CHICAGO -- A dispute over Indiana's ability to retroactively tax bank income from municipal bonds issued in the state may be headed for the state supreme court.

Indiana is appealing a recent state tax Court ruling that found the state improperly taxed bank income on municipal bonds and U.S. government securities issued before May 1989.

Lis Daily, a spokeswoman for the Indiana attorney general's office, said yesterday that the state last month filed a petition for review with the Indiana Supreme Court. The state high court has the option to choose whether or not to hear the appeal, she said.

At stake is $100 million to $175 million that the state may face in refunds to banks that have paid taxes on municipal bond and U.S. securities income since 1990.

In September, the Indiana Tax Court ruled that the state improperly taxed on a retroactive basis bank income from municipal bonds issued by entities in the state.

The case, filed against the Indiana Department of State Revenue by Fort Wayne National Corp., concerns a law passed by the legislature in 1989 that replaced a variety of local and state taxes on financial institutions with a single franchise tax. Under the law, the 8.5% tax rate applies to an institution's adjusted gross income, including income from municipal bonds sold by Indiana governments and from U.S. government securities.

The Fort Wayne bank argued that taxing tax-exempt bonds violated both the state and federal constitutions, according to William Landers, a partner at Baker & Daniels, the law firm representing the bank.

"The bonds were sold as tax-exempt, and the bank purchased them with that understanding," Landers said.

He said that the contract clause in both constitutions was used to argue that as a part of the contract between the bond seller and the bondholder, Indiana had promised the bonds "were or would remain tax-exempt."

The bank filed a claim for about $690,000 that it paid in taxes in 1990, Landers said. The Fort Wayne bank was not protesting taxes that it paid on bonds purchased after the franchise tax took effect in 1990, he said.

While the tax court ruled in the bank's favor, it did not base its ruling on constitutional grounds, Landers said. Instead, the court found that the state had improperly amended a statute that exempts taxation, with the exception of a state inheritance tax, on federally tax-exempt bonds issued by Indiana entities. The amendment allowed for the retroactive collection of the franchise tax on bank-held bonds issued before May 1989.

In addition to striking down the retroactive bank tax on municipal bond income, the court ruled that the state was precluded from retroactively collecting the tax on U.S. government securities held be banks.

Bill Sheldrake, the director of tax and revenue policy in the state's budget agency, said that if the decision is upheld by the high court, it could cost the state and local governments $100 million to $175 million in refunds to banks. The largest refunds would be from taxes collected on income from U.S. government securities held by banks, he held.

Because the bank franchise tax replaced "a hodgepodge" of both state and local taxes on financial institutions, Sheldrake said that local governments would also feel the effect of refunds. The local governments receive about 60% to 75% of the revenues from the tax, which generates about $70 million a year, he said.

Sheldrake said the tax court's decision does not affect any bank income from municipal bonds issued outside of Indiana, which were not exempt from Indiana tax.

Tom Williams, director of government relations at the Indiana Bankers Association, said that if the Fort Wayne bank is successful in the state supreme court, other Indiana banks are expected to file for refunds with the state department of revenue.

"We have informed our members of the decision of the tax court, and we will be initiating a study on the impact of the financial institutions tax since it went into effect and try to get the impact of the court decision," Williams said.

In addition to Indiana, Tennessee and Minnesota have similar franchise taxes on financial institutions, according to Landers.

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