United States: Kentucky Court Decision Could Undercut Single State Funds

A recent Kentucky Court of Appeals decision could have profound implications for single state tax-exempt mutual funds, as well as the special appeal of in-state municipal bonds and in-state "section 529" state-sponsored college savings funds to residents of the issuer’s state.

Single state tax-exempt mutual funds appeal to residents of states that tax interest on bonds of other states but exempt their own bonds from tax. These states confer a double-tax exemption on their residents, but only for bonds issued by the home state and certain political subdivisions and authorities. The Kentucky court decision, Davis et al v. Department of Revenue of the Finance and Administration Cabinet, Commonwealth of Kentucky, ruled that these tax statutes violate the commerce clause of the United States constitution. The decision, handed down in January 2006, has been appealed to the Kentucky Supreme Court.

As explained below, this is hardly a trivial attack and bears close watching by all participants in the municipal markets. Though statutes favoring home state bond interest have been in place nationwide for many years — by one count, over 40 states have tax statutes that do so — the law in this area provides a very real basis for a constitutional attack on such statutes. Yet the only two courts that have considered the issue are split on it. And a review of the Supreme Court precedents in this area leaves the subject open for robust debate. An analysis of the complex constitutional principles underlying this debate follows.

At the heart of the issue is the scope of the commerce clause and its less well-known corollary, the dormant commerce clause. The federal commerce clause provides that the Congress has the power to regulate interstate commerce. A corollary rule has developed, known as the "dormant commerce clause," that prohibits states from favoring the economic interests of their own citizens and from impeding interstate commerce. Taken together these constitutional principles make the federal government the exclusive regulator of interstate commerce.

Like many areas of constitutional law, the commerce clause is an area where bright lines are difficult to draw. Commerce is an abstract concept. Most transactions can be viewed as having an interstate effect even if they occur wholly in-state. And the centralized power represented by the commerce clause raises historical tensions of our political system between federal and state power. These factors have led to court decisions in the commerce clause area that can be hard to reconcile.

States frequently have been found to have interfered with interstate commerce where a state statute on its face discriminates against out-of-state interests. Such facially discriminatory statutes are presumed to interfere with interstate commerce and are rarely upheld. Examples of statutes struck down on this basis include: a Maine statute that gave a tax exemption to camps serving principally Maine residents; a New York statute that gave preferential tax treatment to stock transfers resulting from sales made through New York brokers; and a Hawaiian excise tax that exempted locally-produced alcoholic beverages. In fact, a tax imposed on out-of-state interests but not in-state interests can generally be considered the "third rail" in this area.

Commentators have noted that the sweeping rhetoric of these facial discrimination cases, if taken literally, would be at odds with many state tax statutes that provide preferences for in-state activity such as tax incentives for locating economic development projects within the state. On the other hand, even some of those economic development tax incentives are being challenged in the courts. So, the law regarding the scope of the dormant commerce clause continues to develop.

An important exception to the dormant commerce clause exists for a state acting as a "market participant", as opposed to regulating commerce among third parties. Under this exception, the Supreme Court has upheld a Maryland statute providing an incentive payment to in-state scrap metal firms on a preferential basis; a South Dakota statute allowing a state-owned cement plant to sell to in-state customers before out-of-state customers; and a Boston executive order requiring contractors for city construction projects to agree that at least half of their work force would consist of Boston residents.

The market participant exception has been justified on various grounds. Where a state is adding to the flow of interstate commerce as a primary actor it should be allowed to do so on terms that favor its own residents. Since the activity is being paid for with state revenue, the state should be able to confer the benefit on the state residents who are paying for it. State sovereignty must allow some freedom for states to act as participants in commerce, in the same way that private companies can. Courts have also been somewhat wary of treading into the federal versus state sovereignty issues that are raised by the dormant commerce clause.

Determining when a state is acting as a market participant, as opposed to a regulator, is not always easy. For example, the Supreme Court struck down an Alaska statute that required all purchasers of timber from state-owned lands to partially process the timber in-state before export. The Supreme Court ruled that Alaska’s requirement did not fit within the market participant exception. Although the state was selling its own timber, it was going beyond that transaction to regulate the market for timber processing. Thus, decisions in this area can hinge on very subtle distinctions.

What makes the issue in the Kentucky case so interesting is that it involves the state’s discriminatory use of its taxing power, a clearly regulatory activity, to support its activities as a market participant. When the state issues its bonds it is acting as a participant in the capital markets. It is directly "renting" the capital of investors. And it is adding its bonds to the stream of commerce. It is therefore arguably consistent with the rationale of the market participant exception for the state to provide incentives to its own residents to purchase those bonds and thereby lower the cost of capital to the in-state beneficiaries of those projects, who also ultimately must pay for them. At least one commentator has endorsed this view and suggested that taxing power used in this fashion does not violate the dormant commerce clause.

The Kentucky court flatly rejected this notion. The only other reported case addressing this question squarely is an earlier Ohio state court decision, Shaper v. Tracy. Shaper similarly held that the state was not a market participant when exercising its taxing power. Yet Shaper still upheld the state’s preferential tax exemption for Ohio bond interest on the rationale that the dormant commerce clause only prohibits a state from favoring its own citizens over the citizens of other states. The court reasoned that a state may still favor itself as a state, at the expense of other states. This is a novel theory that may ultimately serve as the basis for upholding the constitutionality of the state tax preference for home state bond interest, but the Kentucky court did not follow it. Although Shaper rejected the application of the market participant exception to these tax statutes, its theory that a state may favor itself (as opposed to its citizens) sounds very much like the market participant exception.

Handicapping which way courts will come out on this issue is difficult. There is a strong argument to be made that the market participant theory should apply when a state issues its own bonds — and the state tax preference for in-state bond interest should be upheld. As described above, this result is consistent with the Supreme Court precedents and the rationale behind the market participant exception. Also, the prevalence of statutes favoring home state bonds would likely be given some practical weight if the issue comes before the Supreme Court. Finally, the effects of economic protectionism and the risks of economic balkanization that the commerce clause seeks to guard against do not seem to be implicated to the same degree by the state tax statutes at issue.

However, there is certainly ample precedent for a court to cite to invalidate these state tax exemption statutes. There is no question that the state’s taxing power, applied in a manner singling out non-residents, creates a very high burden for validity under the dormant commerce clause. And, importantly, the two courts that have addressed this issue have both rejected the market participant exception, although one court found a novel way to still uphold the statute.

The implications of this decision are significant. The decision has been appealed to the Kentucky Supreme Court, and may well wind up in the United States Supreme Court. If it stands, then the Davises and the class they represent would be entitled to a refund of taxes paid on interest on their out-of-state bonds. The case is based on the federal constitution and so could be applied in other states with similar discriminatory tax statutes. Even if not taken up by the United States Supreme Court, it might still become the law through litigation in other states.

If the statute is invalidated, there are two ways to cure the dormant commerce clause problem — the state can either tax interest on all municipal securities or on none of them. But in either event, equal treatment of all municipal bond interest would remove the particular attractiveness of a state’s municipal securities to its residents.

That would be a big change in the market. Stay tuned for further developments.

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