A North Carolina county purchases office furniture from a local office supply store for its newly arrived manager.  A construction contractor for a North Carolina city buys drywall from a hardware store to repair a water-damaged wall in a city building.  Must the office supply and hardware store charge and collect North Carolina sales taxes when completing these sales?  Yes, but North Carolina law entitles both the municipality and county to a refund of all sales taxes paid in connection with each purchase.

At present, North Carolina law entitles counties, municipalities, and 29 other types of governmental entities to an annual refund of North Carolina state and local sales and use taxes paid upon (1) almost all direct purchases—those that an eligible entity pays directly to a retailer or the North Carolina Department of Revenue (“NCDOR”), and (2) indirect purchases—those that an eligible entity’s contractor pays directly to a retailer or NCDOR—of “building materials, supplies, fixtures, and equipment that become a part of or annexed to any building or structure that is owned or leased by the governmental entity and is being erected, altered, or repaired for use by the governmental entity.” G.S. 105-164.14(c). [1]

North Carolina is the only state in the country that both broadly imposes sales and use taxes upon its local governments’ purchases and also refunds these taxes to local governments.  But the primary reason why the General Assembly adopted such a system is not due to constitutional constraints or innovative public policy.  Instead, the current refund system is a product of a 1961 political compromise forged to stave off the economic effects of a wholesale repeal of a previous exemption for local government purchases in effect from 1933 to 1961.

This blog post explains how that political compromise came into being.

The 1961 General Assembly Implements Governor Sanford’s Tax Plan for Public Education

The North Carolina General Assembly first imposed a statewide retail sales tax in 1933.  See N.C. Pub. Laws 1933, c. 445, § 406.  Subject to limited exceptions, that tax applied—at a rate of three percent—to all retail sales of commodities in North Carolina.  Id. at § 405.  One of those exceptions applied to any “sale[s] of any merchandise . . . to the State of North Carolina or any of its subdivisions [i.e., local governments].”  Id. at § 406(d) (emphasis added).  Expanding in 1939 to include “sales of building materials to contractors to be used in construction work for State or local governments,” these exemptions for “direct” and “indirect” purchases persevered until June 30, 1961.[2]  See N.C. Pub. Laws 1939, c. 158, § 406(d).

Terry Sanford won the governorship in November 1960, promising to increase expenditures for North Carolina’s public elementary and secondary schools.  He acted upon his campaign promises in the first months of 1961, and in March requested that the legislature “remove all exemptions from the sales tax” in an effort to increase state spending for public education.[3]  Noting that the state’s sales tax was “extremely difficult to administer” due to “so many assorted exemptions,” Governor Sanford stated in his 1961 budget message to the General Assembly that North Carolina “collect[ed] the lowest sales tax per capita of all the 34 states having a sales tax.”[4]  Removing those exemptions, according to Sanford, would both ease administration for North Carolina’s merchants and increase state revenue by an estimated $83 million (equivalent to approximately $846 million in 2023).[5]  These funds could be used to increase state expenditures for public schools.  Three days after Sanford delivered his budget message to the General Assembly, legislators simultaneously introduced two bills (S78 and H175) implementing Sanford’s tax proposals in the North Carolina State Senate and House of Representatives.

The proposed removal of the exemptions for direct and indirect purchases drew the ire of many, but not all, local government officials across the state.  As it still does today (see G.S. 115C-521(b)), North Carolina law in 1961 required counties to “provide funds” to local boards of education in an amount necessary to provide, among other things, “suitably equipped” school buildings.  Accordingly, counties supported the repeal due to a potential accompanying increase in state appropriations for public schools, which might lessen county financial burdens.  However, not generally obligated or permitted to financially support local boards of education, municipalities largely opposed the repeal of the exemption.[6]

County Support

The General Counsel of the North Carolina Association of County Commissioners (“NCACC”) noted shortly after the introduction of S78 and H175 that “if the Governor’s program [was] not adopted and if no additional state taxes [were] levied, increased support of public schools, welfare and health programs [would] again fall on the already over-burdened property tax.”[7]  Similarly, the Chairman of the Guilford County Board of Commissioners conceded in a March 28 letter to Governor Sanford that repealing the sales tax exemption for county and municipal purchases would “slightly increase the burden of ad valorem taxes,” but noted that his board supported the repeal in light of Sanford’s plans to increase expenditures for public schools.[8]  Echoing those views, the NCACC Board of Directors formally endorsed Governor Sanford’s tax proposals—including the repeal of the sales tax exemption for county purchases—in April 1961.[9]

Municipal Opposition

In contrast to county officials, the North Carolina League of Municipalities and municipal officials opposed repealing the sales tax exemption for local government purchases.  Municipalities—which did not (and still do not) bear responsibility for funding public schools—stood to gain less than counties from increased state spending on public school expenditures.  A number of municipal governing boards—including those in Concord, High Point, Lumberton, and Rocky Mount—adopted formal resolutions opposing the repeal in S78 and H175,[10] while the League’s General Counsel testified before the Joint House and Senate Finance Committee in April 1961 to oppose the repeal of the exemption on behalf of the League’s members.[11]

