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)
522 Fifth Avenue, New York, New York 10036
(Address of principal executive offices) (Zip code)
Ronald E. Robison
522 Fifth Avenue, New York, New York 10036
(Name and address of agent for service)
Registrant's telephone number, including area code: 212-296-6990
Date of fiscal year end: December 31, 2007
Date of reporting period: June 30, 2007
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, 2007
TOTAL RETURN FOR THE 6 MONTHS ENDED JUNE 30, 2007
<Table>
<Caption>
LEHMAN LIPPER
BROTHERS CALIFORNIA
CALIFORNIA MUNICIPAL
EXEMPT DEBT FUNDS
CLASS A CLASS B CLASS C CLASS D INDEX(1) INDEX(2)
-0.25% -0.20% -0.47% -0.12% 0.13% -0.02%
</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, 2007, 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. Currently, the Distributor has agreed to waive the 12b-1 fee on
Class B shares to the extent it exceeds 0.24% of the average daily net assets of
such shares on an annualized basis. The Distributor may discontinue this waiver
in the future.
MARKET CONDITIONS
Economic growth was initially sluggish but became decidedly more positive as the
period progressed. Weaker consumer spending and rising energy prices weighed on
the economy in the first quarter of 2007. At the same time, troubles in the
sub-prime mortgage market surfaced, intensifying concerns about the already weak
residential housing sector. Against this backdrop, speculation began to emerge
that the Federal Open Market Committee (the "Fed") might reduce its target
federal funds rate. As the months progressed, energy prices continued to rise
and productivity gains slowed, but employment growth remained strong and various
economic indicators began to improve. This led to anticipation of a rebound in
economic growth and renewed concerns about inflation, which effectively
dispelled expectations of a near-term ease in Fed monetary policy and yields
moved higher across the Treasury curve. In the last weeks of June, however,
yields declined when news of the failure of two of Bear Stearns'
mortgage-related hedge funds fueled a flight-to-quality Treasury market rally.
Despite the market's volatility and the changing outlook for the economy and
monetary policy during the period, the target federal funds rate has remained
unchanged at 5.25 percent for the past year.
Municipal bond yields generally followed the same path as Treasury yields,
declining in January and February then rising for most of the remainder of the
period. Yields on long-term issues (as represented by the 30-year AAA rated
municipal bond) moved from 4.10 percent at the beginning of the period to 4.55
percent in mid-June, then declined to 4.45 percent by the end of the period.
Yields on 10-year bonds moved in a similar pattern while yields on short-term
municipals remained relatively stable. As such, the slope of the curve steepened
for the overall period, with a 75 basis point yield advantage, or "pick-up", for
30-year maturities relative to one-year maturities at the end of June. Despite
the steepening, however, the curve still ended the period relatively flat
2
in historic terms as the yield pick-up from one to 30 years has averaged 150
basis points over the past three years.
Long-term municipal bonds performed relatively in line with Treasuries until
late June when the flight to quality helped Treasuries outperform. The 30-year
municipal-to-Treasury yield ratio, which measures the relative attractiveness of
these two sectors, held steady at 85 percent through March, then rose slightly
to end the period at 87 percent. A rising ratio indicates that municipals
underperformed Treasuries but became more attractive on a relative price basis.
Issuance of municipal bonds jumped nearly 50 percent in the first calendar
quarter, due primarily to a surge in refundings, but fell off in the second
quarter as rising interest rates discouraged borrowers from issuing new debt at
higher rates. Nonetheless, new issue volume for the first half of 2007 totaled
$226 billion, a 27 percent increase versus the same six-month period in 2006.
The top five issuing states during the reporting period were California, Texas,
Florida, New York, and Pennsylvania. Together, these states accounted for 47
percent of total market volume.
New issue volume in California totaled more than $41 billion during the period,
a 75 percent increase versus the same period last year. The state continued to
enjoy a generally good economic footing, with a large and diverse economic base,
a small positive general fund balance, an improved financial outlook, and a
relatively well-funded pension system. Additionally, California's debt levels
remain moderate despite accelerating debt issuance. Per capita and median
household incomes were above national averages but the state's unemployment rate
was slightly higher than the nation's average.
As a final note, the U.S. Supreme Court agreed in May to review Davis v. The
State of Kentucky Department of Revenue, a case that questions whether
differential tax treatment of in-state and out-of-state municipal bond interest
is constitutional. The executive branch of the Commonwealth of Kentucky is
seeking to overturn a state court ruling that it is unconstitutional to treat
interest on bonds issued by government entities in their state more favorably
for tax purposes than interest on bonds issued in other states. Given that the
majority of states currently exempt only interest on their municipal bonds from
state income taxes, the market will be closely watching this case.
PERFORMANCE ANALYSIS
All share classes of Morgan Stanley California Tax-Free Income Fund
underperformed the Lehman Brothers California Exempt Index and the Lipper
California Municipal Debt Funds Index for the six months ended June 30, 2007,
assuming no deduction of applicable sales charges.
During the reporting period, the Fund's interest-rate positioning continued to
reflect our anticipation of higher rates. As a result, at the end of June, the
Fund's option-adjusted duration* stood at 7.4 years. This defensive posture
proved additive to performance as interest rates rose for the overall period.
The Fund's performance was also enhanced by several holdings that appreciated
when they were pre-refunded.**
3
The Fund maintained its high quality bias with approximately 86 percent of the
portfolio rated A or better as of end of period. In particular, the Fund was
overweighted in higher-rated bonds in sectors such as public power, higher
education, water and sewer, and transportation. This high credit-quality profile
impeded performance since lower-rated bonds outperformed during the period. That
said, we have been adding to positions in BBB rated securities, which helped
boost returns. It should also be noted that the Fund contained no bonds subject
to the Alternative Minimum Tax (AMT) during the period. These positions were
eliminated from the portfolio prior to the start of the year and we intend to
continue to run the Fund as AMT free at least through the end of 2007.
