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Lessons from Davis

Each year, the U.S. Supreme Court hears few cases concerning state taxes. It is not uncommon for the Court to decline to hear any cases at all in any given year. So, the Court's decision to hear a state tax case signals its significance.

Until May of this year, when the Supreme Court issued its opinion in Department of Revenue v. Davis, 128 S.Ct.1801 (2008), it had been nearly 90 years since the Supreme Court issued a substantive Opinion in a Kentucky tax case — almost a century. In 1929, the Supreme Court issued an Opinion in Helson v. Kentucky, 279 U.S. 245 (1929), a case that involved a question as to the constitutionality of Kentucky's tax on gasoline under the Commerce Clause of the United States Constitution.

Back in 1996, the Supreme Court granted a petition for writ of certiorari in St. Ledger v. Revenue Cabinet, 517 U.S. 1206 (1996), yet another Commerce Clause case; however, the Court simply vacated the Kentucky Supreme Court's Opinion and remanded the case for further consideration in light of its then recently issued Opinion in Fulton Corp. v. Faulkner, 516 U.S. 325 (1996). It almost goes without saying that there had been a long dry spell in Opinions issued by the Supreme Court on Kentucky tax matters.

Davis brought Kentucky back into the center of what could be described as the "national state tax spotlight." And, given the publicity that the Davis case has received, most practitioners are aware of the core issue, i.e., whether it is a violation of the Commerce Clause of the United States Constitution for the State to impose its income tax on interest earned on bonds issued by its sister states, while exempting interest earned on bonds issued by itself. The well-publicized answer is that Kentucky's scheme for the taxation and exemption of bond interest does not violate the Constitution.

Despite the fact that Davis did not result in the Commonwealth issuing refunds to numerous Kentucky taxpayers, as was the result of the St. Ledger litigation, there are several takeaways from Davis. In this regard, a little background is helpful.


Davis seemed destined to go to the Supreme Court. It originated in Jefferson Circuit Court as a class action — a rarity as nearly all Kentucky state tax cases originate in the Kentucky Board of Tax Appeals. Coincidentally, St. Ledger also began as a class action in Jefferson Circuit Court. The Circuit Court ruled in the favor of the Department of Revenue, and the case was appealed to the Kentucky Court of Appeals, which held for the plaintiff/taxpayers that Kentucky's bond taxation system discriminated against interstate commerce. The Kentucky Supreme Court declined to review the case, but the United States Supreme Court agreed to review it — again, a procedural anomaly.

The plaintiff/taxpayers in Davis were residents of Kentucky, and their income was subject to Kentucky's individual income tax. And so, in setting forth the facts, the Supreme Court focused on the statutes that make up Kentucky's individual income tax system.

Of course, the Court highlighted the difference between Kentucky's income tax treatment of interest earned on bonds issued by Kentucky and its treatment of bonds issued by other states. But, the Court also highlighted the fact that there was no difference in the treatment of interest earned on bonds issued by private entities (as opposed to governmental entities) regardless of the private issuer's home. This foreshadowed the Court's conclusion.

Notably, the Davis Opinion did corporate income tax system as it relates to interest on state and local bonds, but presumably the result would have been the same, likewise with the taxability of gain or loss from any sale thereof. Perhaps more significantly, the Court explicitly said that it would not evaluate, at least in Davis, the differential treatment of interest earned on tax-exempt state government issued private-activity bonds that are used to finance projects by private entities. Post-Davis, this could very well be one of the next challenges that we see develop.

Critical to the Court's holding in Davis is that Kentucky and its sister states have for approximately two centuries issued bonds to finance and fund public works and have provided exemptions from their income taxes. These tax exemptions, which the Court referred to as differential tax schemes, make tax-exempt bonds more attractive than taxable bonds of comparable risk even though tax-exempt bonds yield lower rates of interest.

An observation — when a differential scheme of taxation has been in place for many, many years, it would seem, from a practical matter, that a court may be more inclined to justify the long-standing practice than to strike it down. The Supreme Court's approach in Davis seems to validate this theory. Plus, in Davis, all of the states jumped on the bandwagon, so to speak, and requested that the Court uphold the constitutionality of this widespread and historical practice. These circumstances seemed to make the plaintiff/taxpayers battle an uphill fight.

