In an eagerly awaited decision, the U.S. Supreme Court ruled that Kentucky may continue to exempt municipal bonds issued within the state, while continuing to tax those from other jurisdictions.
By a 7-2 vote, the court reversed a ruling by Kentucky’s Court of Appeals, which determined that all bonds must receive the same tax treatment.
The case, Kentucky v. Davis, was originally brought in 2003 as a class-action suit by Kentucky investors who sought equal tax treatment for municipal bonds, regardless of where they were issued. Originally, the trial court ruled against the couple, but the result was overturned by the Kentucky Court of Appeals.
Supreme Court Justice David Souter, in his opinion favoring the original trial court decision, found that overturning the long-standing practice of taxing out-of-state bonds would be financially disruptive to the states that do so.
The court also indicated that the tax exemption on in-state bonds was a traditional government function and did not discriminate against interstate commerce – the key argument by the plaintiffs.
The states had contended that eliminating the system of exemptions that began 90 years ago would have a disastrous impact on their finances. In the $2.5 trillion municipal bond market, 42 states exempt some or all interest from income tax for residents while taxing interest on bonds from other states.
In the majority opinion, Souter said that Kentucky’s tax exemption, which is similar to that in most other states, does not violate the Constitution’s commerce clause.