Ohio's tax on out-of-state bonds spurs suit that worries industry.

CHICAGO - A lawsuit charging that Ohio is violating the U.S. Constitution by taxing income on out-of-state municipal bonds could seriously affect the municipal market, industry observers said yesterday.

The class action suit, which was filed last year by a bondholder in a Cleveland suburb, claims that Ohio, which exempts its own bonds from its income tax, is violating the commerce clause of the Constitution with its tax.

Specifically, the suit charges that "the imposition of state income tax upon interest paid by non-Ohio governmental entities is an unreasonable burden on interstate commerce and is nothing more than a protectionist measure that cannot withstand scrutiny under the commerce clause of the United States Constitution."

Last month Franklin County Common Pleas Court Judge Evelyn J. Stratton ruled in Ohio's favor, saying the commerce clause "was never intended to govern transactions between government entities."

However, Clint Krislov, a Chicago attorney representing Serene G. Shaper, the bondholder, said the decision will be appealed to the Ohio Court of Appeals and that he expects to take the case all the way to the U.S. Supreme Court.

"There is no question in my mind that the court will hold that state bonds are instruments of commerce," Krislov said.

He contended that states are participating in a market when they issue bonds and that states that tax income on other states' bonds are using their taxing power to "discriminate in interstate commerce."

Currently, 42 states collect income taxes on out-of-state bonds, while exempting all or some of their own bonds from taxation.

Municipal industry observers said the success of such a lawsuit in the U.S. Supreme Court would have implications for mutual funds that offer single-state funds and for the market as a whole, which would both lose the advantages of double tax-exemption on bonds. In addition, states that levy an income tax on out-of-state bonds could lose millions of dollars of annual revenues.

Richard Lehmann, president of the Bond Investors Association, said that if the suit prevails, "there would be a major, major change in the municipal market."

"All the state funds that were created as tax shelters would all be pointless," Lehmann said. "It would also mean that every municipal bond would be marketable in every state because of equal tax treatment, and that would tremendously liquefy the municipal market because everyone would be in the market for every bond."

On the other hand, Lehmann said some issuers, such as New York City, would see their cost of issuance "sky-rocket" because the benefit of double tax exemption would be gone for buyers in the city, and those buyers could put their money in "safer paper."

Richard Ciccarone, a senior vice president and director of tax-exempt fixed-income research at Kemper Securities Inc., agreed that a favorable decision in the case "would throw the specialty state market in disarray."

"The disruption in the market would be substantial, victimizing buyers of in-state paper who were willing to accept lower interest rates because of the double tax exemption and now have concentrated risk," Ciccarone said.

Andrew Jennings, manager of the municipal trading desk at Franklin Advisors Inc., said the impact on single-state funds would depend on whether the high court would rule retroactively or prospectively.

Heather Ruth, president of the Public Securities Association, said while the group has no position on the matter, its policy has been to let states decide how to tax interest on their bonds or the bonds of other states.

"If for any reason the tax liability would be removed on outstanding bonds, it would raise the value of the bonds commensurately," Ruth said.

Krislov said the Ohio case is supported by recent Supreme Court decisions that struck down the higher taxes states were charging on materials such as toxic waste from other states.

"You can't tax incoming toxic waste more heavily than in-state toxic waste," Krislov said. "And you can't treat the bonds of a sister state as if they were an incoming Scud [missile] either."

Krislov said he might file similar cases in other states, but declined to name the states.

The momentum in the Supreme Court "seems to be in the direction of a kind of seamless economy," Lehmann said, which could help the Ohio case.

The case also has a supporter in James F. Blumstein, a law professor at the Vanderbilt Law School, who addressed the matter of state taxation of municipal bonds in an article written in 1978.

"The argument that this is purely a government thing is ridiculous," Blumstein said. "This is an industry - not just a government - issuing bonds."

Moreover, the system of double tax exemption in some states actually leads to higher bond yields for some issuers whose bonds are marketed out of state and must have yields that will attract investors who will have to pay their states' income tax on the bonds, Blumstein said.

Lawrence Pratt, Ohio's assistant attorney general who represented the state, said he feels confident that the state will prevail. Judge Stratton "completely" accepted the state's argument that the commerce clause cannot be applied to a state marketing its own products, Pratt said.

Pratt said Ohio began taxing the income on out-of-state bonds in the 1970s and that the state collects about $20 million annually from taxing those bonds.

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