Reflecting a commitment to diversification, the Fund's net assets of
approximately $469 million were invested among 12 long-term sectors and 57
credits. As of the close of the period, the Fund's largest allocations were to
the water and sewer, hospital and transportation sectors.
There is no guarantee that any sectors mentioned will continue to perform well
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.
** Pre-refunding, or advance refunding, is a financing structure under which new
bonds are issued to repay an outstanding bond issue on its first call date.
<Table>
<Caption>
TOP FIVE SECTORS
Water & Sewer 18.7%
Hospital 15.7
Transportation 15.6
General Obligation 12.0
Appropriation 11.0
</Table>
<Table>
<Caption>
LONG-TERM CREDIT ANALYSIS
Aaa/AAA 63.9%
Aa/AA 4.8
A/A 17.6
Baa/BBB 11.5
Ba/BB or Less 2.2
</Table>
Data as of June 30, 2007. 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.
4
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 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, 2007
WEIGHTED AVERAGE MATURITY: 16 YEARS(A)
<Table>
0-5 10
6-10 15
11-15 29
16-20 22
21-25 10
26-30 7
31+ 7
</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, 2007
YEARS BONDS CALLABLE -- WEIGHTED AVERAGE CALL PROTECTION: 5 YEARS
<Table>
2007 (a) 2
2008 16
2009 5
2010 2
2011 18
2012 8
2013 10
2014 7
2015 16
2016 4
2017 + 12
</Table>
COST (BOOK) YIELD(B) -- WEIGHTED AVERAGE BOOK YIELD: 5.3%
<Table>
2007(a) 5.8
2008 5.4
2009 5.2
2010 6.5
2011 5.1
2012 5.1
2013 5.1
2014 5.4
2015 5.2
2016 5.0
2017+ 5.9
</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 5.8% on 2% of the
long-term portfolio that is callable in 2007.
Portfolio structure is subject to change.
7
PERFORMANCE SUMMARY
AVERAGE ANNUAL TOTAL RETURNS -- PERIOD ENDED JUNE 30, 2007
<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 4.26%(3) 4.47%(3) 3.75%(3) 4.60%(3)
(0.17) (4) (0.51) (4) 2.75(4) --
5 YEARS 4.25(3) 4.32(3) 3.70(3) 4.47(3)
3.34(4) 4.00(4) 3.70(4) --
10 YEARS -- 4.67(3) -- --
-- 4.67(4) -- --
SINCE INCEPTION 4.49(3) 6.76(3) 3.99(3) 4.75(3)
4.03(4) 6.76(4) 3.99(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. 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. The Fund is in the Lipper California
Municipal Debt Funds classification as of the date of this report.
(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 01/01/07 - 06/30/07.
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*
------------- ------------- ---------------
01/01/07 -
01/01/07 06/30/07 06/30/07
------------- ------------- ---------------
CLASS A
Actual (-0.25% return)...................................... $1,000.00 $ 997.50 $5.05
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,019.74 $5.11
CLASS B
Actual (-0.20% return)...................................... $1,000.00 $ 998.00 $4.71
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,020.08 $4.76
CLASS C
Actual (-0.47% return)...................................... $1,000.00 $ 995.30 $7.47
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,017.31 $7.55
CLASS D
Actual (-0.12% return)...................................... $1,000.00 $ 998.80 $3.87
Hypothetical (5% annual return before expenses)............. $1,000.00 $1,020.93 $3.91
</Table>
- ------------------
* Expenses are equal to the Fund's annualized expense ratios of 1.02,% 0.95%,
1.51% and 0.78% 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
1.06%, 0.99%, 1.55% and 0.82% 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 June 30, 2007, 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. Currently, the Distributor has agreed to waive the 12b-1
fee on Class B shares to the extent it exceeds 0.24% of the average daily net
assets of such shares on an annualized basis. The Distributor may discontinue
this waiver in the future.
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, 2006, 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 discussed with the Adviser the
performance goals and the actual results achieved in managing the Fund. The
Board concluded that the Fund's performance was competitive with that of its
performance peer group.
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 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
On April 25, 2007, 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
until April 30, 2008. On June 20, 2007, the Board again considered and weighed
all of the above factors and concluded that it would be in the best interest of
the Fund and its shareholders to approve renewal of the Management Agreement to
continue until June 30, 2008.
