Dept. of Revenue of KY v. Davis (06-666)

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Oral argument: Nov. 5, 2007

Appealed from: Kentucky Court of Appeals (Jan. 6, 2006)

MUNICIPAL BONDS, TAX EXEMPTION, DORMANT COMMERCE CLAUSE

Currently, Kentucky taxes interest income earned by holders of out-of-state municipal bonds but does not tax interest income earned by holders of in-state municipal bonds. Catherine and George Davis, Kentucky taxpayers and owners of out-of-state bonds, argue that Kentucky’s tax policy violates the Commerce Clause of the United States Constitution by interfering with interstate commerce. Kentucky argues, in response, that it is free to set the economic terms of the bonds it sells, and that its policy represents a legitimate balance between its desire to encourage investment in local public infrastructure and its need to raise tax revenue. The Kentucky Court of Appeals agreed with the Davises and found Kentucky’s tax scheme unconstitutional. The Supreme Court’s decision in this case will impact the validity of similar tax schemes in at least 41 other states. A ruling in the Davises’ favor would eliminate tax considerations in an investor’s decision between bonds issued by the investor’s State and bonds issued by another State, arguably benefiting all states by eliminating inefficient market segmentation. On the other hand, a ruling in Kentucky’s favor would prevent a disruptive change in the status quo, which would permit states to exercise greater discretion as they strike a balance between economic development and revenue collection.

Question presented

Whether Kentucky’s income tax scheme violates the Commerce Clause of the United States Constitution in its negative, or dormant, aspect by exempting from taxation interest income on bonds issued by Kentucky and its local governmental subdivisions while taxing interest income on bonds issued by other States and local governmental subdivisions.

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Issue

Does Kentucky’s tax policy of taxing income bonds issued by sister states but exempting from taxation bonds issued by Kentucky violate the dormant Commerce Clause of the United States Constitution?

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Facts

The Commonwealth of Kentucky (“Kentucky”) taxes interest income on state and local bonds of sister states but does not tax interest income derived from municipal bonds issued by Kentucky or its political subdivisions. Davis v. Dep’t of Revenue of the Fin. and Admin. Cabinet of Ky., 197 S.W.3d 557, 560 (Ky. Ct. App. 2006). In April 2003, Catherine and George Davis (“the Davises”) filed a class action suit alleging Kentucky’s tax scheme was invalid under the Commerce Clause of the United States Constitution. Id. at 557, 560. The Davises, who were Kentucky taxpayers, claimed that the tax scheme injured them financially by forcing them to pay income tax on their out-of-state municipal bond holdings. Id. at 560. The Davises sought, on their own behalf and on behalf of other similarly-situated taxpayers, a declaration holding that the scheme is unconstitutional, an injunction preventing further enforcement of the tax, and a refund of unconstitutional taxes paid. Brief for Respondent In Opposition to Petition at 1.

In July 2003, the Finance and Administration Cabinet of the Commonwealth of Kentucky (“the Cabinet”) and the Cabinet’s Department of Revenue (“the Department”) moved for summary judgment. See Davis, 197 S.W.3d at 560–61. In August 2004, the Jefferson Circuit Court granted the Department’s motion. Id. According to the Circuit Court, Kentucky’s tax exemption for in-state municipal bonds does not violate the Commerce Clause because Kentucky participates in the municipal bond market as a seller. Brief for Petitioners at 9. Therefore, Kentucky could set the terms of its competition no less than the terms set by private bond-sellers. Id. The Circuit Court also found that the scheme furthers Kentucky’s constitutionally legitimate interests: it encourages Kentucky citizens to help finance local public works projects and also permits Kentucky to collect tax revenue. Id.

On January 6, 2006, the Kentucky Court of Appeals vacated the Circuit Court’s judgment and remanded the case for further proceedings. Brief for Petitioners at 9. The Court of Appeals held that Kentucky’s bond taxation system was unconstitutional on its face because it treated in-state bonds more favorably than out-of-state bonds. Davis, 197 S.W.3dat 564.The Court of Appeals also rejected the argument that Kentucky was a seller of municipal bonds, recognizing that taxation is a “primeval governmental activity.” Davis, 197 S.W.3dat 564 (citing New Energy Co. v. Limbach, 486 U.S. 269, 277 (1988)).

