7660 / Is interest on obligations issued by state and local governments taxable?

Interest on certain categories of private purpose bonds is tax-exempt, although tax-exempt interest on some private activity bonds is a tax preference item for both the individual and corporate alternative minimum tax (note that the corporate AMT was repealed for tax years beginning after 2017, see Q 7662, Q 777).¹

Interest on general purpose obligations of states and local governments (i.e., states, territories, possessions of the United States, or political subdivisions of any of them, or the District of Columbia) issued to finance operations of the state, local government, or instrumentality is generally tax-exempt. In addition, some obligations are tax-exempt under special legislation.

In a case of first impression, the issue in Department of Revenue of Kentucky v. Davis was Kentucky’s system of exempting from state income taxes the interest on bonds issued by Kentucky or its political subdivisions, but not on bonds issued by other states and their subdivisions—and specifically, whether that differential tax treatment violated the Commerce Clause of the United States Constitution. After paying state income tax on out-of-state municipal bonds, the taxpayers (George and Catherine Davis) sued for a refund claiming that Kentucky’s differential taxation of municipal bond interest impermissibly discriminated against interstate commerce in violation of the Commerce Clause. The trial court granted judgment for the Commonwealth of Kentucky, but the Kentucky Court of Appeals reversed the trial court’s ruling, finding that Kentucky’s system of taxing only extraterritorial bonds ran afoul of the Commerce Clause. (The Supreme Court of Kentucky denied the motion for discretionary review by the Commonwealth of Kentucky.) The Supreme Court of the United States (in a plurality opinion) reversed the judgment of the Kentucky Court of Appeals, and remanded the case. Relying primarily on recent precedent,² the Court stated that issuing debt securities to pay for public projects is a quintessentially public function with a venerable history, likely motivated by legitimate objectives distinct from simple economic protectionism. The Court determined that Kentucky’s tax exemption system favored a traditional government function, without any differential treatment favoring local entities over substantially similar out-of-state interests and, thus, concluded that this type of law does not impermissibly discriminate against interstate commerce for purposes of the dormant Commerce Clause.³