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October Term, 2007

May 19, 2008

Today the Supreme Court issued one decision, described below, of interest to the business community.

Department of Revenue of Kentucky v. Davis, No. 06-666 (previously discussed in the May 21, 2007 Docket Report). The Supreme Court today upheld a Kentucky law that exempts from state taxes interest earned from bonds issued by the state of Kentucky and its political subdivisions, but that denies the same exemption for interest earned from bonds issued by other states and their subdivisions. Since more than forty other states, including New York and California, have similar laws, the $2 trillion municipal bond market would surely have "change[d] radically" (Slip op. 22) if the court had held Kentucky's "differential tax feature" to be unconstitutional.

Under the Supreme Court's so-called "dormant Commerce Clause" jurisprudence, the Commerce Clause prohibits states from discriminating against interstate commerce. Among other things, a state cannot "tax a transaction or incident more heavily when it crosses state lines than when it occurs entirely within the State." Armco Inc. v. Hardesty, 467 U.S. 638, 642 (1984). Residents of Kentucky who paid Kentucky state income tax on interest earned from holding bonds issued by states other than Kentucky challenged Kentucky's statutory limitation on the tax exemption in state court, claiming that it violated the Commerce Clause. The Court of Appeal of Kentucky invalidated the law, noting that "it obviously affords more favorable taxation treatment to in-state bonds than it does to extraterritorially issued bonds."

In a majority opinion by Justice Souter, the Supreme Court reversed. The Court noted that "the issuance of debt securities to pay for public projects is a quintessentially public function, with [a] venerable history." Slip op. 12. As such, the Court explained, its decision was governed by United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2006), which held that traditional government functions are "not susceptible to [the] standard dormant Commerce Clause scrutiny" applied to laws favoring in-state private businesses because traditional government functions are more likely to be motivated "by legitimate objectives distinct from the simple economic protectionism the Clause abhors." Slip op. 11. The Court went on to hold that because "a foreign State is properly treated as a private entity with respect to state-issued bonds that have traveled outside its borders," id. at 13, Kentucky's law--like the ordinance in United Haulers--treated all private issuers identically. Moreover, "Kentucky, as a public entity, does not have to treat itself as being 'substantially similar' to the other bond issuers in the market." Id. Because the Kentucky bonds are properly treated as the only bonds furthering governmental functions, the tax preference could not constitute the discrimination among substantially similar entities that is forbidden by the dormant Commerce Clause. Finally, the Court refused to remand the case for a balancing of the burdens on commerce against the local benefits of the tax scheme under Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970), on the ground that judges should not "expose the States to the uncertainties of . . . economic experimentation" that the balancing test would allow under these circumstances. Slip op. 27.

Seven separate Justices issued opinions in this case, which deeply divided the Court. In a portion of his opinion joined by only two other justices--Justices Stevens and Breyer--Justice Souter suggested that Kentucky's tax preference was exempt from the dormant Commerce Clause on the ground that Kentucky was primarily acting as a participant in the bond market. Justice Stevens issued a concurrence noting that, even in the absence of the United Haulers precedent, he would uphold the statute because Kentucky was not participating in a private trade or business. Justice Scalia wrote a partial concurrence reiterating his view that the dormant Commerce Clause should be applied only where stare decisis leaves no room for any other result, while Justice Thomas concurred in the judgment on the ground that the Court should reject its prior dormant Commerce Clause jurisprudence altogether. Justice Kennedy, joined by Justice Alito, dissented, agreeing with the state court that the tax preference was "an explicit discrimination against out-of-state issuances for admitted protectionist purposes."



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