The U.S. Supreme Court has upheld the state tax treatment of municipal bond interest, under which a state exempts from its corporate and personal income taxes the interest on bonds issued by the state, but not the interest on bonds issued by sister states. In a 7-2 decision, the U.S. Supreme Court has ruled that states choosing to impose tax on interest income earned by its residents on bonds issued by another state while exempting interest earned on its own bonds does not violate the Dormant Commerce Clause, as the exemptions are deemed to serve a legitimate public purpose. Justice David Souter delivered the opinion of the Court.
Two Kentucky residents challenged Kentucky’s taxation of interest on out-of-state bonds in a 2003 class action lawsuit in state court, claiming that the state imposing its personal income tax on out-of-state interest income violated the Commerce and Equal Protection Clauses of the U.S. Constitution. After the plaintiffs had exhausted their administrative appeals, they filed suit in the Circuit Court for Jefferson County, which granted summary judgment to the state Department of Revenue (“Department”), holding that the taxation of out-of-state bonds was constitutional. The Kentucky Court of Appeals reversed the lower court ruling, finding the state’s bond taxation system facially unconstitutional due to its more favorable treatment of in-state bond interest over interest from extra-territorial bonds. The Court also held that the Department failed to meet its burden of proof in attempting to show that the system was not fatally flawed under the Dormant Commerce Clause. The Kentucky Supreme Court denied review of the case, and the Department sought relief in U.S. Supreme Court, which granted certiorari in May of 2007.
In its May 19, 2008 decision, the U.S. Supreme Court reversed the ruling of the Kentucky Court of Appeals, essentially restoring the original decision of the lower state trial court. The Court held that while Kentucky’s taxation scheme on out-of-state bond interest may have been perceived as discriminatory, actions in furtherance of a government function must be analyzed differently from state laws that favor a private business over its competitors. This is a standard exception to concerns about state “economic protectionism” that normally drive the Dormant Commerce Clause, protecting states that go beyond mere regulation and actively participate in the market to “exercise the right to favor their own citizens.” The Court distinguished the State of Kentucky as a market participant and not a market regulator and, therefore, held that it was not subject to the standard Dormant Commerce Clause scrutiny. The state, as a market participant, had the right to use its status as a government entity to issue the debt securities at the most attractive terms possible (including an exemption on interest paid) to its local residents in furthering its public function of financing public projects.
Forty-seven states filed amicus briefs with the U.S. Supreme Court supporting the State of Kentucky. Based upon this show of support, the majority of the Court recognized that the differential tax scheme is critical to the operation of an identifiable segment of the current municipal financial market.
Justices Kennedy and Alito filed a dissenting opinion in the case. The dissenting Justices maintained that Kentucky’s tax scheme was unconstitutional because it discriminated against interstate commerce to protect local interests. They stated that the majority failed in not recognizing that the challenged state activity was differential taxation, not bond issuance. Justices Kennedy and Alito felt that the Kentucky tax was “an explicit discrimination against out-of-state issuances for admitted protectionist purposes” and was, therefore, void.