12
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2007 (UNAUDITED)
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
California Tax-Exempt Municipal Bonds (104.2%)
General Obligation (12.0%)
California,
$ 5,000 Ser 1990................................................ 7.00 % 08/01/08 $ 5,171,700
2,000 Veterans Ser AT......................................... 9.50 02/01/10 2,260,220
10,000 Economic Recovery, Ser 2004 A........................... 5.00 07/01/16 10,404,300
535 Various Purpose Dtd 04/01/93 (FSA)...................... 5.50 04/01/19 537,225
5,000 Various Purpose Dtd 04/01/02............................ 6.00 04/01/19 5,735,200
2,650 Ser 1996 (Ambac)........................................ 5.25 06/01/21 2,677,613
5,000 Various Purpose Dtd 12/01/05............................ 5.00 03/01/27 5,136,000
3,000 Huntington Beach Union High School District, Ser 2004
(FSA)................................................... 5.00 08/01/27 3,115,710
5,000 Los Angeles, Ser 2004 A (MBIA)............................ 5.00 09/01/24 5,205,300
5,000 San Francisco City & County, Laguna Honda Hospital Ser
2005 (FSA)#............................................. 5.00 06/15/30 5,214,960
Puerto Rico,
8,000 Public Impr Ser 1999.................................... 4.75 07/01/23 7,968,880
3,000 Public Impr Ser 1999 (Secondary MBIA)................... 4.875 07/01/23 3,050,430
------------
- --------
56,477,538
54,185
------------
- --------
Appropriation (11.0%)
California Public Works Board,
2,000 Butterfield State Office 2005 Ser A..................... 5.25 06/01/30 2,086,100
10,000 Department of Corrections Refg 1993 Ser A (Ambac)....... 5.00 12/01/19 10,594,700
3,000 Golden State Tobacco Securitization Corporation,
Enhanced Asset Backed Ser 2005 A........................ 5.00 06/01/45 3,034,110
20,000 Long Beach Financing Authority, Ser 1992 (Ambac).......... 6.00 11/01/17 22,371,000
3,000 Los Angeles Municipal Improvement Corporation, Police
Headquaters Ser 2006 - A (FGIC)......................... 4.75 01/01/31 2,981,070
2,530 Poway Uniform School District Public Financing Authority,
Ser 2007 (Ambac)........................................ 4.625 09/15/42 2,411,672
4,000 San Francisco City & County, City Buildings Ser 2007 A
COPs (FGIC)............................................. 4.50 09/01/37 3,768,840
5,000 Puerto Rico Public Buildings Authority, 2002 Ser D
(Ambac)................................................. 0.00++ 07/01/31 4,233,400
------------
- --------
51,480,892
49,530
------------
- --------
Dedicated Tax (1.3%)
4,000 Anaheim Public Financing Authority, 1997 Ser C (FSA)...... 6.00 09/01/16 4,543,760
1,500 Fontana Public Finance Authority, Ser 2003 A (Ambac)...... 5.375 09/01/25 1,582,980
------------
- --------
6,126,740
5,500
------------
- --------
</Table>
See Notes to Financial Statements
13
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2007 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
Education (8.2%)
California Educational Facilities Authority,
$ 2,000 California College of Arts Ser 2005..................... 5.00 % 06/01/35 $ 2,004,460
3,000 Mills College Ser 2005 A................................ 5.00 09/01/29 3,076,680
2,000 Pitzer College Ser 2005 A............................... 5.00 04/01/35 2,034,580
2,000 University of Redlands Ser 2005 A....................... 5.00 10/01/35 2,039,140
5,000 University of San Diego Ser 1998 (Ambac)................ 5.00 10/01/22 5,103,100
2,000 California Infrastructure & Economic Development Bank,
California Science Center Foundation Phase II Ser 2006 B
(FGIC).................................................. 5.00 05/01/31 2,056,720
1,000 California Municipal Finance Authority, American Heritage
Educational Foundation Ser 2006 A....................... 5.25 06/01/26 1,023,200
2,000 San Diego County, Burnham Institute for Medical Research
Ser 2006 COPs........................................... 5.00 09/01/34 1,993,960
University of California,
10,400 Ser 2007 J (FSA)#....................................... 4.50 05/15/31 10,008,700
9,600 Ser 2007 J (FSA)#....................................... 4.50 05/15/35 9,238,800
------------
- --------
38,579,340
39,000
------------
- --------
Hospital (15.7%)
8,000 Antelope Valley Healthcare District, Refg Ser 1997 A
(FSA)................................................... 5.20 01/01/20 8,202,000
California Health Facilities Financing Authority,
4,000 Cedars-Sinai Medical Center Ser 2005.................... 5.00 11/15/27 4,043,440
5,000 Cedars-Sinai Medical Center Ser 2005.................... 5.00 11/15/34 5,040,600
2,000 Kaiser Permanente Ser 2006 A............................ 5.25 04/01/39 2,050,620
2,500 Sutter/CHS Ser 1996 A (MBIA)............................ 5.875 08/15/16 2,553,900
5,000 California Infrastructure & Economic Development Bank,
Kaiser Hospital Ser 2001 A.............................. 5.55 08/01/31 5,211,800
California Statewide Communities Development Authority,
5,000 Adventist Healthwest 2005 Ser A......................... 5.00 03/01/30 5,037,700
1,440 Cedars-Sinai Medical Center Ser 1992 COPs............... 6.50 08/01/12 1,510,618
3,000 Daughters of Charity Health Ser 2005 A.................. 5.25 07/01/30 3,055,920
14,000 Duarte, City of Hope National Medical Center Ser 1999 A
COPs.................................................... 5.25 04/01/19 14,326,480
5,000 Loma Linda, Loma Linda University Medical Center Ser 2005
A....................................................... 5.00 12/01/20 5,052,900
7,500 Madera County, Valley Children's Hospital Ser 1995 COPs
(MBIA).................................................. 6.50 03/15/15 8,430,150
4,000 Rancho Mirage Joint Powers Financing Authority, Eisenhower
Medical Center Ser 1997 A COPs (MBIA)................... 5.25 07/01/17 4,084,160
5,000 University California, UCLA Medical Center Ser 2004 A
(Ambac)................................................. 5.00 05/15/39 5,099,900
------------
- --------
73,700,188
71,440
------------
- --------
Housing (0.5%)
2,000 Independent Cities Lease Financing Authority, San Juan
- -------- Mobile Estates Ser 2006 A............................... 5.125 05/15/41 2,035,580
------------
</Table>
See Notes to Financial Statements
14
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2007 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
Industrial Development/Pollution Control (1.2%)
$ 5,000 California Pollution Control Financing Authority, San
