January 04, 2008

The Supreme Court of the United States is now poised to resolve an issue of critical importance to the municipal bond community: whether states may continue the common practice of exempting from tax interest on bonds issued by in-state governmental entities while subjecting to tax the interest on bonds issued by out-of-state governmental entities. The municipal bond market is keeping a close eye on this case as its outcome could have a seismic impact on that $3 trillion market.

Summary
On May 21, 2007, the Supreme Court of the United States decided to hear Kentucky v. Davis. By accepting this case, the Supreme Court appears likely to settle the issue of whether a state may exempt from tax interest on bonds issued by in-state governmental entities, while taxing interest on bonds issued by out-of-state governmental entities. Unless the Supreme Court reverses the Kentucky decision, states will no longer be permitted to continue the common practice of offering bonds issued in-state favorable tax status compared to bonds issued by out-of-state entities.

The Court heard oral argument on November 5, 2007, and is expected to render its decision in Davis not later than June 2008. Taxpayers who have paid state income tax on interest on bonds issued by out-of-state governmental entities (and the taxing state exempts from tax interest on bonds issued by that state and its instrumentalities) may consider filing protective refund claims and deferring a decision on such claims pending the outcome of Davis.

If the Court decides in favor of the Commonwealth of Kentucky — the more likely outcome foreseen by most observers — the status quo will be substantially, if not entirely, maintained. A decision by the Supreme Court in favor of the taxpayer, however, could negatively impact the municipal bond market and may jeopardize the fiscal health of many state and local governments.

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Background
By deferring for several months the decision of whether to hear the Davis case, the Supreme Court teased many observers into believing that the Court may simply remand the case to the Kentucky courts for a decision based upon the outcome of another Commerce Clause discrimination case — United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority — that the Court decided on April 30, 2007. At least at first blush, United Haulers may not appear to be so closely related to Davis. In United Haulers, the Court — in a plurality decision — found that a “flow control” ordinance, which required all solid waste produced in Oneida and Herkimer counties to be delivered to a state-created processing facility, did not violate the dormant Commerce Cause. The Court distinguished its 1994 C&A Carbone, Inc. v. Clarkstown decision that struck down, under the Commerce Clause, a flow control ordinance that forced haulers to deliver waste to a particular private processing facility. The plurality of the United Haulers Court found the private versus public difference to be constitutionally significant and upheld the Oneida and Herkimer county ordinances, even though that state-created facility charged the haulers a tipping fee that was substantially higher than the haulers would have paid were they permitted to dispose of the waste out-of-state.

The Opinion of the Court
As noted, United Haulers was a plurality decision, which means that a majority of the Justices could not agree on the rationale pursuant to which to decide the case — but did agree on the conclusion. Delivering the opinion of the Court, Chief Justice Roberts (who was joined by Justices Souter, Ginsburg and Breyer) noted that disposing of trash has long been a traditional governmental activity and that laws favoring government — but treating all in-state and out-of-state private businesses in the same manner — do not discriminate against interstate commerce for purposes of the dormant or negative Commerce Clause.

By way of background, the Commerce Clause vests in Congress the power to “regulate Commerce … among the several States[.]” A strict reading of that rather simple clause grants to Congress the authority to regulate interstate commerce. (See discussion of Justices Scalia’s and Thomas’s concurrences, below). The so-called “dormant” or “negative” aspect of that clause restricts the manner in which states may impose tax on objects of interstate commerce.

The Chief Justice concluded the opinion of the plurality as follows:

We hold that the Counties’ flow control ordinances which treat in-state private business interests exactly the same as out-of-state ones, do not ‘discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.

Therefore, the plurality based its holding upon two primary findings: first, that the ordinances required the trash to be disposed of at a government-owned facility; and second, that the ordinances treated both in-state and out-of-state private haulers in the same manner. These underpinnings of the plurality may prove to be a key factor in how these Justices will view Davis.

Justices Scalia’s and Thomas’s Concurrences
Justice Scalia, while joining in the conclusion of Chief Justice Roberts and the other plurality Justices, wrote separately to reaffirm his view that “the so-called negative Commerce Clause is an unjustified judicial invention, not to be expanded beyond its existing domain.” For that reason, Justice Scalia would only enforce the dormant Commerce Clause on stare decisis grounds where: (1) a law facially discriminates against interstate commerce; and (2) that law is indistinguishable from a type of law previously held unconstitutional by the Court. Justice Scalia distinguished the Oneida and Herkimer flow control ordinances, which required trash to be disposed of at a government-owned facility, from the ordinances in Carbone, which benefited a private entity (even though the private facility in Carbone was required to be sold to the government after five years for one dollar, see below).

Justice Thomas, who also concurred in the plurality’s conclusion, took more of a strict constructionist view than did Justice Scalia. Justice Thomas would pay no heed to the negative Commerce Clause because it “has no basis in the Constitution and has proven to be unworkable in practice.”

The Dissent
Justice Alito, who was joined by Justices Stevens and Kennedy, dissented because they did not perceive any meaningful distinction between United Haulers and Carbone. The dissent, in fact, found the plurality’s public-private distinction to be “both illusory and without precedent” and noted that “the fact that the flow control laws at issue discriminate in favor of a government-owned enterprise does not meaningfully distinguish this case from Carbone.” The dissent was particularly offended by the plurality’s public versus private distinction of Carbone, because the facility in Carbone was built by a contractor who sold it to the town for $1 after five years in exchange for receiving a guaranteed amount of waste flow. For this reason, the dissent found the “only real distinction between the facility at issue in Carbone and its counterpart in this case is that title to the former had not yet formally passed to the municipality [which] exalts form over substance.”

