The Supreme Court Questions Some Answers

The Supreme Court made a practical decision in Department of Revenue of Kentucky v. Davis, holding that the state may impose an income tax on interest derived from state and local bonds from another state while exempting the interest from the bonds issued by the state, its localities, and its instrumentalities.

The Kentucky Court of Appeals had held that the U.S. Constitution's commerce clause "prohibits economic protectionism, that is, regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors." The Supreme Court focused on whether the issuance of bonds by the state and its subdivision was an “in-state economic interest.” While on its face the statute created discriminatory barriers to the state’s financial markets from out-of-state public financing, financing government operations is an area of traditional government activity. As such, the commerce clause was not implicated because governmental activities are not economic interests and a state can constitutionally pass laws that favor its government in relation to all other third parties.

Had the Court chosen to hold the law in conflict with the commerce clause, many states’ bonds would have been less competitive in their own states vis a vis the bonds from outside the state that paid a slightly higher return. But because of the exemption, the return from another state will have to be considerably higher than the rate on the bonds of the resident state. Thus, a state having this two-tier tax structure will generally continue to capture its in-state investors within the government bond market. Because the origin of the bond interest will still matter, accountants must continue to determine in-state and out-of-state percentages in calculating state income tax for clients with interests in municipal bond funds.

The decision was practical in preserving the practice of the states in providing its residents in-state exemption on its own bonds. But its reliance, as the dissent noted, on the state being a market participant was misplaced. The law in question operated on those who hold the bonds and trade them, not those who issue them; thus, the discrimination was not with respect to the government that issued them. The bonds contained no provision promising tax exemption or tax relief to the holder. The security was issued as a formal obligation to repay. Not a word in the terms and conditions of the securities promised favored tax treatment for certain holders. Indeed, that could not be done without impairing marketability. It is simply not commercial or investment practice to make payment obligations turn upon either the residence of the holder or the state of the issuer. The issuer intended to use the interstate market for its bonds and did not encumber them with conditions giving premiums or penalties depending upon the residence of the holders.

Enter the taxing regime that the state imposed apart from the bonds themselves. It is this not the governmental function of issuing bonds that was at issue: The state tax provision at issue could be repealed tomorrow without altering or impairing a single obligation in the bonds. It was the tax that matters; and Kentucky gave favored tax treatment to some securities but not others depending solely upon the state of issuance, and it did so to disadvantage bonds from other states. Under a host of Supreme Court precedents, differential taxation with respect to securities sales was invalid. For example, the law that imposed a higher New York transfer tax on security transactions on the financial markets located in out-of-state markets than applied to those on the New York markets was held thirty years ago to be unconstitutional under the commerce clause. Bonds are commodities in interstate commerce, and in this respect consumers are entitled to choose them over local products just as with milk.

The Supreme Court had just a decade earlier declared that "tax exemption is not the sort of direct state involvement in the market that falls within the market-participation doctrine." Yet, the decision opens up the possibility for further mischief. The dissent would have been less dissatisfied if the holding were specifically limited to this particular situation by reason of the harm to the national markets that might arise by a contrary result. However, by seeming to make the taxing authority included within the notion of market participation, states looking for funds wherever they can find them may well enact further tax schemes that burden out-of-state businesses predominantly or exclusively. Whether this case will survive longer than some of the precedents established within this generation remains an open question.

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