Is proposed legislation that would repeal North Carolina's intangibles tax on stocks, mutual funds, bonds, and other evidences of debt, and replace it with a 1% additional tax on capital gains realized from selling those instruments, constitutional under both the federal Due Process Clause and the NC Constitution's prohibition on retrospective taxation (Art. I, Sec. 16) if the new tax is enacted mid-year (July or August 1994) but applies to taxable years beginning on or after January 1, 1994?

Plain-English summary

Senator John H. Kerr, III, asked the AG for an opinion on the constitutionality of legislation expected to be introduced in the upcoming 1994 Regular Session. The bill would repeal NC's existing intangibles tax on stock, mutual funds, bonds, and related evidences of debt, and substitute an additional 1% tax on capital gains derived from selling those instruments. Those intangibles would be made exempt from ad valorem taxes under the Machinery Act. The legislation was expected to be ratified in July or August 1994 and to apply to taxable years beginning on or after January 1, 1994. Senator Kerr was particularly interested in whether the retroactive features were constitutional.

Senior Deputy AG Reginald L. Watkins responded with a "yes, with one possible reservation" answer covering both the federal and state constitutional questions.

The federal Due Process analysis. The US Constitution contains no specific prohibition on retrospective taxation. Instead, retroactive tax statutes are evaluated under a Due Process standard that asks whether the retroactivity has become "harsh and oppressive" (Welch v. Henry, 305 U.S. 134, 146-47 (1938), where the US Supreme Court permitted Wisconsin to impose a 1935 income tax on dividends received in 1933). NC already taxed the income gain from the instruments in question; the bill would not create a new and distinct tax on the property, but would simply increase the existing rate. As Judge Learned Hand explained in Cohan v. Commissioner, 39 F.2d 540, 545 (2d Cir. 1930), "[n]obody has a vested right in the rate of taxation, which may be retroactively changed at the will of Congress at least for periods of less than twelve months; Congress has done so from the outset." NC case law agrees: Lamb v. Wedgewood South Corp., 308 N.C. 419, 444 (1983) ("no person has vested right in the continuance of the common or statute law"); State ex rel. Banking Comm. v. Citicorp Savings Indus. Bank (proposed), 74 N.C. App. 474, 477 (1985) ("no one has the right for the General Assembly not to change a law").

If enacted in summer 1994 but effective January 1, 1994, the bill would be a mid-year tax statute. The AG noted that "[a]n unbroken line of federal decisions has sustained mid-year acts against all constitutional" challenges. United States v. Hudson, 299 U.S. 498, 500 (1937), specifically held that there was no denial of due process in making an income tax statute retroactive for a relatively short period so as to include profits from transactions consummated while the statute was being enacted.

The NC Constitution analysis. NC Constitution Art. I, Sec. 16 prohibits "retrospective" taxation. But the AG read this not to bar the proposed legislation, on the ground that income tax statutes tax realized gains and a year's income is treated as one thing for income-tax purposes. Ward v. Clayton, 276 N.C. 411, 416 (1970) (income tax statutes address "realized gains and realized losses"); N.C.G.S. § 105-134.2 (income tax is actually assessed in the calendar year following the taxable year for which the assessment is made); Norman v. Bradley, 173 Ga. 482, 160 S.E. 413, 415 (1931) (a year's income is treated "as one thing, not made up of several portions or items"); Herrick v. Lindley, 59 Ohio St. 2d 22, 25 (1979) ("the transaction taxable 'is the realization of income,' and a tax upon income realized after a statute's effective date 'is not retrospective in nature.'"). Realization of actual gain or profit would not occur for a calendar-year taxpayer until the close of 1994. So a statute enacted relatively shortly after the income-producing events, merely raising the rate on net income, would not violate the NC retrospective-taxation prohibition.

