United States Supreme Court Preserves a State’s Right to Tax Municipal Bonds Differently

    By Business Taxation

    Background and Holding of the United States Supreme Court. Many states, including the Commonwealth of Kentucky (Kentucky), do not tax interest earned on bonds issued by the state or its political subdivisions, but do tax interest earned on bonds issued by other states or their political subdivisions. A taxpayer who paid Kentucky income tax on interest income earned on bonds issued by an out-of-state issuer challenged the constitutionality of Kentucky’s laws which (1) distinguish between interest income earned on bonds issued by Kentucky or its political subdivisions and bonds issued by out-of-state issuers, and (2) tax the latter but not the former. The Kentucky Court of Appeals reversed a lower court ruling, and in so doing found that Kentucky’s differential taxing scheme was unconstitutional. Kentucky appealed the decision of its Court of Appeals to the United States Supreme Court (the Court), which granted certiorari and agreed to hear the case, Department of Revenue of Kentucky et. al. v. Davis. On May 19, 2008, the Court, by a plurality 7-2 margin, reversed the decision of the Kentucky Court of Appeals and remanded the case for further consideration, essentially validating the constitutionality of Kentucky’s differential taxing regime.

    Analysis and Discussion. The Commerce Clause of the United States Constitution empowers Congress to regulate commerce among the several states – and by extension to restrain commerce (the so-called Dormant Commerce Clause), which is generally intended to limit states from enacting laws designed to benefit in-state economic interests by burdening out-of-state competitors. Such economic protectionism or Balkanization is an evil that the Framers of the Constitution sought to restrict by way of the Commerce Clause. Over the years of deciding cases and construing and applying the Dormant Commerce Clause, the Court has recognized at least one exception to its application: the market participant exception. When a state goes beyond regulation and itself participates in the market so as to exercise the right to favor its own economic interests or those of its own citizens over others, such actions are generally not viewed as violative of the Dormant Commerce Clause.

    In reaching its decision in Kentucky v. Davis, the Court determined that Kentucky is not merely regulating the market by its disparate tax regime, but it is also participating in the market as an issuer of tax exempt bonds. The Court noted that in cases where a government’s commercial activities and regulatory efforts complement each other in some way, the fact of tying the regulation to the public object of the foray into the market gives the regulation a civic objective different from the discrimination traditionally held to be unlawful: in the paradigm of unconstitutional discrimination the law chills interstate activity by creating commercial advantage for goods and services marketed by local private actors, not by governments and those they employ%u2026 (citations omitted). To summarize, that (1) Kentucky participates in the market by issuing tax exempt bonds and (2) Kentucky’s differential tax regime favors Kentucky and its political subdivisions, not private local entrepreneurs, suffices to exempt, under the market participant exception, Kentucky’s differing taxing regime from constitutional invalidation under the Dormant Commerce Clause. In so doing, the Court followed precedent established in a 2007 Dormant Commerce Clause case, United Haulers Assn. Inc. v. Oneida-Herkimer Solid Waste Management Authority and distinguished Kentucky v. Davis from several other Dormant Commerce Clause cases in which the Court came to different conclusions regarding applicability of the Dormant Commerce Clause under seemingly similar fact patterns. Importantly, the Court’s decision was by plurality and two Justices dissented, so the conclusion reached by the Court was far from unanimous.

    The Court also noted in its decision that (1) the tax exempt bond market is well established and immense, (2) the bonds in question finance governmental (public) facilities, (3) disparate taxing schemes such as Kentucky’s have been enacted by 41 states, (4) all states expressed support for upholding the constitutionality of the differential taxing regime, and (5) invalidating Kentucky’s taxing regime would likely destroy the market for intrastate (single state) tax exempt municipal bond funds. These factors clearly were significant to the Court’s holding in Kentucky v. Davis.

    In reaching its conclusion, the Court refused to undertake a cost-benefit balancing of the burdens and benefits of Kentucky’s differential taxing regime, which was advanced as a possible approach to deciding this question under a particular line of Dormant Commerce Clause cases. The Court also did not address the degree to which its holding would apply to private activity bonds, although it did note that differential treatment of interest on such bonds should be evaluated differently from the treatment of municipal bond interest generally.

    The Court’s holding preserves the status quo and provides states with assurance that the application of a state income tax regime in which holders of tax exempt bonds issued by in-state issuers are afforded a tax exemption that is denied to holders of tax exempt bonds issued by out-of-state issuers is constitutionally permissible.

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances.

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.