Davis filed a class action law suit against the Kentucky Department of Revenue, that Kentucky's policy of taxing out-of-state bonds--but not in-state bonds--violated the dormant Commerce Clause of the United States Constitution. Preferential tax treatment for in-state bonds is common and is offered by nearly all the states that have an income tax. The tax-exempt status of state and municipal bonds permits issuers to borrow money at a lower interest rate because investors are willing to accept lower returns in exchange for not having to pay taxes on the interest they receive. In 1994, the State of Ohio found that preferential tax treatment did not violate the Commerce Clause, which forbids states from discriminating against interstate commerce.
The state trial court ruled in favor of the Kentucky Department of Revenue. The Kentucky Court of Appeals reversed the lower court, striking down the tax policy. The Court found that Kentucky’s bond taxation system is "facially unconstitutional as it obviously affords more favorable taxation treatment to in-state bonds than it does to extraterritorially issued bonds." It also rejected the State's "market participant" argument that, as a bond issuer, it acts as a participant in the bond market and not a regulator of the market, and therefore exempt from the Commerce Clause. The Court of Appeals held that the tax discrimination rather than the bond issuance was the focus of the statute, and the taxation was indisputably undertaken in the state's capacity as a regulator.
Question Presented:
Whether a state violates the dormant Commerce Clause by providing an exemption from its income tax for interest income derived from bonds issued by the state and its political subdivisions, while treating interest income realized from bonds issued by other states and their political subdivisions as taxable to the same extent, and in the same manner, as interest earned on bonds issued by commercial entities, whether domestic or foreign.