The Department filed a motion for discretionary review by the Kentucky Supreme Court, which was denied on August 17, 2006. Brief for Petitioners at 10. On November 9, 2006, the Department petitioned the United States Supreme Court for a writ of certiorari. Brief for Respondent In Opposition to Petition at 2. The Court granted the Department’s petition on May 21, 2007. Brief of Securities Industry and Financial Markets Ass’n as Amicus Curiae at 3.

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Discussion

Does a state that exempts from taxation interest on municipal bonds issued by the state but taxes interest on bonds issued by other states violate the dormant Commerce Clause of the U.S. Constitution? The U.S. Supreme Court’s ruling in this case likely will clarify the limits of state competition in the national bond market and state power to use taxes in order to raise revenue.

Arguments

The Department of Revenue of the Finance and Administration Cabinet of the Commonwealth of Kentucky (“the Department”) argues that Kentucky’s tax scheme does not violate the dormant Commerce Clause or its underlying policies. Brief for Petitioners at 10. The Department claims that the Court should find no reason to invalidate Kentucky’s tax scheme under the dormant Commerce Clause because the scheme does not constitute economic protectionism, threaten national unity, or threaten the private free market. Id. at 11–12. The Department also maintains that Kentucky bonds are substantially different from bonds issued by other States. Hence, Kentucky is free to set the terms on which it participants in the bond market.  See id. at 11, 44–45.

The Davises counter that Kentucky’s tax scheme is discriminatory both on its face and in its impact. Brief for Respondents at 12, 18, 20. The Davises argue that the disparate treatment of bonds impact out-of-state entities that cannot vote in Kentucky elections. This results in an undemocratic scenario which the Framers intended the Commerce Clause to prevent. Id. at 29. According to the Davises, municipal bonds and the States issuing them are substantially similar. Additionally, Kentucky’s status as a market participant does not permit Kentucky to impose taxes that discriminate against out-of-state interests. See id. at 21, 36–37.

Implications of Possible Outcomes

Should the Department prevail, states likely would continue to employ tax schemes favoring in-state bonds over out-of-state bonds. See Brief for Respondents at 31. States would continue to collect revenue from such schemes. See id. Moreover, states would retain the ability to use tax policy to encourage their citizens to invest in local projects instead of out-of-state projects. See Brief for Petitioners at 23.

However, discriminatory tax policies arguably lead to a “race to the bottom” that leaves all states worse off. See Brief for Respondents at 31. Under Kentucky’s scheme, the argument goes, Kentucky can access other states’ citizens, but the scheme blocks access of other states to Kentucky citizens. Id. This permits Kentucky to unfairly compete against other states for revenue from holders of state bonds. If all states adopt the same discriminatory system, they can compete on equal terms.  However, because states lack access to other states’ citizens, each suffers a loss of net revenue. Id.

Should the Davises prevail, at least 42 States would have to change their municipal bond income tax laws to eliminate in-state bias. Brief of the National Federation of Municipal Analysts as Amicus Curiae (“Municipal Analysts Brief”) at 16. This substantially would affect the interests of municipal bondholders, who likely based their investment decisions in part upon prevailing State tax structures. Id. at 16–17. Investors would be able to focus on the economic opportunity offered by a particular bond investment without the influence of individual state tax policies. See Brief for Respondents at 29-30, 46. Investors likely would respond by readjusting their portfolios, which disrupts the bond market. See Municipal Analysts Brief at 16–17. Consequently, single-state mutual funds likely would disappear. Id. at 18. This could present a problem for smaller municipalities, which currently depend on investment by single-state funds. Brief of Nuveen Investments as Amicus Curiae at 18–19.

However, the Davises argue that, as a whole, states and municipalities would realize a net benefit from a free municipal bond market. Brief for Respondents at 31.  States could enjoy greater revenues resulting from the unrestricted flow of capital. Id. at 9. Bondholders, also would benefit because they would become freer to choose stable, low-cost investment vehicles for riskier, high-cost alternatives.  Id.

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Analysis

Constitutional Background: The Dormant Commerce Clause

The central question in this case is whether or not a State may exempt interest income earned by holders of its municipal bonds from taxation while taxing interest income earned by holders of bonds issued by sister States. The Commerce Clause of the United States Constitution provides that: “Congress shall have Power … [t]o regulate Commerce with foreign Nations, and among the several States …” U.S. Const. art. I, § 8, cl. 3. By its plain language, the Commerce Clause grants Congress the power to regulate interstate commerce. United Haulers Assoc., Inc., v. Oneida-Herkimer Solid Waste Management Authority, 127 S.Ct. 1786, 1792 (2007).

