U.S. Supreme Court to Hear Kentucky Tax Case Regarding the Taxation of Municipal Bond Interest

June 14, 2007

In January 2006, the Kentucky Court of Appeals, in Davis v. Department of Revenue held unconstitutional the Kentucky statutes which exempt from Kentucky income tax the interest on bonds issued within Kentucky, while taxing interest on most non-Kentucky municipal bonds.  The Court held that the taxing scheme violated the Commerce Clause of the U.S. Constitution because it discriminated against interstate commerce; i.e., by affording more favorable tax treatment to in-state bonds, Kentucky’s tax system benefited in-state economic interests by burdening out of state competitors.  Subsequently, the Kentucky Supreme Court denied discretionary review, and the Kentucky Department of Revenue asked the U.S. Supreme Court to review the case.

On May 21, 2007, the U.S. Supreme Court agreed to take the case.  The Court is expected to hear the case in the fall and may issue a decision in the winter or spring of 2008.  If the Supreme Court sides with the Kentucky Department of Revenue, there will be no change to Kentucky’s current tax system and that of most other states.  On the other hand, if the Kentucky taxing scheme is held unconstitutional, a state will not be able to exempt municipal bond interest on bonds issued in the state, while taxing interest on out of state municipal bonds.  Each state would have to decide whether to tax or exempt the interest from all municipal bonds (both in and out of state). 

Kentucky residents who invested in out of state municipal bonds and paid tax on the interest from those bonds may be entitled to refunds from the Kentucky Department of Revenue if the U.S. Supreme Court holds that Kentucky’s taxing scheme is unconstitutional.  Under Kentucky law, in cases where a state tax statute is held unconstitutional, applications for refunds must be made within two years from the date the taxpayer paid the tax.  Thus, affected Kentucky taxpayers should consider filing protective refund claims to ensure they will receive a refund in the event Kentucky’s taxing scheme is ultimately held unconstitutional.

We would be glad to discuss how the Davis case may affect you in more detail.  If you are interested in learning more, please contact Sam Graber at either 502-568-0248 or sgraber@fbtlaw.com or any of the members of Frost Brown Todd’s Tax Practice Group.

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