U.S. Supreme Court reverses decision in Kentucky case over out-of-state bond taxes

By Cristal Cody

Springdale, Ark., May 19 - The U.S. Supreme Court reversed a decision by the Kentucky Court of Appeals on Monday in a case over taxes levied on bonds issued outside the state.

Kentucky exempts from state income taxes interest on bonds that are issued by the state or its political subdivisions but not on bonds sold by other states and their subdivisions.

The case, Kentucky Department of Revenue v. George W. Davis, was argued Nov. 5, 2007.

Davis claimed the differential tax discriminated against interstate commerce.

The trial court ruled for Kentucky. The State Court of Appeals reversed the decision and found that the state's policy was against the Commerce Clause.

The U.S. Supreme Court reversed the Court of Appeals decision and remanded the case.

The court's opinion, delivered by justice David Souter, said that laws favoring a state's municipal bonds have a legitimate objective beyond economic protectionism - benefiting in-state economic interests by burdening out-of-state competitors - "since issuing debt securities to pay for public projects is a quintessentially public function, with a venerable history."

The court noted that it was being asked to "invalidate a century-old taxing practice presently employed by 41 states and supported by all."

Furthermore, "there is no forbidden discrimination because Kentucky, as a public entity, does not have to treat itself as being 'substantially similar' to other bond issuers in the market," the court observed.

Looking at the entire fixed-income market, nearly every taxing state "believes its public interests are served by the same tax-and-exemption feature," the court said. "These facts suggest that no state perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with that government when it enters the market."

The court also expressed concern that if the tax preference was abolished, so would many of the single-state bond funds that buy the debt of "smaller and lesser known municipalities."

It added: "[T]here is no suggestion that the interstate markets would welcome the weaker municipal issues that would lose their local market homes after a Davis victory.

"Financing for long-term municipal improvements would thus change radically if the differential tax feature disappeared."

The Securities Industry and Financial Markets Association is pleased with the decision to uphold longstanding state-tax exemptions for municipal bonds, according to a statement following the release of the decision.

The statute benefits the state and residents by providing incentives to invest in the bonds, which secure financing for local municipalities at lower interest rates, Sifma said.

Changing that structure would have long-reaching negative effects to the municipal bond market, Sifma said.

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