The clause also contains an implied component, known as the “dormant” Commerce Clause. United Haulers, 127 S.Ct. at 1792–93. Pursuant to Supreme Court case precedent, the dormant Commerce Clause forbids States from discriminating against out-of-state economic interests, with limited exceptions. See id. If a state law motivated by “simple economic protectionism” discriminates against interstate commerce, it is “virtually per se”invalid. Id. at 1793.  The Supreme Court has reasoned that protectionist measures lead to the economic retaliation that the framers of the Commerce Clause sought to prevent. Brief for Respondent at 11.

The Impact of the Kentucky Exemption on Interstate Commerce

The Davises claim that Kentucky’s tax exemption for in-state bonds discriminates against interstate commerce by favoring in-state interests over out-of-state interests. Brief for Respondent at 12. The exemption is facially discriminatory, according to the Davises, because it explicitly favors bonds issued by Kentucky over bonds issued by sister States. Id. at 16–17 (citing Camps Newfound/Owatonna v. Town of Harrison, 520 U.S. 564 (1997)).

The Davises argue that the Court should apply prior precedent from Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318 (1977).  Brief for Respondent at 14.  In Boston Stock Exchange, the Supreme Court established that states may not encourage in-state activity by imposing discriminatory taxes on interstate transactions in a national market. 429 U.S. at 332. The Davises argue that Kentucky’s income tax exemption interferes with a prospective bond purchaser’s economic decision-making process in the same way that the transactional tax did in Boston Stock Exchange. Brief for Respondent at 14. Kentucky’s exemption encourages Kentucky citizens to purchase Kentucky bonds.Id. at 14–15. Moreover, bonds are a nationally-traded commodity. Id. at 15. Therefore, according to the Davises, Kentucky’s exemption is invalid under the Commerce Clause. Id. at 14—15. 

Moreover, the Davises argue, the exemption’s disparate impact renders it unconstitutional regardless of its purpose. Brief for Respondent at 17. The Supreme Court held in West Lynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994) that tariffs on interstate commerce are “patently unconstitutional.” 512 U.S. at 193. Moreover, states may not obtain the benefits of an impermissible tariff by imposing equivalent indirect taxes. Id. at 18–19 (citing West Lynn Creamery, 512 U.S. at 195).

According to the Davises, the Kentucky exemption is similar to a tariff.  Brief for Respondent at 18.  Like a tariff, the exemption helps Kentucky municipalities sell bonds, discourages Kentucky citizens from purchasing bonds issued by sister States, and helps Kentucky collect tax revenue from out-of-state activities. Id. Therefore, the Davises argue, the exemption is unconstitutional on disparate impact grounds. Id. at 18–19

Are Kentucky and its Bonds “Substantially Similar” to Other States and their Bonds?

According to the Davises, the Department of Revenue (“the Department”) effectively concedes that Kentucky’s tax scheme is discriminatory in its practical effect by recognizing that the exemption makes Kentucky bonds more attractive to Kentucky citizens. See Brief for Petitioners at 3, 6. However, the Department contends that this is irrelevant for Commerce Clause purposes. See id. at 16. Under Supreme Court jurisprudence, a state law is only discriminatory if it treats “substantially similar entities” differently. Id. at 18–19 (citing General Motors Corp. v. Tracy, 519 U.S. 278 (1997)). According to the Department, neither Kentucky nor its bonds are “substantially similar” to sister States and their bonds because only Kentucky issues bonds to finance capital projects in Kentucky. Brief for Petitioners at 20.

The Davises argue in response that all municipal bond issuers—and municipal bonds—are substantially similar. Brief for Respondent at 21 According to the Davises, all municipal bond issuers are substantially similar for Commerce Clause purposes because their activities are similar and they sell bonds on the same national bond market. Id. Moreover, all municipal bonds are commodities that are rated by independent agencies and actively traded on a national market. Id. at 21–22. These attributes strongly suggest that all municipal bonds are substantially similar. Id.

Is Kentucky Acting as a Market Participant?

