................................ 231,012 $ 2,791,129 510,370 $ 6,347,742
Conversion from Class B......................... 894,934 10,791,004 26,881,166 333,835,771
Reinvestment of dividends and distributions..... 290,796 3,507,038 709,137 8,718,752
Redeemed........................................ (2,195,669) (26,529,176) (2,517,480) (31,217,088)
---------- ------------ ----------- ------------
Net increase (decrease) - Class A............... (778,927) (9,440,005) 25,583,193 317,685,177
---------- ------------ ----------- ------------
CLASS B SHARES
Sold............................................ 158,780 1,928,971 636,974 7,964,926
Conversion to Class A........................... (889,299) (10,791,004) (26,729,720) (333,835,771)
Reinvestment of dividends and distributions..... 108,869 1,321,456 545,578 6,775,281
Redeemed........................................ (934,768) (11,372,106) (3,444,670) (43,042,005)
---------- ------------ ----------- ------------
Net decrease - Class B.......................... (1,556,418) (18,912,683) (28,991,838) (362,137,569)
---------- ------------ ----------- ------------
CLASS C SHARES
Sold............................................ 38,862 474,089 223,514 2,798,084
Reinvestment of dividends and distributions..... 21,978 266,623 73,982 915,630
Redeemed........................................ (186,283) (2,263,484) (338,227) (4,230,339)
---------- ------------ ----------- ------------
Net decrease - Class C.......................... (125,443) (1,522,772) (40,731) (516,625)
---------- ------------ ----------- ------------
CLASS D SHARES
Sold............................................ 99,773 1,208,407 211,330 2,634,719
Reinvestment of dividends and distributions..... 51,543 623,553 154,996 1,915,329
Redeemed........................................ (345,184) (4,175,697) (628,321) (7,815,094)
---------- ------------ ----------- ------------
Net decrease - Class D.......................... (193,868) (2,343,737) (261,995) (3,265,046)
---------- ------------ ----------- ------------
Net decrease in Fund............................ (2,654,656) $(32,219,197) (3,711,371) $(48,234,063)
========== ============ =========== ============
</Table>
6. Expense Offset
The expense offset represents a reduction of custodian and transfer agent fees
and expenses for earnings on cash balances maintained by the Fund.
25
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
7. Risks Relating to Certain Financial Instruments
The Fund may invest a portion of its assets in residual interest bonds, which
are inverse floating rate municipal obligations. The prices of these securities
are subject to greater market fluctuations during periods of changing prevailing
interest rates than are comparable fixed rate obligations.
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, are named as
defendants in a consolidated class action. This consolidated action also names
as defendants certain individual Trustees and Directors of the Morgan Stanley
funds. The consolidated amended complaint, filed in the United States District
Court Southern District of New York on April 16, 2004, generally alleges 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
other 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 efforts to recommend these funds to investors. The
complaint seeks, among other things, unspecified compensatory damages,
rescissionary damages, fees and costs. The defendants have moved to dismiss the
action. On March 9, 2005, Plaintiffs sought leave to supplement their complaint
to assert claims on behalf of other investors, which motion defendants opposed.
On April 14, 2006, the Court granted defendants' motion to dismiss in its
entirety. Additionally, the Court denied Plaintiff's motion to supplement their
complaint. This matter 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 accepted accounting principles.
These "book/tax" differences are either considered temporary or
26
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2006 (UNAUDITED) continued
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.
As of December 31, 2005, the Fund had temporary book/tax differences primarily
attributable to post-October losses (capital losses incurred after October 31
within the taxable year which are deemed to arise on the first business day of
the Fund's next taxable year), mark-to-market of open futures contracts and book
amortization of discounts on debt securities.
10. New Accounting Pronouncement
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 meet before
being recognized in the financial statements. FIN 48 is effective for fiscal
years beginning after December 15, 2006. The Fund will adopt FIN 48 during 2007
and the impact to the Fund's financial statements, if any, is currently being
assessed.