- -------- Diego Gas & Electric Co 1996 Ser A...................... 5.90 % 06/01/14 $ 5,435,400
------------
Public Power (6.5%)
20,000 Los Angeles Department of Water & Power, 2001 Ser A
(FSA)................................................... 5.25 07/01/22 20,781,800
Southern California Public Power Authority,
3,500 Mead-Adelanto 1994 Ser A (Ambac)........................ 6.44+++ 07/01/15 3,989,895
2,500 Mead-Phoenix 1994 Ser A (Ambac)......................... 6.44+++ 07/01/15 2,849,925
2,750 Transmission Refg Ser 2002 A (FSA)...................... 5.25 07/01/18 2,894,980
------------
- --------
30,516,600
28,750
------------
- --------
Tobacco Settlement (5.9%)
5,000 California County Tobacco Securitization Agency, Los
Angeles County Securitization Corp Ser 2006............. 0.00++ 06/01/28 4,288,200
Golden State Tobacco Securitization Corporation,
4,000 Enhanced Asset Backed Ser 2007 A-1#..................... 5.125 06/01/47 3,913,360
10,000 Enhanced Asset Backed Ser 2007 A-1#..................... 5.75 06/01/47 10,457,150
Tobacco Securitization Authority of Northern California,
Sacramento County Tobacco Securitization Corporation
4,000 Ser 2006 A-1............................................ 5.00 06/01/37 3,868,480
5,000 Ser 2005 A-1............................................ 5.50 06/01/45 5,102,650
------------
- --------
27,629,840
28,000
------------
- --------
Transportation (15.6%)
10,000 Alameda Corridor Transportation Authority, Sr Lien Ser
1999 A (MBIA)........................................... 5.25 10/01/21 10,383,100
Foothill/Eastern Transportation Corridor Agency,
5,000 Toll Road Ser 1999 (MBIA)............................... 5.125 01/15/19 5,173,150
14,000 Toll Road Ser 1999...................................... 0.00++ 01/15/23 13,044,220
5,200 Port of Oakland, Ser 2002 M (FGIC)........................ 5.25 11/01/19 5,490,212
5,000 San Francisco Airports Commission, San Francisco Int'l
Airport Second Ser Refg Issue 27B (FGIC)................ 5.125 05/01/26 5,158,550
9,500 San Francisco Bay Area Rapid Transit District, Sales Tax
Ser 1998 (Ambac)........................................ 4.75 07/01/23 9,581,985
San Joaquin Hills Transportation Corridor Agency,
6,000 Toll Road Refg Ser 1997 A (MBIA)........................ 0.00 01/15/15 4,381,680
10,000 Toll Road Senior Lien Ser 1993.......................... 5.00 01/01/33 9,793,900
10,000 San Jose, Airport Ser 2001 A (FGIC)....................... 5.00 03/01/25 10,254,700
------------
- --------
73,261,497
74,700
------------
- --------
Water & Sewer (18.7%)
20,000 California Department of Water Resources, Center Valley
Ser Y (FGIC)............................................ 5.00 12/01/25 20,566,400
4,000 Corona Public Financing Authority, Water Ser 1998
(FGIC).................................................. 4.75 09/01/23 4,036,080
</Table>
See Notes to Financial Statements
15
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2007 (UNAUDITED) continued
<Table>
<Caption>
PRINCIPAL
AMOUNT IN COUPON MATURITY
THOUSANDS RATE DATE VALUE
- ---------------------------------------------------------------------------------------------------------
$ 8,000 Eastern Municipal Water District, Water & Sewer Refg Ser
1998 A COPs (FGIC)...................................... 4.75 % 07/01/23 $ 8,041,120
Los Angeles Department of Water & Power,
5,000 Water 2001 Ser A........................................ 5.125 07/01/41 5,074,000
5,000 Water 2003 Ser A (FGIC)................................. 5.00 07/01/43 5,080,450
20,000 Los Angeles, Wastewater Refg Ser 2003 B (FSA)............. 5.00 06/01/22 20,680,000
5,000 San Diego County Water Authority, Ser 2004 A COPs (FSA)... 5.00 05/01/29 5,138,350
10,000 San Diego Public Facilities Authority, Sewer Ser 1993 A... 5.25 05/15/20 10,004,700
4,000 San Francisco Public Utilities Commission, Water 2002 Ser
A (MBIA)................................................ 5.00 11/01/20 4,165,960
5,000 West Basin Municipal Water District, Refg Ser 2003 A COPs
(MBIA).................................................. 5.00 08/01/30 5,119,600
------------
- --------
87,906,660
86,000
------------
- --------
Refunded (7.6%)
4,000 Bay Area Toll Authority, San Francisco Bay Area Toll
Bridge 2001 Ser D....................................... 5.00 04/01/11+ 4,161,320
10,000 California Department of Water Resources, Power Supply Ser
2002 A.................................................. 5.375 05/01/12+ 10,738,600
10,000 East Bay Municipal Utility District, Water Ser 2001
(MBIA).................................................. 5.00 06/01/11+ 10,420,200
10,000 Sacramento Financing Authority, Water & Capital
Improvement Ser 2001 A (Ambac).......................... 5.00 06/01/11+ 10,420,200
------------
- --------
35,740,320
34,000
------------
- --------
478,105 Total California Tax-Exempt Municipal Bonds (Cost $470,732,270).............. 488,890,595
------------
- --------
Short-Term California Tax-Exempt Municipal Obligations (0.8%)
2,000 California Health Facilities Finance Authority, Adventist
West Ser 1998 A (Demand 07/02/07)....................... 3.81* 09/01/28 2,000,000
1,700 San Pablo Redevelopment Agency, Ser 2006 (Ambac) (Demand
07/02/07)............................................... 3.88* 12/01/32 1,700,000
------------
- --------
3,700 Total Short-Term California Tax-Exempt Municipal Obligations
(Cost $3,700,000)......................................................... 3,700,000
------------
- --------
481,805 Total Investments (Cost $474,432,270)........................................ 492,590,595
------------
- --------
Floating Rate Note Obligations Related to Securities Held (6.1%)
(28,500) Notes with interest rates ranging from 3.71% to 3.75% at
- -------- June 30, 2007 and contractual maturities of collateral ranging
from 06/15/30 to 06/01/47 (see Note 1D) ## (Cost $(28,500,000))............ (28,500,000)
------------
</Table>
<Table>
$453,305 Total Net Investments (Cost $445,932,270) (a)...................... 98.9% 464,090,595
========
Other Assets in Excess of Liabilities.............................. 1.1 5,266,743
----- ------------
Net Assets......................................................... 100.0% $469,357,338
===== ============
</Table>
See Notes to Financial Statements
16
Morgan Stanley California Tax-Free Income Fund
PORTFOLIO OF INVESTMENTS - JUNE 30, 2007 (UNAUDITED) continued
- ---------------------
<Table>
COPs Certificates of Participation.