The reservation. Some categories of previously issued state and county bonds carry statutory tax exemptions in their authorizing acts: hospital, medical, housing, and port authority bonds under N.C.G.S. §§ 122A-19, 131A-21, 131E-28, and 143B-456. The NC Constitution Art. V, Sec. 2(19) provides that the power of taxation "shall never be surrendered, suspended or contracted away." As Railroad v. Reid, 64 N.C. 156, 159 (1870), put it, no one is entitled to a perpetual tax exemption that could "impoverish the State for all time." That suggests gain from previously exempt instruments could now be swept in. But that opens up two related constitutional problems and one practical one:

1. Retrospective taxation as applied to bonds that were sold with a statutory tax-exempt promise becomes a harder question than retrospective taxation of generally-taxed income.
2. Contract impairment (federal Contracts Clause; state analogues) could be invoked by bondholders who paid a price premium for the tax exemption.
3. Fiscal implications for state creditworthiness exist if NC is seen as willing to claw back tax exemptions on previously issued bonds. Bond markets price that risk into future issuances.

The AG flagged these issues for the General Assembly's consideration but did not commit to a constitutional ruling. The opinion's bottom line is that the basic intangibles-tax-to-capital-gains-tax shift is constitutionally fine, but sweeping in previously exempt bonds requires careful analysis the opinion does not undertake.

Currency note

This opinion was issued in 1995. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

NC's intangibles tax was eventually repealed and the taxation structure for stocks, mutual funds, bonds, and other evidences of debt has been substantially restructured since 1995 (capital gains are now taxed as part of NC personal income tax under the general individual income tax rate). The constitutional principles the opinion identifies (federal "harsh and oppressive" standard for retroactive taxation, NC's narrower "retrospective taxation" prohibition treated through the realized-income lens, and the special problems of taxing previously tax-exempt bonds) remain durable. Any current proposal to change tax treatment of investment income with retroactive effect should be analyzed against the current NC income tax statutes (Article 4 of Chapter 105 of the General Statutes), current US Supreme Court retroactive-tax doctrine, and any later state AG opinions or court decisions, especially the line of cases interpreting Welch v. Henry. The bond-tax-exemption reservation remains a flag for any future legislation reaching previously exempt bonds.

Common questions

Q: What is the difference between "retroactive" and "retrospective" taxation?
A: Loosely used as synonyms. "Retroactive" generally means a statute applies to events that occurred before its enactment. "Retrospective" is the NC Constitution's term and is interpreted similarly. The NC retrospective-taxation prohibition has not been read to bar all retroactive tax statutes; it has been read narrowly to bar statutes that genuinely impose new tax burdens on completed transactions, while permitting rate changes and mid-year income tax adjustments because income is treated as a single annual quantity.

Q: What was NC's intangibles tax?
A: A property tax on certain intangible personal property (stocks, bonds, mutual funds, accounts receivable) imposed in addition to the income tax on the income those intangibles generated. The tax was widely criticized as administratively burdensome and as discouraging investment in NC. The 1994 bill discussed in the opinion would have replaced it with a higher tax on capital gains realized from selling the same instruments.

Q: Why is a mid-year tax statute different from a fully retroactive one?
A: Federal courts treat a calendar-year income tax as a unitary tax on the year's whole income, which is not realized for tax purposes until the year closes. Under that view, a statute enacted in June 1994 that applies to all 1994 income is not really "retroactive" in a problematic sense, because the year's income is not yet realized when the statute takes effect. A statute enacted in 1994 that applied to 1992 income would be more problematic.

Q: Why are previously tax-exempt bonds different?
A: Because the bonds were marketed and sold on the strength of a statutory tax exemption. Buyers paid a price that reflected the exempt status (accepting a lower interest rate than they would have demanded on taxable bonds). Now reaching back to tax the gain on those bonds disrupts settled expectations and the underlying bargain between the bondholder and the issuer. It also raises potential federal Contracts Clause issues and a separate question under the NC Constitution about whether tax exemptions can be retracted.

Q: Did the bill the senator was asking about actually pass?
A: The opinion does not say. The repeal of NC's intangibles tax happened over several years through a sequence of statutory changes; the 1994 bill the senator was asking about may or may not have been enacted in the exact form described. Either way, the AG's analysis was guidance on what would be constitutional, not a forecast of legislative success.

Q: What is the practical takeaway for a current legislator considering retroactive tax legislation?
A: First: a mid-year income tax change applying to the current calendar year is on solid ground constitutionally, both federally and under NC law. Second: reaching back to prior years is harder federally and more vulnerable under NC's retrospective-taxation prohibition. Third: reaching previously tax-exempt bonds is harder still because the contract-impairment and creditworthiness concerns layer on top of the retrospective-taxation question. The 1995 opinion is a useful template for staging these issues.