Dormant Commerce Clause

Moving on to the so-called "Dormant Commerce Clause," which lies at the heart of theDavis issue, the Supreme Court has consistently interpreted the Commerce Clause, which affirmatively grants Congress the power to regulate commerce among the states, to contain a negative command that has been construed to limit the power of states to tax interstate commerce in the absence of Congressional legislation. In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Supreme Court summarized the four tests to which a state tax levy must conform to survive scrutiny under the Commerce Clause. An in-depth discussion of these is, take my word for it, well beyond the scope of this article.

It should be pointed out that the Supreme Court's Dormant Commerce Clause jurisprudence has been the subject of much debate in recent years — even within the Supreme Court itself. Some would discard it. Davis, however, confirmed that the Commerce Clause's negative implication has been "sensed" by the Court for many years (as it was in Helson nearly 90 years ago), so hopefully, this will continue to remain an important check on states' taxing power.

The Davis Court observed that modern Dormant Commerce Clause law is driven by concerns about economic protectionism; however, this purpose is limited by the concept of federalism, which favors a degree of local autonomy. After making these observations, the Court opted to skip reciting all four prongs of the Complete Auto Test, and immediately focused on the third prong — the prohibition on discrimination against interstate commerce. Under this prong, a discriminatory law is virtually per se invalid. For example, the tax law at issue in St. Ledger discriminated against interstate commerce and was thus, per se invalid.

It is patently obvious that the Court declined to mention Complete Auto in its opinion. This may or may not be significant depending on whether you think that the Court is leaning toward reversing well over a century, nearly two, of Dormant Commerce Clause law. Perhaps the Court's failure to acknowledge the other three prongs is a subtle indication that the Court no longer views some of the other prongs as viable, but it would seem more likely that the Court felt no need to mention the other three prongs because they were not at issue.

After reciting the rule that a law discriminating against commerce is per se invalid, the Court then discussed the market participation doctrine, which is an exception to the anti-discrimination mandate that applies when a state participates in a "market.” This is best illustrated by the classic example of a state owned cement plant that participates in the cement market andand gives its in-state customers first dibs on its cement. The state therein is a market participant and may lawfully discriminate against interstate commerce under the market participation exception.

Last year, in United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S.Ct. 1786 (2007), the Court recognized that a state that regulates commerce in the context of a state or local government performing a traditional governmental function (such as trash collection) does not discriminate against interstate commerce. United Haulers was the harbinger of the death of the Commerce Clause challenge to Kentucky's system of taxing interest on government issued bonds. Before United Haulers, some (including Kentucky's Court of Appeals) thought that the system unconstitutionally discriminated against interstate commerce because it treated out-of-state bonds less favorably than in-state bonds — pretty straightforward.

But, reasoning that Kentucky's tax exemption for interest earned on its bonds favored a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state commercial interests, the Court held that Kentucky's tax scheme did not discriminate against interstate commerce for purposes of the dormant Commerce Clause. In other words, in issuing its bonds to finance public projects, Kentucky was acting as a government, not as a private business. And so, the Court focused on both Kentucky's activities as a bond issuer and on its activities as a regulator imposing a tax and granting an exemption therefrom.

Although three of the Justices agreed to an analysis of the market participation exception, most of the Justices did not, because the Court held that the differential tax scheme was not discriminatory and thus, it was not necessary to apply this exemption to uphold the constitutionality of Kentucky's bond taxation system. The Court also declined to engage in a balancing test to determine whether or not the nondiscriminatory burden on commerce outweighed the benefit of the practice at issue so that it should be struck down; instead, it suggested that Congress was the better forum to make such a determination, i.e., to affirmatively exercise its Commerce Clause power.

While the Supreme Court left Kentucky's bond taxation system unchanged, a few final to follow its Dormant Commerce Clause jurisprudence declined to overturn decades and decades of its precedent. As such, Kentucky and the other states must continue to adhere to its limitations in enacting tax statutes. Also, watch for litigation regarding the differential treatment of private-activity bonds. And, perhaps more generally, it is better to strike when the iron is hot — that is, to challenge constitutionally suspect tax laws shortly after they are enacted — rather than waiting. Doing so will increase your chances of success.

About the author: Mark A Loyd, Esq., CPA, is an associate in the tax and finance practice group of Greenebaum Doll & McDonald in Louisville. He is a member of the KyCPA board of directors, editorial board and industry task force; and former chair of the taxation committee. 



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