* Current coupon of variable rate demand obligation.
+ 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 $6,839,820 which represents 1.5% of net assets.
# Underlying security related to inverse floaters entered into
by the Fund. (see Note ID).
## Floating rate note obligations related to securities held.
The interest rates shown reflect the rates in effect at June
30, 2007.
(a) The aggregate cost for federal income tax purposes
approximates the aggregate cost for book purposes. The
aggregate gross unrealized appreciation is $19,927,022 and
the aggregate gross unrealized depreciation is $1,768,697,
resulting in net unrealized appreciation of $18,158,325.
Bond Insurance:
- ---------------
Ambac Ambac Assurance Corporation.
FGIC Financial Guaranty Insurance Company.
FSA Financial Security Assurance Inc.
MBIA Municipal Bond Investors Assurance Corporation.
</Table>
See Notes to Financial Statements
17
Morgan Stanley California Tax-Free Income Fund
FINANCIAL STATEMENTS
Statement of Assets and Liabilities
June 30, 2007 (unaudited)
<Table>
Assets:
Investments in securities, at value
(cost $474,432,270)..................... $492,590,595
Cash..................................... 22,771
Receivable for:
Interest............................. 5,965,999
Shares of beneficial interest sold... 28,899
Receivable from Distributor.............. 165,266
Prepaid expenses and other assets........ 56,247
------------
Total Assets......................... 498,829,777
------------
Liabilities:
Floating rate note obligations........... 28,500,000
Payable for:
Shares of beneficial interest
redeemed............................ 304,971
Distribution fee..................... 248,242
Investment advisory fee.............. 169,988
Dividends to shareholders............ 105,507
Administration fee................... 31,019
Transfer agent fee................... 6,536
Accrued expenses and other payables...... 106,176
------------
Total Liabilities.................... 29,472,439
------------
Net Assets........................... $469,357,338
============
Composition of Net Assets:
Paid-in-capital.......................... $449,430,837
Net unrealized appreciation.............. 18,158,325
Accumulated undistributed net investment
income.................................. 397,338
Accumulated undistributed net realized
gain.................................... 1,370,838
------------
Net Assets........................... $469,357,338
============
Class A Shares:
Net Assets............................... $27,246,164
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 2,294,276
Net Asset Value Per Share............ $11.88
============
Maximum Offering Price Per Share,
(net asset value plus 4.44% of net
asset value)........................ $12.41
============
Class B Shares:
Net Assets............................... $368,610,278
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 30,839,573
Net Asset Value Per Share............ $11.95
============
Class C Shares:
Net Assets............................... $22,559,399
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 1,888,564
Net Asset Value Per Share............ $11.95
============
Class D Shares:
Net Assets............................... $50,941,497
Shares Outstanding (unlimited authorized,
$.01 par value)......................... 4,276,764
Net Asset Value Per Share............ $11.91
============
</Table>
Statement of Operations
For the six months ended June 30, 2007 (unaudited)
<Table>
Net Investment Income:
Interest Income....................... $12,417,735
-----------
Expenses
Investment advisory fee............... 1,144,901
Distribution fee (Class A shares)..... 234,544
Distribution fee (Class B shares)..... 192,461
Distribution fee (Class C shares)..... 84,618
Interest and residual trust
expenses............................ 416,617
Administration fee.................... 194,895
Transfer agent fees and expenses...... 78,219
Shareholder reports and notices....... 68,442
Professional fees..................... 34,784
Custodian fees........................ 13,787
Trustees' fees and expenses........... 7,202
Registration fees..................... 2,315
Other................................. 26,050
-----------
Total Expenses.................... 2,498,835
Less: amounts waived/reimbursed....... (95,148)
Less: expense offset.................. (13,734)
-----------
Net Expenses...................... 2,389,953
-----------
Net Investment Income............. 10,027,782
-----------
Net Realized and Unrealized Gain
(Loss):
Net realized gain..................... 1,371,053
Net change in unrealized
appreciation........................ (12,151,505)
-----------
Net Loss.......................... (10,780,452)
-----------
Net Decrease.......................... $ (752,670)
===========
</Table>
See Notes to Financial Statements
18
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, 2007 DECEMBER 31, 2006
------------- -----------------
(unaudited)
Increase (Decrease) in Net Assets:
Operations:
Net investment income....................................... $ 10,027,782 $ 22,026,008
Net realized gain........................................... 1,371,053 3,146,171
Net change in unrealized appreciation....................... (12,151,505) (1,018,346)
------------ ------------
Net Increase (Decrease)................................. (752,670) 24,153,833
------------ ------------
Dividends and Distributions to Shareholders from:
Net investment income
Class A shares.......................................... (4,049,870) (12,766,269)
Class B shares.......................................... (4,476,702) (5,999,996)
Class C shares.......................................... (418,915) (883,715)
Class D shares.......................................... (1,123,997) (2,272,801)
Net realized gain
Class A shares.......................................... (41,894) (1,481,325)
Class B shares.......................................... (563,737) (650,009)
Class C shares.......................................... (34,443) (114,574)
Class D shares.......................................... (77,628) (265,713)
------------ ------------
Total Dividends and Distributions....................... (10,787,186) (24,434,402)
------------ ------------
Net decrease from transactions in shares of beneficial
interest.................................................. (27,952,786) (60,270,569)
------------ ------------
Net Decrease............................................ (39,492,642) (60,551,138)
Net Assets:
Beginning of period......................................... 508,849,980 569,401,118
------------ ------------
End of Period
(Including accumulated undistributed net investment income
of $397,338 and $439,040, respectively)..................... $469,357,338 $508,849,980
============ ============
</Table>
See Notes to Financial Statements
19
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (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
20
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (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 and are included in interest income. 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 Trust 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 trust 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 option to tender their notes to the Dealer Trusts for redemption at par
at each reset date. At June 30, 2007, Fund investments with a value of
$38,832,970 are held by the Dealer Trusts and serve as collateral for the
$28,500,000 in floating rate note obligations outstanding at that date.
