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High Court: Taxing Out-of-State Muni Bonds Is OK

The Supreme Court overturns a lower court decision by ruling that it is constitutional for states to give a tax break on muni bonds issued within their borders.
Robert Willens, CFO.com | US
May 23, 2008

Municipal bonds have been making headlines lately, moving from the muni bond scandal in San Diego to the Securities and Exchange Commission's investigation into JPMorgan's bidding practices to Moody's announcement that it plans to rate the bonds on the same scale as corporate debt. Now the Supreme Court has joined the fray, finding that it is constitutional for states to offer a tax break on muni bonds issued within their borders.

Indeed, the interest on muni bonds, which are held by individuals and corporations, is taxed differently depending on the state in which the bond is issued. Some states do not tax the interest on public bonds issued within their borders; others do. Kentucky is a case in point: the interest on bonds issued by Kentucky and its political subdivisions is exempt from tax, whereas interest on municipal bonds of other states and their political subdivisions is taxable.

The Supreme Court recently decided whether this differential tax scheme offended the Constitution's Commerce Clause, and in reversing the lower court's decision from which an appeal was taken, ruled that it did not, in Department of Revenue of Kentucky v. Davis_US_ (2008). Here's why.

The "Dormant" Commerce Clause
The Supreme Court, with Justice David Souter writing for the majority, noted that the modern law of the so-called dormant Commerce Clause is driven by concern about "economic protectionism" — regulatory measures that are designed to benefit in-state economic interests by burdening out-of-state competitors. However, the framers' distrust of the "economic Balkanization" that such protectionism could engender was limited by their "Federalism" — an approach that favored a degree of local autonomy.

Under the resulting protocol, within which a balancing of these conflicting imperatives is sought, the Supreme Court is required to ask whether a law discriminates against interstate commerce. A discriminatory law is, virtually, per se invalid and will survive only if it advances a legitimate local purpose that cannot be served by reasonable, nondiscriminatory, alternatives.

Permissible Discrimination
Nevertheless, when a state or local government enters the market "as a participant," it is not subject to the restraints of the Commerce Clause. This exception reflects a basic distinction between states as market participants and states as market regulators.* Moreover, a government function is not susceptible to standard dormant Commerce Clause scrutiny, owing to its likely motivation by legitimate objectives distinct from economic protectionism. (See United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority_US_ (2007).)

That case noted that "...laws favoring local government may be directed toward any number of legitimate goals unrelated to protectionism...." This logic, Justice Souter concluded, applies with "even greater force" to laws that favor a state's municipal bonds, since the issuance of debt securities to pay for public projects "is a quintessentially public function."

Finally, in a case decided in the 19th century, Bonaparte v. Tax Court, 104 US 592 (1882), the high court had held that a foreign state is treated as a private entity with respect to bonds that have traveled outside of its borders. Accordingly, under United Haulers Association, supra, the taxing scheme employed by Kentucky and most other states is valid because it benefits a public issuer (Kentucky) while treating all "private issuers" (including foreign states) exactly the same.

Market Dislocation Avoided
In addition, the Supreme Court's decision was influenced by the untoward effect on the markets that a contrary holding — which would have found the differential taxing scheme invalid — would have wrought. The Court noted that the differential taxing scheme is critical to the operation of an identifiable segment of the municipal finance market as it currently functions — single state funds. This fact alone, the court concluded, demonstrates that the unanimous desire of the states (every state, even those without income taxes, had filed briefs with the court in support of the status quo) to preserve the "tax feature" is a far cry from the private protectionism that has driven the development of the dormant Commerce Clause.

As a result, and for myriad reasons, the Supreme Court ruled that Kentucky's scheme of taxing interest on municipal bonds issued by in-state interests, while different than the way it taxes out-of-state "paper," is permissible. To be sure, any discrimination resulting from this two-tiered tax system was more than counterbalanced by the fact that laws favoring local government are presumed to be directed to any number of legitimate goals unrelated to the evil (with which the Commerce Clause is concerned) of economic protectionism.


Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

*Kentucky acts in dual roles: issuing bonds (in its role as a "market participant") and setting taxes (although if it were viewed, exclusively, as such a taxing authority its actions would seem to invite Commerce Clause scrutiny). Accordingly, the Supreme Court said, "... our cases on market participation joined with regulation...prescribe exceptional treatment for this direct governmental activity in commercial markets for the public's benefit..." The fact that the regulatory effort is tied to the public object of the foray into the market gives the regulation a "civic objective" different from the discrimination (which has been) held to be unlawful.




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