On May 21, the U.S. Supreme Court agreed to review a recent Kentucky court decision that held that Kentucky cannot impose income tax on interest earned on bonds issued in other states while exempting interest earned on bonds issued by Kentucky and its municipalities. The Supreme Court will hear the case (Department of Revenue of Kentucky v. Davis) in the Court’s term that begins next Fall and is likely to decide the case early next year. If the Supreme Court affi rms the Kentucky decision (as it probably should), the result can be expected to have a dramatic impact on the market for state-specifi c tax-exempt bond funds.
In Davis, the Kentucky Court of Appeals held early last year that Kentucky’s practice of exempting interest paid on its own bonds and, at the same time, taxing interest income earned on bonds issued by other states and their municipalities violates the Commerce Clause of the U.S. Constitution, because the practice improperly discriminates against inter state commerce in municipal bonds. Kentucky’s practice, which is typical of most states, provides Kentucky residents with a substantial tax incentive to purchase in-state bonds rather than out-of-state bonds. This, the court reasoned, improperly disadvantages issuers of out-of-state bonds in their efforts to sell those bonds to Kentucky residents. Accordingly, the court ruled that interest on out-of-state bonds should be exempt from Kentucky income tax so long as instate bonds are exempt.
In reaching its conclusion, the Kentucky court disagreed with the only other reported court decision on the subject, a 1994 decision by the Ohio Court of Appeals. The Kentucky court also distinguished the Commerce Clause issue from that presented in the only existing U.S. Supreme Court decision on a state’s tax treatment of other states’ municipal bonds – an 1888 decision that the Full Faith and Credit Clause of the U.S. Constitution does not require one state to exempt interest earned on another state’s bonds simply because the other state exempts it. The Kentucky court noted that the Supreme Court was not presented with the Commerce Clause issue in that case.
After the issuance of the Kentucky Court of Appeals decision, the Kentucky Department of Revenue unsuccessfully sought review by the Kentucky Supreme Court. Thereafter, the Department of Revenue fi led a petition for a writ of certiorari with the U.S. Supreme Court, which has now been granted. The Supreme Court’s decision to hear the Davis case seems unsurprising, given the need to resolve the split in the lower courts over an issue with broad ramifi cations. What may be more surprising is that this tax issue has lain largely dormant for so many years, when the potential for a Commerce Clause attack on states’ discrimination against out-of-state bonds seems so clear (at least in hindsight).
The Davis decision, if ultimately affi rmed by the U.S. Supreme Court, will undoubtedly undercut the demand for state-specifi c tax-exempt bond funds. If a state must treat out-of-state and in-state bonds identically for tax purposes, there will no longer be a tax incentive for a resident of a particular state to invest in a tax-exempt bond fund that holds only bonds issued by that state, its subdivisions and instrumentalities.