Contractual maturities of the floating rate note
21
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
obligations and interest rates in effect at June 30, 2007 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 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 Subchapter M of the Internal Revenue Code applicable to
regulated investment companies and to distribute substantially all of its
taxable and nontaxable income to its shareholders. Therefore, no provision for
federal income taxes is required. The Fund files tax returns with the U.S.
Internal Revenue Service and various states. Generally, the tax authorities can
examine all tax returns filed for the last three years. If applicable, the Fund
recognizes interest accrued related to unrecognized tax benefits in interest
expense and penalties in other expenses in the Statement of Operations. The Fund
adopted the provisions of the Financial Accounting Standards Board's (FASB)
Interpretation number 48 Accounting for Uncertainty in Income Taxes, on June 30,
2007. As of June 30, 2007, this did not result in an impact to the Fund's
financial statements.
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
22
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
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. Such
voluntary waivers may be terminated at any time without notice.
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 shares; (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 shares; and (iii) Class
C -- up to 0.75% of the average daily net assets of Class C shares.
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
June 30, 2007.
At June 30, 2007, 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
23
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
12b-1 fees collected in excess of the actual distribution expenses incurred.
This receivable represents this excess amount as of June 30, 2007.
The Distributor has agreed to waive the 12b-1 fee on Class B shares to the
extent it exceeds 0.24% of the average daily net assets of such shares on an
annualized basis. The Distributor may discontinue this waiver in the future. For
the six months ended June 30, 2007, the distribution fee was accrued for Class B
shares at the annual rate of 0.17%.
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 six months ended June 30, 2007, the
distribution fee was accrued for Class A shares and Class C shares at the annual
rate of 0.24% and 0.73%, respectively.
The Distributor has informed the Fund that for the six months ended June 30,
2007, it received contingent deferred sales charges from certain redemptions of
the Fund's Class A shares, Class B shares and Class C shares of $1,426 , $64,196
and $3,332, respectively and received $39,115 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, 2007 aggregated
$23,925,494 and $36,174,181, 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, 2007 included in Trustees' fees
and expenses in the Statement of Operations amounted to $2,945. At June 30,
2007, the Fund had an accrued pension liability of $60,316 which is included in
accrued expenses in the Statement of Assets and Liabilities.
24
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
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. 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 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.
25
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
6. 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, 2007 DECEMBER 31, 2006
--------------------------- -------------------------
(unaudited)
SHARES AMOUNT SHARES AMOUNT
----------- ------------- ---------- ------------
CLASS A SHARES
Sold............................................... 227,452 $ 2,750,783 561,176 $ 6,820,180
Conversion from Class B............................ -- -- 894,934 10,791,004
Conversion to Class B.............................. (21,312,264) (257,677,039) -- --
Reinvestment of dividends and distributions........ 183,623 2,222,088 644,718 7,811,064
Redeemed........................................... (1,422,939) (17,236,559) (4,607,144) (55,839,391)
----------- ------------- ---------- ------------
Net decrease -- Class A............................ (22,324,128) (269,940,727) (2,506,316) (30,417,143)
----------- ------------- ---------- ------------
CLASS B SHARES
Sold............................................... 176,536 2,145,520 297,066 3,625,123
Conversion from Class A............................ 21,172,173 257,677,039 -- --
Conversion to Class A.............................. -- -- (889,299) (10,791,004)
Reinvestment of dividends and distributions........ 203,624 2,455,669 236,268 2,880,749
Redeemed........................................... (1,510,147) (18,294,894) (1,854,198) (22,605,127)
----------- ------------- ---------- ------------
Net increase (decrease) -- Class B................. 20,042,186 243,983,334 (2,210,163) (26,890,259)
----------- ------------- ---------- ------------
CLASS C SHARES
Sold............................................... 84,223 1,027,336 102,257 1,250,054
Reinvestment of dividends and distributions........ 21,459 259,761 49,863 607,734
Redeemed........................................... (123,448) (1,496,533) (402,316) (4,912,822)
----------- ------------- ---------- ------------
Net decrease -- Class C............................ (17,766) (209,436) (250,196) (3,055,034)
----------- ------------- ---------- ------------
CLASS D SHARES
Sold............................................... 167,721 2,023,187 481,825 5,825,582
Reinvestment of dividends and distributions........ 57,695 696,677 19,003 1,446,629
Redeemed........................................... (371,649) (4,505,821) (592,150) (7,180,344)
----------- ------------- ---------- ------------
Net increase (decrease) -- Class D................. (146,233) (1,785,957) 8,678 91,867
----------- ------------- ---------- ------------
Net decrease in Fund............................... (2,445,941) $ (27,952,786) (4,957,997) $(60,270,569)
=========== ============= ========== ============
</Table>
7. 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 transfer agent and
custodian.
26
Morgan Stanley California Tax-Free Income Fund
NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2007 (UNAUDITED) continued
8. 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 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, 2006, the Fund had temporary book/tax differences primarily
attributable to book amortization of discounts on debt securities.
