The Kentucky Court of Appeals made a ruling that may have far reaching implications for the municipal bond market. The Court of Appeals ruled that it is unconstitutional for the state to tax interest revenue received by its residents from tax-free bonds issued by other states and political subdivisions.

The state is expected to appeal the decision to the Kentucky Supreme Court. If it is upheld, the ruling may likely encourage other similar challenges to taxation in other state that tax out-of-state issues.

The Case was brought against the Kentucky Department of revenue in 2003. The appeals court found Kentucky's taxation system "clearly" unconstitutional because it allows more favorable tax treatment to in-state bonds than it does for "extraterritorially issued" bonds.

The Kentucky ruling also paves the way for the plaintiffs to seek class-action certification. This could make the state potentially responsible for refunding tax payments, not only to those who filed the suit, but also to other Kentucky taxpayers who join the lawsuit.

If the lawsuit is ultimately successful, it could have a major impact on the municipal bond market. Present tax policy causes most municipal bond investors to purchase bonds issued in their state of residence in order to avoid state taxes. A dramatic change in investor preference could significantly change municipal finance through the country.

Tax-free bond investors and revenue officials from other states will be following this case very closely.

College savings plans and other state programs could be affected significantly.

If the Supreme Court decides to review this case and sides with the state appeals court ruling that it is unconstitutional to tax out-of-state bonds while not taxing those issued in state, the same reasoning could be applied to 529 plans and could wipe out the state tax advantages that many states offer.

Established under Section 529 of the Internal Revenue Code, college savings plans allow adults to save money in special accounts that will be free from federal income tax when used to pay for the QUALIFIED HIGHER-EDUCATION expenses of their children and other beneficiaries. Many states try to lure assets to their in-state programs by offering residents a deduction on personal income tax returns for contributions to these plans.

There are presently at least 38 states that refrain from taxing bonds in state. This case will affect those states.

On May 22, 2007 the Kentucky Supreme Court passed up an opportunity to review this case.