By Business Taxation

Before this article is published, the U.S. Supreme Court (the Court) should have determined whether to hear Kentucky v. Davis¹, on a petition by writ of certiorari by the Commonwealth of Kentucky (the Commonwealth or Kentucky). This case is of significance to the states and their political subdivisions engaged in borrowing funds through the authorization and issuance of tax-exempt municipal securities² because, if affirmed by the Court, it will nationalize the market for municipal bonds of any state. Further, this case is important to the municipal securities industry where underwriting tax-exempt bond mutual funds is currently limited to state-specific offerings. It is hoped that the Court will hear this case and provide bright line guideposts in the nascent concept of tax parity of municipal securities to assist municipal securities practitioners.

Kentucky v. Davis arose from an appeal by taxpayers to a grant by the trial court of summary judgment in favor of the Department of Revenue of the Finance and Administration Cabinet for the Commonwealth of Kentucky over the issue of Kentucky’s state policy of taxing the interest on tax-exempt municipal bonds issued by sister states. The central issue in the case is the constitutionality under the dormant Commerce Clause of the U.S. Constitution³ of a state exempting from taxation the interest on bonds issued by the state or its political subdivisions while taxing the income on out-of-state bonds, which are tax-exempt under the Internal Revenue Code and under the tax laws of such sister state. The Kentucky Court of Appeals⁴ ruled in favor of the taxpayers to the effect that taxing out-of-state bonds while exempting in-state bonds from taxation was found to be discriminatory in violation of the Commerce Clause without the benefit of any judicially recognized exception. The Kentucky Supreme Court refused to hear the case on further appeal, and the Commonwealth sought certiorari on the ground of unconstitutionality and a contrary holding on similar facts in an Ohio decision, Shaper v. Tracy⁵, causing a split among state courts.⁶

In the Shaper case, an Ohio appeals court found that under identical facts, Ohio taxpayers were not entitled to relief from paying tax on out-of-state tax-exempt bonds they owned on the theory that Ohio’s tax regime violates the Commerce Clause. The court in Shaper applied recognized exceptions to finding unconstitutionality under the dormant Commerce Clause (discussed supra) and upheld the state tax prohibiting the exemption from taxation of interest on non-Ohio municipal securities.

The dormant Commerce Clause forbids states from interfering with interstate commerce by protecting in-state economic interests at the expense of out-of-state economic interests. In analyzing the constitutionality of a statute under the Commerce Clause, one that is found to be per se discriminatory will be upheld under a strict scrutiny standard if there exists a reason unrelated to economic protectionism to justify the discriminatory action.⁷Alternatively, if a court finds that the statute is not facially invalid, but its impact is discriminatory, a court may apply a balancing test to determine if there is any legitimate reason for the discriminatory action.⁸

This analysis has led the Court to create several exceptions to the application of the dormant Commerce Clause, namely, the market participant exception, the sovereign entity exception, and the subsidy exception. The market participant exception sanctions a state’s discriminatory actions when the state is a market participant, for example, when the state is a buyer or a seller (say, as an issuer of municipal securities)⁹ In Kentucky v. Davis, the Commonwealth argued the market participant exception, not as a business enterprise, but as a sovereign acting on behalf of itself, in a manner to favor itself over other sovereign states.¹⁰ Further, the Commonwealth argued that the Court has not found a constitutional basis that would prohibit a state from favoring its own citizens over out-of-state citizens,¹¹ and that the in-state tax exemption is an inducement to Commonwealth residents to purchase the Commonwealth’s bonds instead of corporate securities or bonds of other states.¹² The Commonwealth pointed out to the Court that the issuance and sale of tax-exempt bonds by any state that exempts from taxation the income earned by its citizens from its bonds while taxing the income earned by its citizens on sister state tax-exempt obligations is a question that needs to be formally addressed by the Court to prevent further division.¹³

In the appeal to the Court, the respondent-taxpayers, the Davises, argued that Kentucky’s tax statute is facially invalid and violates the dormant Commerce Clause per se, and that the court of appeals decision (finding the statute unconstitutional) is consistent with the Court’s jurisprudence in this area.¹⁴ The respondents argued that reduced borrowing costs for the Commonwealth’s tax-exempt bonds is a form of economic protectionism and, therefore, not constitutionally permissible.¹⁵

Some commentators have equated the concept of the tax exemption on in-state municipal securities to that of a subsidy, which the Court has found to be permissible¹⁶ (i.e., when an increase in yield on a municipal security inures to the benefit of in-state bondholders). This argument most recently was advanced in West Lynn Creamery v. Healy.¹⁷ The Court, in West Lynn Creamery, determined that, when a pure subsidy is funded out of the general revenue and paid for by all taxpayers, there is no burden on interstate commerce.¹⁸ Applying this analysis to Kentucky v. Davis, all taxpayers pay for a state tax exemption equally from the general fund of the state, therefore, providing the exemption does not burden interstate commerce. However, the court of appeals did not adopt this view.