9. Accounting Pronouncements
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:
<Table>
<Caption>
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31,
MONTHS ENDED --------------------------------------------------------------
JUNE 30, 2007 2006 2005 2004 2003 2002
------------- --------- --------- -------- -------- --------
(unaudited)
Class A Shares
Selected Per Share Data:
Net asset value, beginning of period... $ 12.16 $ 12.16 $ 12.46 $ 12.58 $ 12.68 $ 12.34
------- -------- -------- ------- ------- -------
Income (loss) from investment
operations:
Net investment income.............. 0.25 0.49 0.52 0.54 0.55 0.57
Net realized and unrealized gain
(loss)............................. (0.26) 0.06 (0.10) (0.02) (0.01) 0.44
------- -------- -------- ------- ------- -------
Total income from investment
operations............................ (0.01) 0.55 0.42 0.52 0.54 1.01
------- -------- -------- ------- ------- -------
Less dividends and distributions from:
Net investment income.............. (0.25) (0.49) (0.51) (0.53) (0.55) (0.57)
Net realized gain.................. (0.02) (0.06) (0.21) (0.11) (0.09) (0.10)
------- -------- -------- ------- ------- -------
Total dividends and distributions...... (0.27) (0.55) (0.72) (0.64) (0.64) (0.67)
------- -------- -------- ------- ------- -------
Net asset value, end of period......... $ 11.88 $ 12.16 $ 12.16 $ 12.46 $ 12.58 $ 12.68
======= ======== ======== ======= ======= =======
Total Return+.......................... (0.25)%(2) 4.64% 3.44% 4.26% 4.31% 8.37%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)............................... 1.02 %(3)(4)(5) 0.86%(5) 0.86%(5) 0.81% 0.78% 0.80%
Total expenses (before expense offset,
exclusive of interest and residual
trust expenses)....................... 0.85 %(3)(4) 0.85% 0.86% 0.81% 0.78% 0.80%
Net investment income.................. 4.08 %(3)(5) 4.06%(5) 4.11%(5) 4.29% 4.34% 4.53%
Supplemental Data:
Net assets, end of period, in
thousands............................. $27,246 $299,414 $329,938 $19,203 $17,422 $20,775
Portfolio turnover rate................ 5 %(2) 6% 23% 10% 11% 12%
</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) Does not reflect the effect of expense offset of $0.01%.
(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, before expense offset, would have been as
follows:
</Table>
<Table>
<Caption>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
------------ ------- --------------
June 30, 2007 1.06% 4.04%
December 31, 2006 0.89 4.02
December 31, 2005 0.87 4.10
</Table>
28
See Notes to Financial Statements
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, 2007 2006 2005 2004 2003 2002
------------- --------- --------- -------- -------- --------
(unaudited)
Class B Shares
Selected Per Share Data:
Net asset value, beginning of
period........................ $ 12.24 $ 12.24 $ 12.52 $ 12.65 $ 12.75 $ 12.42
------- -------- -------- ------- ------- -------
Income (loss) from investment
operations:
Net investment income...... 0.25 0.52 0.54 0.54 0.55 0.56
Net realized and unrealized
gain (loss)................ (0.27) 0.05 (0.08) (0.02) (0.02) 0.42
------- -------- -------- ------- ------- -------
Total income from investment
operations.................... (0.02) 0.57 0.46 0.52 0.53 0.98
------- -------- -------- ------- ------- -------
Less dividends and
distributions from:
Net investment income...... (0.25) (0.51) (0.53) (0.54) (0.54) (0.55)
Net realized gain.......... (0.02) (0.06) (0.21) (0.11) (0.09) (0.10)
------- -------- -------- ------- ------- -------
Total dividends and
distributions................. (0.27) (0.57) (0.74) (0.65) (0.63) (0.65)
------- -------- -------- ------- ------- -------
Net asset value, end of
period........................ $ 11.95 $ 12.24 $ 12.24 $ 12.52 $ 12.65 $ 12.75
======= ======== ======== ======= ======= =======
Total Return+.................. (0.20)%(2) 4.81% 3.74% 4.22% 4.27% 8.13%
Ratios To Average Net
Assets(1):
Total expenses (before expense
offset)....................... 0.95 %(3)(4)(6) 0.69%(6) 0.68%(6) 0.78%(5) 0.83%(5) 0.93%(5)
Total expenses (before expense
offset, exclusive of interest
and residual trust
expenses)..................... 0.78 %(3)(4) 0.68% 0.68% 0.78% 0.83% 0.93%
Net investment income.......... 4.15 %(3)(6) 4.23%(6) 4.29%(6) 4.32%(5) 4.29%(5) 4.40%(5)
Supplemental Data:
Net assets, end of period, in
thousands..................... $368,610 $132,162 $159,221 $526,026 $599,737 $682,046
Portfolio turnover rate........ 5 %(2) 6% 23% 10% 11% 12%
</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) Does not reflect the effect of expense offset of $0.01%.
