Kentucky Department of Revenue v. Davis

The U.S. Supreme Court has granted a request by the Kentucky Dept. of Revenue to consider whether the state violates the Commerce Clause by exempting from income taxes the interest on bonds issued by Kentucky and its localities, while taxing the interest on bonds issued by other states and their localities.

Last year, in Davis v. Kentucky Dept. of Revenue, the Kentucky Court of Appeals ruled that Kentucky's taxation of income from bonds issued outside the state is facially unconstitutional because it violates the dormant Commerce Clause of the U.S. Constitution. The decision reversed a trial court's summary judgment against resident taxpayers who had paid personal income tax on out-of-state bond income and then filed a class action on behalf of corporations, estates, trusts and other individual taxpayers challenging the constitutionality of the bond tax provisions. The appeals court also vacated and remanded a finding that the taxpayers lacked standing to file the class action. The Kentucky Supreme Court denied cert.

“A big problem is that the majority of states provide a Davis-type of exemption for their issued bonds,” remarks Lynn Gandhi, a partner with Miller Canfield Paddock & Stone PLC in Detroit. “The plus is the willingness of the [U.S. Supreme] Court to take on a ‘consistency’ and ‘fairness’ issue regarding subvert discrimination against interstate commerce.”

Kentucky’s arguments
The Kentucky DOR presented several reasons for why the U.S. Supreme Court should accept its petition for cert. It argued that the decision conflicts with the Ohio Court of Appeal's ruling in Sharper (1994) that the Commerce Clause does not prohibit one sovereign from providing itself a competitive advantage over another sovereign. The DOR also argued that the Kentucky decision creates uncertainty for all states and localities.

Additionally, the DOR raised the market participant defense. Under that defense, if the state is a player in the market, it exempts the state or gives the state a defense to a Commerce Clause allegation. The Kentucky Court of Appeals previously rejected the market participant defense, finding that state was not really a market participant, but rather a market regulator in that it was issuing its own bonds.

The High Court agreed to review Davis for the following reasons:

• the case presents an important question of federal constitutional law on which state courts are divided, and
• the decision is at odds with prior decisions of the High Court and presents an important constitutional question that should be settled by the court.

A national issue
Most states tax interest income on bonds issued by other states while exempting the interest of their own bonds and bonds of their political subdivisions. This provides in-state bonds with a competitive advantage over bonds issued by out-of-state entities, including those with higher credit ratings, when the bonds are being marketed to in-state taxpayers. As a result, public financing in these states may occur at a lower interest rate than would otherwise be the case. But like the taxpayers in Davis, many believe it is questionable that such inequitable treatment of interest income can survive constitutional scrutiny and are challenging that practice.

In Dune [], a similar case, the North Carolina Supreme Court recently granted the state's petition for review of an appellate court's decision upholding class certification in an action challenging North Carolina's income taxation of interest earned on out-of-state bonds.

Pat Derdenger, a partner with Steptoe & Johnson LLP in Phoenix, is local counsel for taxpayers in another similar case pending at the Arizona Board of Tax Appeals.

“Arizona, like a good number of states, exempts interest on bonds issued by the state of Arizona and political subdivisions of the state of Arizona, but taxes interest on bonds from other states,” he notes.  He also noted that the pending municipal bond case is very similar to the recent Ladewig case where Arizona’s income tax deduction for dividends received from Arizona based corporations (dividends received from out of state corporations were taxed) was struck down as violating the commerce clause.

Possible remedies and implications
The Kentucky Court of Appeals did not specify a remedy for the unconstitutional taxation that it found in Davis. However, if the Supreme Court upholds the ruling and invalidates all similar taxing schemes, state and local governments may have to provide “meaningful backward-looking relief” under McKesson (1990), in the form of tax refunds to holders of out-of-state bonds or the collection of back taxes from holders of in-state bonds.

“The case will affect many states, and may have the effect of affecting revenue projections immediately,” Gandhi observes.

Derdenger predicts that if the Kentucky ruling is upheld by the Supreme Court, it will drastically change the municipal bond market.

“Investors looking at the best value for a bond will look to see if there is a municipality in another state with a good solid credit rating that is providing a higher interest rate than what they can get by buying that bond from municipalities in their own state,” he explains. “So you will see a nationalization of the muni bond market.”

Derdenger suggests that even if the High Court upholds the Kentucky ruling, it may render a decision that would be prospective only and not allow refunds. However, he notes that there was a 2001 decision by the Arizona Supreme Court that required the state to pay refunds to taxpayers due to disparate treatment of in-state and out-of-state dividends received.

“Arizona exempted dividends received from Arizona corporations—organizations that were defined to have more than 50% of their income derived from Arizona sources,” Derdenger explains. “But there was no exemption for dividend income received from non-Arizona corporations. Then, in the Estate of Helen Ledewig (2001), Arizona courts struck that down as violative of the Commerce Clause. Over the course of the last two or three years the Arizona Dept. of Revenue has been refunding those taxes plus interest. We could have the same thing with respect to this muni bond case.”

Who will win?
Only time will tell how the High Court will rule on the bond taxation issue, but other Supreme Court decisions may shed light on the possible outcome.

In a recent Supreme Court case, United Haulers Association, Inc., a trade association made up of solid waste management companies, and six haulers that operated in Herkimer and Oneida counties in New York filed suit alleging that county flow control ordinances violate the Commerce Clause by discriminating against interstate commerce. They provided evidence which showed without the flow control laws and associated tipping fees, they could dispose of solid waste at out-of-state facilities at a much lower cost. Ruling in the haulers’ favor, a federal district court held that nearly all flow control laws had been categorically rejected in the Supreme Court’s C & A Carbone Inc. (1994) decision. The Second Circuit reversed, reasoning that Carbone and U.S. Supreme Court dormant Commerce Clause precedents allow for a distinction between laws that benefit public as opposed to private facilities.

The High Court agreed that the county flow control ordinances do not discriminate against interstate commerce. It stated that, “The contrary approach of treating public and private entities the same under the dormant Commerce Clause would lead to unprecedented and unbounded interference by the courts with state and local government.”

“Taxpayers who like to read tea leaves will be parsing the court's recent decision in United Haulers,” says Richard Pomp, a professor at the University of Connecticut Law School. “The good news from that case for taxpayers is that only [Justices] Scalia and Thomas believe there is no dormant Commerce Clause. This should be welcomed by those who feared that the new court would emasculate the doctrine. The other good news is that the United Hauler court did not apply the market participant doctrine. A broad application of that doctrine would not have boded well for the taxpayer in Davis. The bad news is that the court bent over backwards in favor of the public sector in United Hauler."

Derdenger points out the similarity of Davis to Paul S. Davis v. Michigan Dept. of Treasury (1989), a case in which the U.S. Supreme Court struck down Michigan’s disparate treatment of taxation of pension benefits.

“States exempted pension benefits from their own state’s pension fund but if you had a pension from the U.S. government or another state it was subject to tax,” he notes.

“The High Court will not hear arguments or issue its ruling in Davis until sometime during its next term, which begins in October 2007.

Editor’s note: Derdenger can be reached at(602) 257-5209 or pderdenger@steptoe.com, Gandhi at (313) 496-7527 or gandhi@millercanfield.com, Pomp at (860) 570-5251 or rpomp@law.uconn.edu.