Could North Carolina replace its intangibles tax with an additional 1% tax on gains from selling stocks and bonds, effective from the start of the year in which the bill passes?

Plain-English summary

Senator John H. Kerr, III, asked whether a proposed bill could repeal the intangibles tax on stocks, mutual funds, bonds and related debt instruments and add a 1% tax on gains from selling them. The bill was expected to pass in July or August but apply to taxable years beginning the preceding January 1. The AG answered that, with one possible reservation, a bill along those lines would not violate federal or state constitutional prohibitions.

For federal due process, the AG explained that retroactive taxation can be allowed unless it becomes "harsh and oppressive." The opinion says North Carolina already taxed gains from these instruments, so the proposal would raise an existing tax rate. It also cites federal decisions sustaining income-tax acts that apply to the full calendar year of enactment.

The AG likewise concluded that the proposed rate increase was not retrospective taxation forbidden by the North Carolina Constitution's Art. I, Sec. 16. The opinion treats annual income as one amount and says the tax on it is assessed in the following calendar year. It concludes that raising the rate on net income relatively shortly after the income-producing events is permissible.

The reservation concerns previously issued tax-exempt debt. The opinion identifies bonds issued by hospital, medical, housing and port authorities or agencies whose profits the General Assembly had exempted from income tax. Article V, Section 2(19) says the State's taxing power "shall never be surrendered, suspended or contracted away," which the AG cited as a reason those gains may be taxable under the proposal. The AG did not resolve that issue. The opinion says taxing those instruments makes the retrospective-taxation and possible contract-impairment questions more difficult, and asks legislators to consider creditworthiness and policy implications before expressly including them.

Currency note

This opinion analyzes proposed legislation as described in the request, not an enacted tax law. It refers to a proposed effective date in 1994. Check the law governing the tax year and instrument at issue before relying on its conclusions.

Background and statutory framework

The proposed bill would exempt the listed intangibles from ad valorem tax under the Machinery Act and substitute an additional tax on gains from their sale. The AG distinguished the ordinary gain already subject to income tax from gains on debt instruments whose profits had been exempted by their authorizing statutes. The latter category is the opinion's express reservation; it gives no definitive constitutional answer for including those gains.

Common questions

Would a July or August enactment applying from January 1 automatically violate federal due process?

The AG said no. The opinion cites decisions sustaining mid-year income-tax laws and concludes that the proposed rate increase would withstand a federal constitutional challenge.

Did the AG conclude that previously exempt bond gains could be taxed?

No definitive conclusion. The AG said Article V, Section 2(19) suggests those gains might be included, but expressly described the retrospective-taxation and possible contract-impairment issues as more difficult. The opinion also raised state creditworthiness and policy considerations.

Does the opinion establish what tax applies to a bond sale today?

No. It assesses a proposed bill and identifies a separate unresolved issue for previously exempt instruments. The applicable law and the instrument's terms must be checked for the relevant tax year.

Citations

• N.C. Const. Art. I, Sec. 16 (retrospective taxation)
• N.C. Const. Art. V, Sec. 2(19) (taxing power)
• N.C.G.S. § 105-134.2 (income-tax assessment)
• N.C.G.S. §§ 122A-19, 131A-21, 131E-28 and 143B-456 (examples of instruments previously exempted)
• Welch v. Henry, 305 U.S. 134 (1938) (federal due-process analysis)
• Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) (tax-rate changes)
• United States v. Hudson, 299 U.S. 498 (1937) (mid-year income tax)
• Ward v. Clayton, 276 N.C. 411, 172 S.E.2d 531 (1970) (realized gains and losses)
• Railroad v. Reid, 64 N.C. 156 (1870) (perpetual tax exemptions)

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