Background and statutory framework

NC's intangibles tax was a fixture of the state's revenue structure for much of the 20th century, but became increasingly unpopular as competing states moved to abandon similar taxes. The shift to capital gains taxation discussed in the 1994 bill was part of a broader national trend.

The constitutional framework the AG navigated has three layers. Federal Due Process under the US Constitution gives the General Assembly wide latitude on tax-rate retroactivity, with the "harsh and oppressive" line being the outer limit. NC's Art. I, Sec. 16 prohibition on retrospective taxation is read more narrowly than its text might suggest, because of the realized-income approach NC takes to income tax. The Contracts Clause (federal) and Art. V, Sec. 2(19) (state) limit the legislature's ability to extract value from holders of state obligations that were explicitly tax-exempt when issued.

The 1995 opinion is a useful primer on staged constitutional analysis. The AG works through each constitutional provision in turn, identifies the applicable standard, applies it to the proposed legislation, and flags the residual issue separately rather than mixing it into the main analysis. Legislative drafters reviewing a future intangibles-to-capital-gains shift could use the same staging.

Citations

• N.C. Const. Art. I, Sec. 16 (prohibition on retrospective taxation)
• N.C. Const. Art. V, Sec. 2(19) (power of taxation shall never be surrendered, suspended, or contracted away)
• N.C.G.S. § 105-134.2 (NC income tax assessed in calendar year following the taxable year)
• N.C.G.S. § 122A-19 (housing authority bonds tax-exempt)
• N.C.G.S. § 131A-21 (medical care facilities bonds tax-exempt)
• N.C.G.S. § 131E-28 (hospital bonds tax-exempt)
• N.C.G.S. § 143B-456 (state ports authority bonds tax-exempt)
• Welch v. Henry, 305 U.S. 134 (1938) (federal Due Process standard for retroactive taxation; "harsh and oppressive" test)
• Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) (no vested right in the rate of taxation)
• Lamb v. Wedgewood South Corp., 308 N.C. 419, 302 S.E.2d 868 (1983) (no vested right in continuance of common or statute law)
• State ex rel. Banking Comm. v. Citicorp Savings Indus. Bank (proposed), 74 N.C. App. 474, 328 S.E.2d 895 (1985) (no right for General Assembly not to change a law)
• United States v. Hudson, 299 U.S. 498 (1937) (mid-year income tax statute does not deny due process)
• Ward v. Clayton, 276 N.C. 411, 172 S.E.2d 531 (1970) (income tax addresses realized gains and realized losses)
• Norman v. Bradley, 173 Ga. 482, 160 S.E. 413 (1931) (year's income is one thing, not made up of portions)
• Herrick v. Lindley, 59 Ohio St. 2d 22, 391 N.E.2d 729 (1979) (tax on income realized after statute's effective date is not retrospective)
• Railroad v. Reid, 64 N.C. 156 (1870) (no one entitled to perpetual tax exemption that would impoverish the State for all time)

Source

• Landing page: https://ncdoj.gov/opinions/bonds-and-other-evidences-of-debt/

Original opinion text

Senator John H. Kerr, III
Post Office Box 1616
Goldsboro, North Carolina 27533-1616

Re: Advisory opinion; constitutionality of additional 1% tax upon gain derived from the sale of stocks, mutual funds, bonds and other evidences of debt; North Carolina Constitution, Art. I, Sec. 16

Dear Senator Kerr:

You request our opinion as to the constitutionality of legislation expected to be introduced in the forth coming 1994 Regular Session. As outlined, a bill would repeal the existing intangibles tax upon stock, mutual funds, bonds and related evidences of debt and substitute an additional 1% tax upon capital gain derived from the sale of this property. These intangibles would be made exempt from ad valorem taxes imposed by The Machinery Act. The legislation would probably be ratified in July or August and apply to taxable years beginning on or after January 1, 1994. You appear to be especially interested in our advice as to any possible impermissible retroactive features of these amendments.

