WASHINGTON (Reuters) - The U.S. Supreme Court on Monday ruled that cities and states can keep offering special tax breaks on their municipal bonds, a decision that preserves a top incentive for investors in the $2.5 trillion municipal bond market.
The 7-2 high-court ruling reversed a Kentucky appeals court decision that said it was unconstitutional for the state to grant tax breaks on interest from bonds issued in Kentucky while taxing interest from bonds issued in other states.
The high-court decision was an important victory for municipal bond issuers in most states. It allows them to keep a valuable tool for holding down financing costs for public projects. Without the special tax breaks, municipal bond issuers would have to compensate investors with higher interest rates.
The ruling also lifted a threat to an important segment of the mutual fund industry. The nearly 500 funds organized around bonds issued in a single-state would have had to disband or re-organize if the lower court ruling was upheld. Such funds held total net assets of nearly $375 billion in March, according to the Investment Company Institute.
“This removes a cloud of uncertainty that had been hanging over the market for at least six months. It will help heal the market,” said Bob Millikan, portfolio manager at BB&T Asset Management in Raleigh, North Carolina. “Many of the states that had been at risk of losing their specialty status will benefit. Their prices had been lower because of that risk.”
All told, 42 states follow Kentucky’s practice, and a Supreme Court ruling to uphold the lower court decision would have forced them to change their systems, with each state having to decide either to tax interest on in-state bonds or give breaks to out-of-state ones.
“We believe the court properly determined that municipal bonds are different with regard to the commerce clause,” said Tom Dresslar, spokesman for California Treasurer Bill Lockyer. “We’re not out to make a buck. When we issue these bonds it’s to provide a public service.”
He added that if the court had gone the other way “it wouldn’t have been doomsday but it could have created the potential for higher borrowing costs.”
The ruling also prevented a massive revaluation of the market.
Bruce Whiteford, managing director at Bessemer Trust in New York said a ruling in the other direction would have revalued with market with debt from high-tax states losing value relative to low-tax states. .
The cash market for munis was unchanged on the high court ruling, traders said.
“I’m not seeing anything at all,” a Chicago-based trader said. “If there would have been a different decision, me and probably everyone else on the street would probably have gone to the bar.”
He added that the high court “kept us on pins and needles for a while.” The justices heard oral arguments in the case in November, six months ago.
“The only explanation why it took so long was they didn’t think it was very important,” the trader said.
The decision, with Justices Anthony Kennedy and Samuel Alito dissenting, overturned a Kentucky appeals court ruling that Kentucky’s tax breaks violate the Commerce Clause of the U.S. Constitution.
“For the better part of two centuries states and their political subdivisions have issued bonds for public purposes, and for nearly half that time some states have exempted interest on their own bonds from their state income taxes, which are imposed on bond interest from other states. The question here is whether Kentucky’s version of this differential tax scheme offends the Commerce Clause. We hold that it does not,” Justice David Souter wrote for the court majority.
During oral arguments in November, justices tangled over whether municipal bonds were commodities like manufactured goods or were simply methods used to finance government work.
Those who support the tax breaks say they keep the costs of debt manageable for the small governments and school districts issuing the bonds. Because the breaks attract investors, issuers can pay lower yields on the bonds.
Kentucky residents George and Catherine Davis brought the lawsuit against their state, saying that the practice violates the Commerce Clause of the U.S. Constitution, which gives the federal government power to regulate trade among states.
For the clause to work, states cannot erect trade barriers, the lawsuit maintained.
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additional reporting by James Vicini, Karen Pierog in Chicago, Michael Connor in Miami, Joan Gralla in New York and Jim Christie in San Francisco; Editing by Diane Craft
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