Like most other states, Kentucky exempts interest on bonds issued by in-state entities from state income taxes, while subjecting interest on bonds from other states to the Kentucky state income tax. Petitioners, Kentucky residents who paid state income tax on interest from out-of-state municipal bonds, challenged Kentucky’s tax scheme as impermissibly discriminating against interstate commerce. The trial court upheld Kentucky’s tax scheme, but was overturned on appeal by the Kentucky Court of Appeals.

In reversing the decision of the Kentucky Court of Appeals, the U.S. Supreme Court, in Department of Revenue of Kentucky v. Davis, held that “Kentucky’s tax exemption favors a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state interests. This type of law does ‘not discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.”

An adverse decision from the Supreme Court would have caused major disruptions in the municipal bond markets. The ruling thus comes as welcome news for municipal bond funds, but especially for single-state funds, which focus on a particular state’s municipal bonds to drive fund sales.