Market Participant Versus Market Regulator
Neither the plurality nor either of the concurring opinions discussed the market participant theory, which allows a state to engage in otherwise discriminatory practices (e.g., selling exclusively to or buying exclusively from state residents) when it is acting as a market participant and not as a market regulator. The dissent, however, emphatically stated that the Oneida and Herkimer ordinances do:

exactly what the market participant theory says they cannot: While acting as market participants by operating as a fee-for-service business enterprise in an area where there is an established interstate market, respondents are regulating that market in a discriminatory manner and claiming that their special governmental status somehow insulates them from a dormant Commerce Clause challenge.

Blank Rome Observations

• Although none of the four United Haulers opinions mentioned—even in passing—we think it worthwhile to look at Davis in light of the 1996 Supreme Court case of Fulton v. Faulkner, which invalidated a North Carolina intangibles tax that was imposed on a fraction of the value of corporate stock owned by North Carolina residents inversely proportional to the corporation’s exposure to the state’s income tax.
• Both Davis and Fulton involve tax statutes that grant favorable tax treatment to owners of securities that are issued by entities that engage in in-state activities (paying North Carolina corporate taxes in the case of Fulton and carrying out governmental purposes in the case of Davis).
• One distinction that may be drawn between Davis and Fulton is that the Kentucky bonds issued in Davis were issued by a governmental entity and the stock at issue in Fulton was that of a private business enterprise.
• The significance of the public-private distinction is of no import, however, to the extent that the Justices give credence to the market participant versus market regulator theory.
• It is important to note that in Davis all the market participants are governments, whether in-state or not.
  
• Among the questions that remain as we await a decision in Davis are:
• Would the three justices in the United Haulers dissent continue to maintain their view that the public-private distinction is not constitutionally significant? Or, would they accept the proposition that the issuance of governmental debt is an essential and traditional government function and, therefore, does not implement the Commerce Clause?
• Would Justice Thomas continue to view the notion of a dormant Commerce Clause to be specious and, therefore, validate Kentucky’s taxing scheme?
• Would Justice Scalia find the facts of Fulton to be sufficiently aligned with Davis so that stare decisis would require that Fulton controlled the outcome of Davis?
• Would all of the remaining four justices find that: (a) the public-private distinction is relevant and remains constitutionally significant; (b) the Commonwealth of Kentucky was acting as a market participant when it issued the bonds and when it enacted a law that favored such bonds over bonds issued by out-of-state governments; and (c) while Kentucky’s statute “treats in-state private business interests exactly the same as out-of-state ones” it is significant that it does not treat in-state governmental entities the same as out-of-state ones?
• The questions the justices posed at the oral argument indicate that they may be wrestling with how to reconcile their commerce clause precedent, which they admit to be a "quagmire" — with an apparent reluctance to disrupt the status quo of the municipal bond and finance markets.
  
• Perhaps the most difficult issue with which to deal while awaiting the Davis decision is how to anticipate the wide variety of remedy options that could be crafted if the Court were to affirm the decision of the Kentucky Court of Appeals.
• If the Court overrules the Kentucky Court of Appeals — except to the extent that municipal bond market participants have adjusted their positions in preparation for a possible affirmance — the order of the municipal bond market likely would not be materially disrupted.
• If, on the other hand, the Court affirms the Kentucky decision and invalidates the discriminatory taxing scheme currently employed by the vast majority of states, a number of potential remedies — each of which would be left to the respective state legislative or judicial branches or both — could be adopted.
• Supreme Court precedent dictates that, where a taxing statute is found to be unconstitutionally discriminatory, litigants are to be provided with “meaningful backward looking relief.” In general terms, and as described below in more detail, this means that litigants who have timely filed refund claims are to granted refunds of unconstitutionally paid taxes or tax is to be imposed retroactively in a manner that cures the constitutional infirmity. That said, state governments may find creative ways to craft prospective-only remedies.
• Retroactive remedies would likely occur in one of two general ways: (a) adopting legislation or implementing a judicial determination exempting all bonds and requiring a state to refund taxes paid on out-of-state bond interest to all taxpayers who had filed refund claims in a timely fashion; or (b) imposing tax on the interest on in-state bonds. Both options have equally unappealing fiscal downsides. Depending upon the volume of timely filed refund claims (taxpayer’s counsel stated in oral argument that approximately $4 million of refund claims are pending in Kentucky), the former remedy may cause an unanticipated and, therefore, unmanageable drain on a state or local government budget. State laws that exempt from taxation bonds issued by the state’s instrumentalities coupled with the purchasers’ reliance on such exemption pose a significant impediment to adopting the latter remedy—not to mention the business and political fallout that could be caused by the potentially devastating market volatility that may ensue.
• A verdict upholding the Kentucky Court of Appeals would likely increase government financing costs, especially in high-tax states (e.g., New York, New Jersey, and California) because the tax advantage of purchasing bonds issued by in-state entities would be removed.
• Crafting a remedy going forward is a bit of an easier pill to swallow because market participants may plan their affairs based on knowledge of a prospective remedy. That said, additional complexity arises with respect to how to treat future interest received on currently outstanding bonds (and on which interest rates and prices have been fixed based upon the current taxing scheme remaining in place) and those that will be issued in the future.
• Taxpayers have filed similar claims in Arizona and North Carolina. While the Supreme Court is expected to issue its decision before it recesses for the summer at the end of June, taxpayers, tax administrators, bond issuers and bond traders can continue to speculate.

Any person who has a question regarding the issues raised in this State Tax Alert may obtain additional guidance from a member of our Tax Group or our Public Finance Group.