The Department argues that Kentucky may exempt its bonds from taxation while taxing bonds issued by sister states because it is a participant in the bond market. Brief for Petitioners at 40.  The Department turns for authority toSouth-Central Timber Development, Inc. v. Wunnicke, 467 U.S. 82, 94 (1984). Id.  In Wunnicke, the U.S. Supreme Court held that if a state is acting as a market participant, the dormant Commerce Clause does not prohibit it from using its market position to favor in-state activity. Wunnicke, 467 U.S. at 94.According to the Department, the tax-exempt status of Kentucky bonds owned by Kentucky taxpayers is indistinguishable from the price and interest rate of the bonds: all are part of the economic package Kentucky offers to purchasers as part of its market activities. See Brief for Petitioners at 45–46.

Nuveen Investments, Inc. agrees, arguing as amicus curiae that Kentucky’s tax exemption for in-state bonds is financially equivalent to a subsidy granted to Kentucky citizens who purchase Kentucky bonds. See Brief of Nuveen Investments, Inc. as Amicus Curiae in Support of Petitioners at 7–8. As a market participant, Kentucky may sell bonds to in-state purchasers on more favorable terms than those offered to out-of-state purchasers. Id. Nuveen argues that it would be illogical to invalidate a tax policy with effects equivalent to a constitutional subsidy policy, because the distinction between the two schemes is merely formalistic. See id. at 8–9.

The Kentucky Court of Appeals was not persuaded, holding that taxation is a “primeval government activity.” Davis, 197 S.W.3d at 564. Therefore, according to the Court of Appeals, Kentucky’s participation in the bond market as a seller does not excuse its bond taxation polices. Id. The Davises agree with the reasoning of the Court of Appeals. Brief for Respondent at 36. The restrictions of the dormant Commerce Clause apply to state regulatory actions. Wunnicke, 467 U.S. at 93.  Therefore, the state is not a market participant if it is sets terms no private actor could impose.  Brief for Respondent at 36.

The Davises argue further that there is a constitutional difference between an in-state subsidy and a discriminatory tax, even if their practical effects are similar. Brief for Respondent at 36–39. The Davises acknowledge that a State might be able to subsidize in-state activity without subsidizing out-of-state activities. Id. at 37. However, they argue that under the Supreme Court’s jurisprudence, a state may not achieve a similar result by applying disproportionate taxes to out-of-state activity. Id. (citing New Energy Co., v. Limbach, 486 U.S. 269, 277 (1988)).

Is Kentucky’s Scheme Justified?

The Department argues that it should prevail even if the Court finds that the exemption is impermissible on its face. Brief for Petitioners at 22. According to the Department, Kentucky’s tax exemption is motivated by the legitimate purpose of securing financing for public works in Kentucky while obtaining tax revenue from out-of-state bonds. Id. at 22–23. In response, the Davises argue that the Department failed to meet its burden to prove (or even argue) that the discriminatory exemption is necessary. Brief for Respondent at 25.

Should the Court Defer to Practical Considerations?

The Department argues that in light of the practical impact that the case may have on the municipal bond market, the Court should “proceed cautiously lest [it] imperil” Kentucky’s ability to provide municipal services. Brief for Petitioners at 19 (citing Tracy, 519 U.S. at 303–04). According to the Department, this case turns on legislative policy questions better left to Congress, which to this point has left state municipal bond tax schemes alone. Brief for Petitioners at 39–40. 

The Davises argue in response that Kentucky and its amici have “overblown” the potential economic impact of this case. Brief for Respondent at 45. Moreover, according to Davises, practical considerations cannot save a patently unconstitutional tax scheme. Brief for Respondent at 43–48 (citing Tracy, 519 U.S. at 309; Harper v. Va. Dep’t of Taxation, 509 U.S. 86 (1993)). 

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Conclusion

The Court’s decision in this case likely will clarify the limits of state discretion in municipal bond tax policy. A decision for Kentucky will permit states to collect tax revenue from out-of-state municipal bonds but use tax policy to promote investment in in-state municipal bonds, nevertheless. This would maintain the status quo: arguably preventing substantial disruption in the municipal bond market and helping smaller municipalities attract investment. If the Davises prevail, states will have to make a choice between revenue collection and bond promotion, and either tax all municipal bond income or no municipal bond income, at all. On average, this result would arguably benefit all states by encouraging investors to make investment decisions based on the economic merits of a particular bond, rather than tax consequences. Either result will resolve an apparent conflict between Commerce Clause jurisprudence and the longstanding tax policy of many states.

Authors

Prepared by: Tiffany Sepulveda, Bryan Hall

Edited by: Ferve Ozturk

Additional Sources

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