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:
<Table>
<Caption>
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31,
MONTHS ENDED -----------------------------------------------------------------
JUNE 30, 2006 2005 2004 2003 2002 2001
------------- --------- -------- -------- -------- --------
(unaudited)
Class A Shares
Selected Per Share Data:
Net asset value, beginning of period... $12.16 $12.46 $12.58 $12.68 $12.34 $12.49
------ ------ ------ ------ ------ ------
Income (loss) from investment
operations:
Net investment income.............. 0.25 0.52 0.54 0.55 0.57 0.57
Net realized and unrealized gain
(loss)............................. (0.23) (0.10) (0.02) (0.01) 0.44 (0.10)
------ ------ ------ ------ ------ ------
Total income from investment
operations............................ 0.02 0.42 0.52 0.54 1.01 0.47
------ ------ ------ ------ ------ ------
Less dividends and distributions from:
Net investment income.............. (0.25) (0.51) (0.53) (0.55) (0.57) (0.58)
Net realized gain.................. -- (0.21) (0.11) (0.09) (0.10) (0.04)
------ ------ ------ ------ ------ ------
Total dividends and distributions...... (0.25) (0.72) (0.64) (0.64) (0.67) (0.62)
------ ------ ------ ------ ------ ------
Net asset value, end of period......... $11.93 $12.16 $12.46 $12.58 $12.68 $12.34
====== ====== ====== ====== ====== ======
Total Return+.......................... 0.11%(2) 3.44% 4.26% 4.31% 8.37% 3.90%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)............................... 0.85%(3)(4) 0.86%(4) 0.81% 0.78% 0.80% 0.80%
Net investment income.................. 4.11%(3)(4) 4.11%(4) 4.29% 4.34% 4.53% 4.62%
Supplemental Data:
Net assets, end of period, in
thousands............................. $314,265 $329,938 $19,203 $17,422 $20,775 $17,147
Portfolio turnover rate................ 4%(2) 23% 10% 11% 12% 13%
</Table>
- ---------------------
<Table>
+ 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) Not annualized.
(3) Annualized.
(4) 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 would have been as follows:
</Table>
<Table>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
----------------- ---- ----
June 30, 2006 0.88% 4.08%
December 31, 2005 0.87 4.10
</Table>
See Notes to Financial Statements
28
Morgan Stanley California Tax-Free Income Fund
FINANCIAL HIGHLIGHTS continued
<Table>
<Caption>
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31,
MONTHS ENDED ---------------------------------------------------------------------
JUNE 30, 2006 2005 2004 2003 2002 2001
------------- --------- --------- --------- --------- ---------
(unaudited)
Class B Shares
Selected Per Share Data:
Net asset value, beginning of
period............................ $12.24 $12.52 $12.65 $12.75 $12.42 $12.57
------ ------ ------ ------ ------ ------
Income (loss) from investment
operations
Net investment income.......... 0.26 0.54 0.54 0.55 0.56 0.55
Net realized and unrealized
gain (loss).................... (0.24) (0.08) (0.02) (0.02) 0.42 (0.11)
------ ------ ------ ------ ------ ------
Total income from investment
operations........................ 0.02 0.46 0.52 0.53 0.98 0.44
------ ------ ------ ------ ------ ------
Less dividends and distributions
from:
Net investment income.......... (0.26) (0.53) (0.54) (0.54) (0.55) (0.55)
Net realized gain.............. -- (0.21) (0.11) (0.09) (0.10) (0.04)
------ ------ ------ ------ ------ ------
Total dividends and
distributions..................... (0.26) (0.74) (0.65) (0.63) (0.65) (0.59)
------ ------ ------ ------ ------ ------
Net asset value, end of period..... $12.00 $12.24 $12.52 $12.65 $12.75 $12.42
====== ====== ====== ====== ====== ======
Total Return+...................... 0.13%(2) 3.74% 4.22% 4.27% 8.13% 3.56%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)........................... 0.67%(3)(5) 0.68%(5) 0.78%(4) 0.83%(4) 0.93%(4) 1.04%(4)
Net investment income.............. 4.29%(3)(5) 4.29%(5) 4.32%(4) 4.29%(4) 4.40%(4) 4.38%(4)
Supplemental Data:
Net assets, end of period, in
thousands......................... $137,463 $159,221 $526,026 $599,737 $682,046 $696,481
Portfolio turnover rate............ 4%(2) 23% 10% 11% 12% 13%
</Table>
- ---------------------
<Table>
+ 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) Not annualized.