Because of the novelty and importance of Kentucky v. Davis to the municipal securities industry, some observers believe the Court will hear the case. An affirming decision from the Court may provide definitive rules by which to apply dormant Commerce Clause analysis. Indeed the dissents in Camps Newfound/Owatanna v. Town of Harrison, Maine evidence pause for concern among the justices that the Court’s jurisprudence in the area of the dormant Commerce Clause may have gone astray. Interestingly in Justice Thomas’s dissent, he finds another basis a taxpayer could use to challenge state taxation of municipal securities: the Import-Export Clause.¹⁹ Justice Thomas’s dissent includes a discussion of the historical significance and meaning of the Import-Export Clause and its application to the imposition of taxes on written property that crosses state borders.²⁰ It is Justice Thomas’s contention that the Import-Export Clause prohibits not only taxation of foreign imports, but also the taxation of commerce between the states.²¹

Should the Court hear the case, there are at least two important outcomes. First, the Court could decide to uphold the Kentucky Court of Appeals decision and clarify the dormant Commerce Clause in that context. States would have to decide whether to tax all municipal securities or exempt all municipal securities from state taxation. State concern as to how much revenue would be gained or lost from taxation would take center stage. Further, state concern would focus on potentially significant borrowing rate increases, if all state and local government bonds are taxed at the state level. With affirmation by the Court, there may suffer the demise of single-state mutual funds.²²Some estimate that the interest rate on single-state mutual funds may be between 10 to 25 basis points lower than the mutual funds of those states that do not provide the state tax exemption. Those states that do not offer tax exemptions may realize reduced borrowing costs because they would no longer have to offer taxable high-yield bonds to attract investment dollars.²³

What are the implications for states like Louisiana that have seen their credit ratings slide in the wake of natural disasters? A thought worth considering is whether a national or multi-state bond fund would be considered less risky than a state-specific fund because the investment pool would be more diverse. The fund theoretically would be more sensitive to national economic cycles and less sensitive to geographic economic cycles–and tax-exempt or not at the state level depending on the Court’s decision in Kentucky v. Davis.

Second, the Court could overturn the court of appeals and adopt an exception to the dormant Commerce Clause doctrine for municipal securities while ignoring Justice Thomas’s argument that the Import-Export Clause should apply to domestic commerce. In that case, the ruling of Kentucky v. Davis will extend no further than Kentucky, and as to state taxation of municipal securities, it will not be a flat world²⁴ after all.

Certainly, creating a national or multi-state market for municipal bonds would seem to be the direction Congress and the U.S. Securities and Exchange Commission would like the Court to move. Likewise, market makers in municipal securities could greatly expand their product mix and investment offerings in a national market, replete with all the trappings of full disclosure and transparency that accompany flat world thinking. With regulators and the regulated community both cheering on the Court to accept certiorari and affirm, the outcome of this case will not go unnoticed.

Endnotes

1. Kentucky v. Davis, No. 2004-CA-001940-MR, 2006 Ky. Ct. App. (6th Cir. Jan. 6,2006) (to be published).
2. I.R.C. %uFFFD%uFFFD 103(a) et seq. & 144 et seq. (1986).
3. U.S. CONST., art. I, %uFFFD 8, cl. 3.
4. Kentucky v. Davis, No. 2004-CA-001940-MR, 2006 Ky. Ct. App. (6th Cir. Jan. 6, 2006), petition for cert. filed(No. 06-666).
5. Shaper v. Tracy, 647 N.E.2d 550 (Ohio Ct. App. 1994).
6. Kentucky v. Davis, No. 2004-CA-001940-MR, 2006 Ky. Ct App. (6th Cir. Jan. 6, 2006), petition for cert. filed(No. 06-666).
7. New Energy Co. of Ind. v. Limbach, 486 U.S. 269, 278 (1988).
8. Camps Newfound/Owatanna, Inc. v. Town of Harrison, Maine, 520 U.S. 564, 598 (1997) (quoting Piker v. Bruce Church, Inc., 397 U.S. 137, 142 (1970)).
9. Shaper, 647 N.E.2d at 763.
10. Kentucky v. Davis, No. 2004CA-001940-MR, 2006 Ky. Ct. App. (6th Cir. Jan. 6, 2006), petition for cert. filed(No. 06-666), at 14.
11. Id. at 15.
12. Id. at 16 (citing Hughes v. Alexandria Scrap Corp., 426 U.S. 794, 810 (1976)).
13. Kentucky v. Davis, No. 2004-CA-001940-MR, 2006 Ky. Ct. App. (6th Cir. Jan. 6, 2006), petition for cert. filed(No. 06-666), at 13.
14. Brief for Respondent at 4, Kentucky v. Davis, No. 2004-CA-001940-MR, 2006 Ky. Ct. App. (6th Cir. Jan. 6, 2006) (No. 06-666).
15. Id. at 7.
16. Dan T. Coenen, Untangling the Market-Participant Exemption to the Dormant Commerce Clause, 88 MICH. L. Rev. 395, 474 (1989).
17. 512 U.S. 186 (1994).
18. Camps Newfound/Owatanna, Inc., 520 U. S. at 564.
19. No state shall, without the consent of the Congress, lay any imposts or duties on imports produce of all duties and imposts, laid by any state on imports or exports, shall be for the use of the treasury of the United States; and all such laws shall be subject to the revision and control of the Congress. U.S. CONST., art. I, %uFFFD 10 cl. 2.
20. Camps Newfound/Owatanna, Inc., 520 U.S. at 621.
21. Id.
22. At current estimates, there are over 1300 single-state mutual funds.
23. John Birger, A Bomb in the Muni Market?, FORTUNE, Feb. 5,2007, at 112, available at http://money.cnn.com/magazines/fortune/fortune_archive/2007/02/05/8399181/index.htm.
24. THOMAS L. FRIEDMAN, THE WORLD IS FLAT: A BRIEF HISTORY OF THE TWENTY-FIRST CENTURY (Farrar, Strauss & Giroux 2005).

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