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Taxing municipal bond interest in California

In a recent decision by the Kentucky Court of Appeals, the court ruled that it is unconstitutional to tax interest from out-of-state municipal (muni) bonds, while in-state muni bond interest is tax exempt (Davis v. Department of Revenue (January 6, 2006) Case No. 2004-CA-001940-MR). This case came before Kentucky's Supreme Court in August 2006, and the court denied review of the decision. The Kentucky Department of Revenue has indicated that it will ask the U.S. Supreme Court to review the Kentucky decision.

How do the Kentucky court decisions affect California taxpayers who invest in out-of-state muni bonds? There is no effect. Judicial decisions regarding the validity of Kentucky law do not affect California law. California taxpayers must continue to follow existing California law, and pay income tax on non-California muni bond interest.

Note: All interest of government obligations is subject to the corporate franchise tax.

For non-California muni bonds to be considered tax-exempt in California, at least one of the following must occur:

  • A change to existing California law.
  • A final decision from a California appellate court finding that it is unconstitutional to tax interest from out-of-state muni bonds, if interest from in-state muni bonds is tax-exempt.

Until one of these changes occurs, FTB will deny claims filed for a refund or credit if they are based on the Kentucky court decisions. Your clients can respond to our denial of their claims through the appeal process. If you file amended returns for your clients for the Muni Bond issue, write "Muni Bond" at the top of the returns, and mail them to the appropriate addresses below.

For personal income tax refunds:
Franchise Tax Board
P O Box 942840
Sacramento CA 94240-0000

For refunds of corporate income tax:
Franchise Tax Board
P O Box 942857
Sacramento CA 94257-0501