U.S. Supreme Court Reverses And Remands "Davis" Case

Originally published May 21, 2008

The U.S. Supreme Court announced on Monday, May 19, that it had reversed and remanded Department of Revenue of Kentucky et al. v. Davis et ux, 197 S.W.3d 557 (Ky. Ct. App. 2006) ("Davis"), holding that Kentucky's differential tax scheme with respect to municipal bond interest does not offend the Commerce Clause. Department of Revenue of Kentucky et al. v. Davis et ux, 553 U.S. ___ (2008).

Background on the Case

Kentucky exempts from state income tax interest earned with respect to bonds issued by Kentucky or its political subdivisions, but does not exempt interest earned on bonds issued by other states and their subdivisions. In 2003, George and Catherine Davis filed a class action complaint in Kentucky Circuit Court alleging that Kentucky's taxing scheme violates the dormant Commerce Clause and the Due Process Clause of the U.S. Constitution. The trial court granted the Kentucky Department of Revenue's motion for summary judgment on the constitutionality of the taxing scheme. The Kentucky Court of Appeals disagreed, holding that Kentucky's bond taxation system did violate the dormant Commerce Clause because it discriminated against interstate commerce. The U.S. Supreme Court granted certiorari and heard oral argument in Davis in 2007 to decide the constitutionality of the differential bond taxing scheme which exists in Kentucky and a majority of states. In a case generating various concurrences as well as two dissents, the Supreme Court concluded that the scheme withstood constitutional challenge.

Majority Relies on United Haulers

The majority opinion, authored by Justice David H. Souter, opens by acknowledging that states are prohibited by the dormant Commerce Clause from engaging in "economic protectionism," by imposing burdens on commerce that are designed to benefit in-state economic interests while burdening out-of-state competitors. Further, Commerce Clause analysis asks whether a challenged law discriminates against interstate commerce. In the latter case, discriminatory laws may only survive if they advance a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives, or if a judicial exception to the prohibition against discrimination, such as the market participant doctrine, applies.

The majority cites with approval, Hughes v. Alexandria Scrap Corp., 426 U.S. 794 (1976) (holding state law authorizing state payments to processors of automobile hulks validly burdened out-of-state processors with more onerous documentation requirements than their in-state counterparts) and Reeves Inc. v. Stake, 447 U.S. 429 (1980) (holding South Dakota's policy of giving in-state customers first priority access to cement produced by a state-owned plant was valid) as market participant doctrine precedents. However, the majority relies instead on the Court's ruling last year in United Haulers, a "case decided independently of the market participation precedents," to dispose of the constitutional challenge to Kentucky's tax-exempt treatment of Kentucky bond interest. United Haulers upheld a "flow control" ordinance requiring trash haulers to deliver solid waste to a processing plant owned and operated by a public authority in New York State. United Haulers Assn., Inc. v. Oneida-Herimer Solid Waste Management Authority, 550 U.S. ___ (2007). In that case, the Court determined that there were compelling reasons to differentiate between a state law that favored the state itself versus a state law that favored in-state private interests over their competitors. Essentially, the Court concluded in United Haulers that where state and local governments providing public goods and services serve the vital functions of protecting the health, safety and welfare of their citizens, laws favoring a state business over all private businesses further the legitimate goals of the state, and are not subject to the dormant Commerce Clause's discrimination prong. The Court emphasized in United Haulers that any other approach would leave the states subject to inappropriate judicial interference in their core governmental functions.

Applying the United Haulers principles to Davis, the majority held that "it follows a fortiori from United Haulers that Kentucky must prevail," because the issuance of debt securities (bonds) to raise revenues to pay for public projects is a "quintessentially public function" with a "venerable history." The Court held that a state's use of bonds to pay for public projects is a public function used to "shoulder the cardinal civic responsibilities listed in United Haulers: protecting the health, safety, and welfare of citizens." Bonds place the cost of a project on the citizens who benefit from them over the years. In addition, by spreading the cost over many years, the state is able to engage in public works beyond what current revenues could support. Hence, the Court concluded, Kentucky had demonstrated that its tax measure was designed to benefit itself as bond issuer, and by extension its citizens, rather than private commercial interests.

In an attempt to defuse the dissent authored by Justice Anthony M. Kennedy and joined by Justice Samuel A. Alito, the majority drafted Footnote 9 that notes that "government public preference is constitutionally different from commercial private preference, and we make the governmental responsibility enquiry to identify the beneficiary as one or the other." 553 U.S. ___ (2008) (slip opinion at 11). If the state law is designed to benefit the government as opposed to private interests, then the irrelevance of the dormant Commerce Clause is established. The dissenting Justices Kennedy and Alito indicted this approach, stating that the pairing up of a tax measure – that itself should be deemed discriminatory under the dormant Commerce Clause – with a governmental function of raising revenues for public projects effectively manipulates the case so as to avoid dormant Commerce Clause review. The dissent predicts that this approach will inevitably deteriorate the scope and vigor of the dormant Commerce Clause's prohibition against discrimination, which it terms "one of the most important protections we have elaborated for the Nation's interstate markets."

The majority opinion also stressed that a fundamental element of the dormant Commerce Clause jurisprudence is the principle that "any notion of discrimination assumes a comparison of substantially similar entities." United Haulers, 550 U.S. ____, (slip opinion at 10) (quoting General Motors Corp. v. Tracy, 519 U.S. 278, 298 (1997)). According to the Court, due to the civic responsibilities that a state assumes as a bond issuer, it occupies a different status than private bond issuers and would therefore not be considered "substantially similar" for purposes of a discrimination analysis under the Constitution. When the proper comparison is made with regard to Kentucky's treatment of similarly situated private bond issuers, the Kentucky tax scheme does not violate the dormant Commerce Clause, because it treats all private bond issuers the same – interest on all private bonds is subject to income taxation by Kentucky.

© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.