(5) 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:
</Table>
<Table>
<Caption>
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
</Table>
<Table>
(6) 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, would have been as
follows:
</Table>
<Table>
<Caption>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
------------ ------- --------------
June 30, 2007 0.99% 4.11%
December 31, 2006 0.72 4.19
December 31, 2005 0.69 4.28
</Table>
29
See Notes to Financial Statements
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, 2007 2006 2005 2004 2003 2002
------------- --------- --------- -------- -------- --------
(unaudited)
Class C Shares
Selected Per Share Data:
Net asset value, beginning of period... $ 12.23 $ 12.23 $ 12.52 $ 12.65 $ 12.74 $ 12.42
------- -------- -------- ------- ------- -------
Income (loss) from investment
operations:
Net investment income.............. 0.22 0.43 0.45 0.47 0.48 0.50
Net realized and unrealized gain
(loss)............................. (0.26) 0.06 (0.08) (0.02) 0.00 0.42
------- -------- -------- ------- ------- -------
Total income from investment
operations............................ (0.04) 0.49 0.37 0.45 0.48 0.92
------- -------- -------- ------- ------- -------
Less dividends and distributions from:
Net investment income.............. (0.22) (0.43) (0.45) (0.47) (0.48) (0.50)
Net realized gain.................. (0.02) (0.06) (0.21) (0.11) (0.09) (0.10)
------- -------- -------- ------- ------- -------
Total dividends and distributions...... (0.24) (0.49) (0.66) (0.58) (0.57) (0.60)
------- -------- -------- ------- ------- -------
Net asset value, end of period......... $ 11.95 $ 12.23 $ 12.23 $ 12.52 $ 12.65 $ 12.74
======= ======== ======== ======= ======= =======
Total Return+.......................... (0.47)%(2) 4.12% 2.97% 3.61% 3.80% 7.59%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)............................... 1.51 %(3)(4)(5) 1.36%(5) 1.36%(5) 1.36% 1.35% 1.35%
Total expenses (before expense offset,
exclusive of interest and residual
trust expenses)....................... 1.34 %(3)(4) 1.35% 1.36% 1.36% 1.35% 1.35%
Net investment income.................. 3.59 %(3)(5) 3.56%(5) 3.61%(5) 3.74% 3.77% 3.98%
Supplemental Data:
Net assets, end of period, in
thousands............................. $22,559 $23,320 $26,385 $27,519 $26,435 $25,825
Portfolio turnover rate................ 5 %(2) 6% 23% 10% 11% 12%
</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) Does not reflect the effect of expense offset of $0.01%.
(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, before expense offset, would have been as
follows:
</Table>
<Table>
<Caption>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
------------ ------- --------------
June 30, 2007 1.55% 3.55%
December 31, 2006 1.39 3.52
December 31, 2005 1.37 3.60
</Table>
30
See Notes to Financial Statements
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, 2007 2006 2005 2004 2003 2002
------------- --------- --------- -------- -------- --------
(unaudited)
Class D Shares
Selected Per Share Data:
Net asset value, beginning of period... $ 12.20 $ 12.20 $ 12.49 $ 12.61 $ 12.71 $ 12.39
------- -------- -------- ------- ------- -------
Income (loss) from investment
operations:
Net investment income.............. 0.26 0.53 0.54 0.56 0.57 0.60
Net realized and unrealized gain
(loss)............................. (0.27) 0.05 (0.08) (0.01) (0.01) 0.41
------- -------- -------- ------- ------- -------
Total income from investment
operations............................ (0.01) 0.58 0.46 0.55 0.56 1.01
------- -------- -------- ------- ------- -------
Less dividends and distributions from:
Net investment income.............. (0.26) (0.52) (0.54) (0.56) (0.57) (0.59)
Net realized gain.................. (0.02) (0.06) (0.21) (0.11) (0.09) (0.10)
------- -------- -------- ------- ------- -------
Total dividends and distributions...... (0.28) (0.58) (0.75) (0.67) (0.66) (0.69)
------- -------- -------- ------- ------- -------
Net asset value, end of period......... $ 11.91 $ 12.20 $ 12.20 $ 12.49 $ 12.61 $ 12.71
======= ======== ======== ======= ======= =======
Total Return+.......................... (0.12)%(2) 4.90% 3.74% 4.48% 4.50% 8.41%
Ratios To Average Net Assets(1):
Total expenses (before expense
offset)............................... 0.78 %(3)(4)(5) 0.61%(5) 0.61%(5) 0.61% 0.60% 0.60%
Total expenses (before expense offset,
exclusive of interest and residual
trust expenses)....................... 0.61 %(3)(4) 0.60% 0.61% 0.61% 0.60% 0.60%
Net investment income.................. 4.32 %(3)(5) 4.31%(5) 4.36%(5) 4.49% 4.52% 4.73%
Supplemental Data:
Net assets, end of period, in
thousands............................. $50,942 $53,954 $53,857 $58,399 $66,143 $75,332
Portfolio turnover rate................ 5 %(2) 6% 23% 10% 11% 12%
</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) Does not reflect the effect of expense offset of $0.01%.
(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, before expense offset, would have been as
follows:
</Table>
<Table>
<Caption>
EXPENSE NET INVESTMENT
PERIOD ENDED RATIO INCOME RATIO
------------ ------- --------------
June 30, 2007 0.82% 4.28%
December 31, 2006 0.64 4.27
December 31, 2005 0.62 4.35
</Table>
31
See Notes to Financial Statements
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
Chairperson of the Board
Ronald E. Robison
President and Principal Executive Officer
J. David Germany
Vice President
Dennis F. Shea
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
LEGAL COUNSEL
Clifford Chance US LLP
31 West 52nd Street
New York, New York 10019
COUNSEL TO THE INDEPENDENT TRUSTEES
Kramer Levin Naftalis & Frankel LLP
1177 Avenue of the Americas
New York, New York 10036
INVESTMENT ADVISER
Morgan Stanley Investment Advisors Inc.
522 Fifth Avenue
New York, New York 10036
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.
Morgan Stanley Distributors Inc., member NASD
(c) 2007 Morgan Stanley
[MORGAN STANLEY LOGO]
MORGAN STANLEY FUNDS
Morgan Stanley
California Tax-Free
Income Fund
Semiannual Report
June 30, 2007
[MORGAN STANLEY LOGO]
CLFSAN-IU07-02911P-Y06/07
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.
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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 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
Ronald E. Robison
Principal Executive Officer
August 9, 2007
/s/ Francis Smith
Francis Smith
Principal Financial Officer
August 9, 2007
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