In a decision that may have far reaching implications for the municipal bond market, the Kentucky Court of Appeals ruled that it is unconstitutional for the state to tax interest received by its residents from tax-free bonds issued by other states and political subdivisions.
The state is expected to appeal the decision to the Kentucky Supreme Court. If upheld, the ruling will likely encourage similar challenges to taxation in other states that tax out-of-state issues.
The case was brought against the Kentucky Department of Revenue in 2003 by Mr. and Mrs. George Davis. The appeals court found Kentucky’s taxation system “clearly” unconstitutional because it allows more favorable tax treatment to in-state bonds than it does for “extraterritorially issued” bonds.
The Kentucky ruling also paves the way for the plaintiffs to seek class-action certification. This could make the state potentially responsible for refunding tax payments, not only to the Davises, but also to other Kentucky taxpayers who join the lawsuit.
If the lawsuit is ultimately successful, it could have a major impact on the municipal bond market. Existing tax policy causes most municipal bond investors to purchase bonds issued in their state of residence in order to avoid state taxes. A dramatic change in investor preference could significantly change municipal finance throughout the country.
Needless to say, tax-free bond investors and revenue officials from other states will be following this case very closely. So will we.