With one possible reservation, we believe a bill drawn along these lines would not offend any federal or state constitutional prohibitions. Analysis under federal law is the easier question. The United State Constitution contains no specific provision barring "retrospective" taxation, such as that found in the North Carolina Constitution. Instead, challenges to a taxing statute's retroactivity are evaluated upon a "due process" basis. Welch v. Henry, 305 U.S. 134, 146 (1938). Under this standard, retroactive application of a tax to a completed transaction is apparently tolerated until such time that the tax can be said to have become "harsh and oppressive." Id. at 147. In Welch, the Court permitted the State of Wisconsin to impose an income tax in 1935 upon dividends received in 1933.

Other than as noted below, North Carolina already income taxes the gain from the instruments in question. The projected legislation would not create a new and distinct tax upon this property, but would merely increase an existing rate of tax. Such a change would not violate the federal constitution since Nobody has a vested right in the rate of taxation, which may be retroactively changed at the will of Congress at least for periods of less than twelve months; Congress has done so from the outset.

Cohan v. Commissioner, 39 F.2d 540, 545 (2d Cir. 1930). See also Lamb v. Wedgewood South Corp., 308 N.C. 419, 444, 302, S.E.2d 868, 882 (1983) (no person has vested right in the continuance of the common or statute law); State ex rel Banking Comm. v. Citicorp Savings Indus. Bank (proposed), 74 N.C. App. 474, 477, 328, S.E.2d 895, 897 (1985) ("no one has the right for the General Assembly not to change a law").

If enacted in the summer but effective the preceding January, the bill would constitute a mid-year taxation statute, or one which applies to the entire calendar year in which ratification occurs. An unbroken line of federal decisions has sustained mid-year acts against all constitutional The Court consistently has held that the application of an income tax statute to the entire calendar year in which enactment took place does not per se violate the Due Process Clause of the Fifth Amendment.

In accord: United States v. Hudson, 299 U.S. 498, 500 (1937) (no denial of due process to make income tax statute retroactive for relatively short period so as to include profits from transactions consummated while statute being enacted.)

In view of these well-settled principles, we believe the bill as outlined will withstand constitutional challenge at the federal level.

With one possible exception, we are equally confident that the amendments would not violate the North Carolina Constitution, and most particularly, Art. I, Sec. 16's prohibition against "retrospective" taxation. There is nothing retrospective about this legislation. Income tax statutes address "realized gains and realized losses." Ward v. Clayton, 276 N.C. 411, 416, 172 S.E.2d 531, 535 (1970). North Carolina's income tax is actually assessed in the calendar year following the taxable year for which the assessment is made. G.S. 105-134.2. A year's income is treated "as one thing, not made up of several portions or items." Norman v. Bradley, 173 Ga. 482, 160 S.E. 413, 415 (1931). For income tax purposes, the transaction taxable "is the realization of income," and a tax upon income realized after a statute's effective date "is not retrospective in nature." Herrick v. Lindley, 59 Ohio St. 2d 22, 25, 391 N.E. 2d 729, 732 (1979).

The expected legislation will add items of income to a taxpayer's annual income stream. Realization of actual gain or profit will not occur until the close of 1994 for a calendar year taxpayer. The preceding authorities satisfy us that a statute merely increasing the rate of taxation upon net income enacted relatively shortly after the events producing gross income does not constitute retrospective taxation forbidden by the North Carolina Constitution.

Our review would not be complete without reference to previously issued state and county debt instruments whose profit the General Assembly has exempted from income taxes. See, e.g., bonds issued by various hospital, medical, housing and port authorities and agencies. G.S. 122A-19, 131A-21, 131E-28 and 143B-456. The North Carolina Constitution, Art. V., Sec. 2(19), provides that the power of taxation "shall never be surrendered, suspended or contracted away." Since no one is entitled to a perpetual tax exemption, which could "impoverish the State for all time," Railroad v. Reid, 64 N.C. 156, 159 (1870), it may be that gain from these prior instrument as well could now be included within the proposed amendments. But then the retrospective taxation question, as well as a possible contract impairment issue, becomes more difficult. Moreover there may be broad fiscal implications regarding the state's creditworthiness, or general policy considerations, which should be addressed before these special undertakings are expressly brought within the proposed legislation.

We hope you find the foregoing helpful.

Reginald L. Watkins
Senior Deputy Attorney General

Special Deputy Attorney General