Home >Department of Revenue of Kentucky v. Davis:  Ruling Does Not Impact Tennessee Individual Income Tax

Department of Revenue of Kentucky v. Davis:
Impact on Tennessee Individual Income Tax

On May 19, 2008, the United States Supreme Court issued a decision in a case that had a potential impact on the Tennessee individual income tax. The case, Department of Revenue of Kentucky v. Davis, 128 S.Ct. 1801 (2008), involved the taxation by Kentucky of income from state and municipal bonds.

Kentucky exempts from its state income tax the interest on bonds issued by it or its political subdivisions; no similar exemption exists for income on bonds issued by other states and their subdivisions. Tennessee also uses this approach in its individual income tax, also known as the "Hall" tax. The reason for this type of exemption is that state and municipal bonds generally pay a lower interest rate than other bonds with the same type of risks; therefore, the state must offer some incentive in order for these bonds to be attractive.

The taxpayers in the Davis case sued the Kentucky Department of Revenue, claiming that Kentucky’s differential taxation of municipal bond income discriminated against interstate commerce in violation of the Commerce Clause of the United States Constitution.  The United States Supreme Court held that an exception to the Commerce Clause exists when states are acting as "market participants."  In other words, when a state goes beyond regulating the market and begins participating in a market, it has the right to favor its own citizens over the citizens of other states. Therefore, Kentucky’s imposition of a differential tax scheme did not violate the Commerce Clause because Kentucky was acting as a bond issuer participating in the bond market.

The Supreme Court's decision permits Tennessee to continue to provide an exemption from the individual income tax for bonds issued by Tennessee and its counties and municipalities.