(3) Annualized.
(4) If the Fund had borne all of its expenses that were reimbursed by the Distributor, the annualized expense and
net investment income ratios would have been as follows:
</Table>
<Table>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
----------------- ---- ----
December 31, 2004 1.03% 4.07%
December 31, 2003 1.35 3.77
December 31, 2002 1.35 3.98
December 31, 2001 1.34 4.06
</Table>
<Table>
(5) 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 would have been as follows:
</Table>
<Table>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
----------------- ---- ----
June 30, 2006 0.70% 4.26%
December 31, 2005 0.69 4.28
</Table>
See Notes to Financial Statements
29
Morgan Stanley California Tax-Free Income Fund
FINANCIAL HIGHLIGHTS continued
<Table>
<Caption>
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31,
MONTHS ENDED ----------------------------------------------------------------
JUNE 30, 2006 2005 2004 2003 2002 2001
------------- -------- -------- -------- -------- --------
(unaudited)
Class C Shares
Selected Per Share Data:
Net asset value, beginning of period.... $12.23 $12.52 $12.65 $12.74 $12.42 $12.57
------ ------ ------ ------ ------ ------
Income (loss) from investment
operations:
Net investment income............... 0.22 0.45 0.47 0.48 0.50 0.51
Net realized and unrealized gain
(loss).............................. (0.23) (0.08) (0.02) 0.00 0.42 (0.11)
------ ------ ------ ------ ------ ------
Total income (loss) from investment
operations............................. (0.01) 0.37 0.45 0.48 0.92 0.40
------ ------ ------ ------ ------ ------
Less dividends and distributions from:
Net investment income............... (0.22) (0.45) (0.47) (0.48) (0.50) (0.51)
Net realized gain................... -- (0.21) (0.11) (0.09) (0.10) (0.04)
------ ------ ------ ------ ------ ------
Total dividends and distributions....... (0.22) (0.66) (0.58) (0.57) (0.60) (0.55)
------ ------ ------ ------ ------ ------
Net asset value, end of period.......... $12.00 $12.23 $12.52 $12.65 $12.74 $12.42
====== ====== ====== ====== ====== ======
Total Return+........................... (0.12)%(2) 2.97% 3.61% 3.80% 7.59% 3.33%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)................................ 1.35%(3)(4) 1.36%(4) 1.36% 1.35% 1.35% 1.34%
Net investment income................... 3.61%(3)(4) 3.61%(4) 3.74% 3.77% 3.98% 4.09%
Supplemental Data:
Net assets, end of period, in
thousands............................. $24,370 $26,385 $27,519 $26,435 $25,825 $16,745
Portfolio turnover rate................. 4%(2) 23% 10% 11% 12% 13%
</Table>
- ---------------------
<Table>
+ 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) Not annualized.
(3) Annualized.
