The United States Supreme Court announced today that they have accepted the Kentucky Department of Revenue’s (the “Department”) petition for certiorari in the review of Davis v. Department of Revenue of the Finance and Administration Cabinet, No. 06-666, reported below at 197 S.W. 3d 557 (Ky. Ct. App. 2006). The Kentucky Court of Appeals held that Kentucky’s bond taxation system violated the dormant Commerce Clause of the U.S. Constitution because it exempted interest earned from Kentucky bonds but did not exempt interest from bonds issued by other states. Additionally, the U.S. Supreme Court today announced that it has requested the Solicitor General to comment on the petition for certiorari filed in General Electric Co. v. Commissioner, New Hampshire Department of Revenue Administration, No. 06-1210, reported below at 914 A.2d 246 (N.H. 2006).

Background

In 2003, George and Catherine Davis (the “Davises”) filed a class action1 complaint in Kentucky Circuit Court alleging that Kentucky’s taxing scheme, which exempts interest income earned from Kentucky bonds but not for other states’ bonds, violates the dormant Commerce Clause and the Due Process Clause of the U.S. Constitution. The trial court granted the Department’s Motion for Summary Judgment on the constitutionality of the taxing scheme. Upon review, the Kentucky Court of Appeals held that Kentucky’s bond taxation system was facially unconstitutional as it violated the dormant Commerce Clause by discriminating against interstate commerce. The court concluded that the following three justifications offered by the Kentucky Department of Revenue (the “Department”) were insufficient to support the constitutionality of Kentucky's bond taxation system:

  • The court was not bound by the fact that a similar system in Ohio was held to be unconstitutional by the Ohio Court of Appeals in Shaper v. Tracey, Tax Commr. 647 N.E.2d 550 (Ohio Ct. App. 1994).
  • The court was not bound by the U.S. Supreme Court’s holding in Bonaparte v. Tax Court, 104 U.S. 592 (1881) that taxation of out-of-state bonds is not prohibited by the U.S. Constitution, because the Bonaparte decision was based on the Full Faith and Credit Clause rather than the Commerce Clause.
  • The state was not acting as a market participant and, therefore, was not exempt from the Commerce Clause, because Kentucky’s decision to tax extraterritorial bonds (as opposed to selling the bonds) was clearly governmental regulation. The market participant theory recognizes that when a sovereign acts as a consumer or vendor in commerce, its actions as a market participant are distinct from its actions as a market regulator and are exempted from Commerce Clause scrutiny. Thus, as a market participant and not a market regulator, the state may favor certain customers (in-state) over others (out-of-state) without triggering a Commerce Clause violation.

Petition for Writ of Certiorari

The Department provided two main reasons why the U.S. Supreme Court should accept the petition. First, the Department contended that the issue presents an important question of federal constitutional law on which the courts are divided, i.e. Shaper, 647 N.E.2d 550. The Department stressed the national importance of this issue as at least 42 states heavily rely upon the issuance of debt to finance public projects, and tax (either in-whole or in-part) out-of-state state bond interest differently from in-state bond interest. Second, the Department contended that the Kentucky decision misapplied previous Supreme Court rulings and that Commerce Clause analysis is improper and unnecessary, based on the market participant doctrine.

Interestingly, the Davises originally did not file a brief opposing the Department’s petition for writ of certiorari. However, on December 14, 2006, the Supreme Court ordered them to file a brief. The Davises ultimately argued that the Court should deny the petition because, in part, the Kentucky court’s decision is consistent with U.S. Supreme Court precedent. Namely, in Fulton Corp. v. Faulkner, 516 U.S. 325, 339 (1996), the Court held that a state tax impermissibly discriminates against interstate commerce when the state’s taxing power effectively increases the tax burden for out-of-state transactions, thereby coercing taxpayers to conduct intrastate business. In Granholm v. Herald, 544 U.S. 460, 472 (2005), the Court held that in all but the narrowest circumstances, state laws violate the Commerce Clause if they mandate differential treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter. Further, as the same issue is currently pending in other states, including North Carolina and Arizona, the Davises contend that the Court should wait to see if there is indeed a “split” in authority among the states.

Impact of Decision?

Should the Court uphold the Kentucky decision, it is likely that Kentucky will exempt all state and municipal bond interest income as an immediate remedy. Kentucky Revised Statute § 141.010(10)(c) requires the addback to federal taxable income of “interest income derived from obligations of sister states and political subdivisions thereof.” This provision would likely be stricken from the Kentucky statutes if the Court does not overturn the Kentucky Court of Appeals decision. However, in the long term, the Kentucky General Assembly could remedy the discrimination by continuing to exempt the bond income from all states’ bonds, or taxing the income from all states’ bonds, including Kentucky.

The broader impact of the Court affirming the decision is that Kentucky is but one of 42 states (27 for corporate income tax purposes) which differentiate taxation of income earned from in-state bonds versus out-of-state bonds.