The chief complaint of the League and its member municipalities, as summarized by one municipal official, was that removal of the exemption “would mean that the cities of North Carolina . . . would have to look to other sources of revenue”—primarily property taxes—in order to pay sales taxes to the state.[12]  The mayor of Charlotte noted that repeal would cost the city at least $150,000 on an annual basis,[13] while High Point’s mayor estimated the repeal would cost his city between $75,000 and $100,000.[14]  These costs would, according to High Point’s mayor, “deprive [the city’s] citizens of services and improvements [that were] so badly needed.”[15]

A second, but less immediately practical concern for municipalities, was the purported violation of the “fundamental and long-standing principle that one level of government ought not to tax another.”[16]  The Mayor of Burlington labeled this “double taxation” upon municipal residents a “very dangerous thing,”[17] while the League’s General Counsel asked the members of the Joint House and Senate Finance Committee whether they could find “some way” to “adequately finance[]” Governor Sanford’s educational program without taxing local government purchases.[18]

A Compromise Emerges: An Annual Refund of Sales and Use Taxes

The League of Municipalities conducted a months-long lobbying campaign against the proposed repeal of the exemption for direct and indirect local government purchases, and Governor Sanford’s papers in the North Carolina State Archives reveal letters and telegrams from officials from more than thirty municipalities across the state opposing the repeal of the exemption.[19]  By mid-May, the State Senate’s Finance Committee appointed an informal “sub-subcommittee”—comprised of Senators W.C. Harris, D.G. Bell, and Hoyle Efird—to consider whether the legislature should retain the current exemption for municipalities and counties.[20]

Although records of the sub-subcommittee’s proceedings do not exist, some historical evidence suggests that the Sanford administration opposed, at a minimum, the retention of a sales tax exemption for building materials purchased by county and municipal construction contractors.  Governor Sanford’s legislative counsel, J. William Copeland, suggested that retaining such an exemption was problematic because it called into question the State’s legal authority to tax purchases made by federal construction contractors.[21]

Shortly after the “sub-subcommittee” met, the Senate Finance Committee approved full repeal of the exemption for direct and indirect purchases while the House Finance Committee approved retention of the exemptions.[22] Despite the disparate outcomes, however, the two committees jointly agreed upon a compromise on May 25, 1961: the state would levy sales and use taxes upon direct purchases made by local governments and indirect purchases made by their construction contractors in order “to close present loopholes,” but would allow counties and municipalities to obtain for annual refunds of those taxes.[23]  Neither historical legislative records nor newspaper accounts clearly explain the type of “loophole” that legislators were attempting to close by implementing this refund system—but legislators may have had concerns about improper attempts by purchasers other than local governments to rely upon an exemption or a retailer’s difficulty in verifying that purchasing local governments or their contractors were entitled to the exemption.

Officials in Charlotte, Elizabeth City, Monroe, and Canton wrote to the Governor to express their gratitude for the compromise, with the Mayor of Canton expressing his hope that the “new arrangement [would] prove to be satisfactory to all parties concerned.”  On June 7, the Senate Finance Committee favorably reported a committee substitute for S78—Sanford’s original tax proposal—that contained the refund provisions agreed upon by the Joint House and Senate Finance Committee.[24]  On June 15, S78—with the refund provisions intact—was ratified. See S.L. 1961, c. 826, § 2(9).  The fundamental provisions that the General Assembly adopted in 1961 have endured until the present day with limited subsequent revisions.

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[1] Eligible entities may not obtain refunds of certain types of North Carolina sales and use taxes paid on certain direct purchases.  In particular, North Carolina law prohibits the State from refunding to eligible entities any sales and use taxes paid incident to the sale of electricity, piped natural gas, telecommunications service and ancillary service, video programming, and prepaid meal plans.

[2] The General Assembly subsequently recodified this provision in 1957 when adopting extensive amendments to the Revenue Act (Chapter 105, Subchapter 1 of the North Carolina General Statutes).  See S.L. 1957, c. 1340, s. 5 (exempting from tax any “[s]ales made to the State of North Carolina or any of its subdivisions . . . [including] . . . [s]ales of building materials made directly to State and local governments in this State . . . and sales of building materials to contractors to be used in construction work for State or local governments.”).  These provisions were in effect when the 1961 General Assembly considered proposals to eliminate the exemption.

[3] Journal of the Senate of the General Assembly of the State of North Carolina 76 (Mar. 6, 1961) (hereinafter, “Senate Journal”).  For an abbreviated account of Sanford’s legislative efforts, see Terry Sanford, But What About the People? 21-27 (Harper & Row: New York, 1966).

[4] Senate Journal at 76.

[5] Id. at 77.

[6] See George H. Esser, Jr., The Cities and the 1961 General Assembly, 28 Popular Government Nos. 1-2, at 13 (Sept.-Oct. 1961) (“[T]he cities . . . pointed out (1) that it was unsound policy for one level of government to directly levy a tax on another level of government, and (2) that payment of the sales tax might help meet school needs but that it would also increase municipal expenditures and therefore the municipal property tax.”).