(4) 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 would have been as follows:
</Table>
<Table>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
----------------- ---- ----
June 30, 2006 1.38% 3.58%
December 31, 2005 1.37 3.60
</Table>
See Notes to Financial Statements
30
Morgan Stanley California Tax-Free Income Fund
FINANCIAL HIGHLIGHTS continued
<Table>
<Caption>
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31,
MONTHS ENDED -------------------------------------------------------
JUNE 30, 2006 2005 2004 2003 2002 2001
------------- -------- -------- -------- -------- --------
(unaudited)
Class D Shares
Selected Per Share Data:
Net asset value, beginning of period............ $12.20 $12.49 $12.61 $12.71 $12.39 $12.53
------ ------ ------ ------ ------ ------
Income (loss) from investment operations:
Net investment income....................... 0.26 0.54 0.56 0.57 0.60 0.60
Net realized and unrealized gain (loss)..... (0.24) (0.08) (0.01) (0.01) 0.41 (0.10)
------ ------ ------ ------ ------ ------
Total income from investment operations......... 0.02 0.46 0.55 0.56 1.01 0.50
------ ------ ------ ------ ------ ------
Less dividends and distributions from:
Net investment income....................... (0.26) (0.54) (0.56) (0.57) (0.59) (0.60)
Net realized gain........................... -- (0.21) (0.11) (0.09) (0.10) (0.04)
------ ------ ------ ------ ------ ------
Total dividends and distributions............... (0.26) (0.75) (0.67) (0.66) (0.69) (0.64)
------ ------ ------ ------ ------ ------
Net asset value, end of period.................. $11.96 $12.20 $12.49 $12.61 $12.71 $12.39
====== ====== ====== ====== ====== ======
Total Return+................................... 0.16%(2) 3.74% 4.48% 4.50% 8.41% 4.12%
Ratios To Average Net Assets(1):
Total expenses (before expense offset).......... 0.60%(3)(4) 0.61%(4) 0.61% 0.60% 0.60% 0.59%
Net investment income........................... 4.36%(3)(4) 4.36%(4) 4.49% 4.52% 4.73% 4.84%
Supplemental Data:
Net assets, end of period, in thousands......... $50,495 $53,857 $58,399 $66,143 $75,332 $83,638
Portfolio turnover rate......................... 4%(2) 23% 10% 11% 12% 13%
</Table>
- ---------------------
<Table>
+ 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) Not annualized.
(3) Annualized.
(4) 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 would have been as follows:
</Table>
<Table>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
----------------- ---- ----
June 30, 2006 0.63% 4.33%
December 31, 2005 0.62 4.35
</Table>
31
See Notes to Financial Statements
TRUSTEES
Michael Bozic
Charles A. Fiumefreddo
Edwin J. Garn
Wayne E. Hedien
James F. Higgins
Dr. Manuel H. Johnson
Joseph J. Kearns
Michael E. Nugent
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
The financial statements included herein have been taken from the records of the
Fund without examination by the independent auditors and accordingly they do not
express an opinion thereon.
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.
Investments and services offered through Morgan Stanley DW Inc., member SIPC.
Morgan Stanley Distributors Inc., member NASD.
(c) 2006 Morgan Stanley
[MORGAN STANLEY LOGO]
MORGAN STANLEY FUNDS
Morgan Stanley
California Tax-Free
Income Fund
Semiannual Report
June 30, 2006
[MORGAN STANLEY LOGO]
CLFSAR-37900RPT-RA06-00724P-Y06/06
Item 2. Code of Ethics.
Not applicable for semiannual reports.
Item 3. Audit Committee Financial Expert.
Not applicable for semiannual reports.
Item 4. Principal Accountant Fees and Services
Not applicable for semiannual reports.
Item 5. Audit Committee of Listed Registrants.
Not applicable for semiannual reports.
Item 6.
Refer to Item 1.
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End
Management Investment Companies.
Not applicable for semiannual reports.
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 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) Code of Ethics - Not applicable for semiannual reports.
(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.
2
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
- -------------------------------------
Ronald E. Robison
Principal Executive Officer
August 10, 2006
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
- -------------------------------------
Ronald E. Robison
Principal Executive Officer
August 10, 2006
/s/ Francis Smith
- -------------------------------------
Francis Smith
Principal Financial Officer
August 10, 2006
3