[7] N.C. Association of County Commissioners, Legislative Bulletin #4 (Mar. 10, 1961), Box 39, MARS Number 368 Terry Sanford Governor’s Papers, State Archives of North Carolina, Raleigh, NC USA (hereinafter “Sanford Papers”).

[8] L.C. Amos, Chairman of the Guilford County Board of County Commissioners, to Governor Terry Sanford, 28 March 1961, Box 24, Sanford Papers.  The Guilford County Board of County Commissioners adopted a resolution on March 20, 1961 expressing “its agreement to the removal of counties from exemption from paying the retail sales and use tax as recommended by Governor Terry Sanford in his tax program presented to the 1961 General Assembly.”  Id.

[9] N.C. Association of County Commissioners, Legislative Bulletin, 17 April 1961, Box 39, Sanford Papers.

[10] Id.

[11] See 13 Southern City No. 4, at 1 (Apr. 1961).  Appearing at the hearing with the General Counsel were elected officials or employees of the cities of Raleigh, Mount Airy, Charlotte, Elizabeth City, Washington, Scotland Neck, Henderson, Statesville, Thomasville, Forest City, Burlington, Durham, Salisbury, and Rocky Mount.  See id.

[12] 13 Southern City No. 3, 2 (Mar. 1961)

[13] Stanford R. Brookshire, Mayor of Charlotte, to Terry Sanford, 23 May 1961, Box 24, Sanford Papers.

[14] Carson C. Stout, Mayor of High Point, to Terry Sanford, 24 May 1961, Box 24, Sanford Papers.

[15] Id.

[16] 13 Southern City No. 6, at 2 (June 1961).

[17] C. Almon McIver, Mayor of Burlington, to Terry Sanford, 22 May 1961, Box 24, Sanford Papers.

[18] 13 Southern City No. 4, at 4 (Apr. 1961).

[19] Opposition was widespread.  Governor Sanford’s papers contain letters or telegrams opposing repeal from officials in Burlington, Canton, Concord, Charlotte, Cherryville, Concord, Fairmont, Greenville, High Point, Jacksonville, Kings Mountain, Louisburg, Lumberton, Marion, Monroe, North Wilkesboro, Newton, Oxford, Rocky Mount, Smithfield, Spring Hope, Statesville, Washington, Wilkesboro, Winston-Salem, and Wilmington.  See Box 24, Sanford Papers.

[20] William Copeland, Legislative Counsel, to Governor Terry Sanford, 19 May 1961, Box 24, Sanford Papers.

[21] The General Assembly repealed an exemption for sales and use taxes for federal contractors in 1943.  See N.C. Pub. Laws 1943, c. 400, § 5(b)).  The Director of the North Carolina Department of Tax Research suggested in a February 1961 memorandum to Terry Sanford that North Carolina’s disparate tax treatment of purchases of building materials by federal construction contractors (which were subject to state sales and use tax) and local construction contractors (which were exempt from state sales and use tax) was likely unconstitutional.  See H.C. Stansbury to Honorable Terry Sanford, Governor of North Carolina, Taxation Under the Sales and Use Taxes of Contractors Working on Federal Projects, Sanford Archives, Box 110 (“It appears very likely that the U.S. Supreme Court would declare the taxation of materials purchased by contractors for use in performing contracts for the Federal government under our sales and use tax [laws] unconstitutional if carried to the courts, so long as sales to contractors of materials for use in performing contracts with the State, its political subdivisions or religious, charitable, and educational institutions are exempt.”).  The Director’s memorandum proved prescient.  The federal government sued the North Carolina Commissioner of Revenue in 1965, claiming that the disparate treatment violated the Fourteenth Amendment.  See U.S. v. Clayton, 250 F. Supp. 827 (E.D.N.C. 1965), appeal dismissed, per curiam, 384 U.S. 156, 86 S. Ct. 1379 (Mem), 16 L.Ed.2d 432 (1966).  The federal government won the suit, securing a permanent injunction that required the State of North Carolina to refund to the federal government sales and use taxes that federal construction contractors paid.  At present, no statute currently authorizes the North Carolina Department of Revenue to provide these refunds, but NCDOR continues to provide these refunds in accordance with the 1966 ruling.  See N.C. Department of Revenue, Sales and Use Tax Division, Sales and Use Tax Bulletins Reflecting Changes Made in the 2022 Regular Session of the North Carolina General Assembly (Jan. 1, 2023), § 74-4(A)(2). Federal procurement regulations currently impose certain recordkeeping requirements upon federal contractors that incur North Carolina sales and use tax liability when purchasing building materials incorporated into federal facilities. See 48 C.F.R. § 29.304(d).  The intent of these requirements is to enable the federal government to obtain an annual refund of sales and use taxes paid on qualifying indirect purchases on the same basis as North Carolina counties and municipalities.

[22] 13 Southern City No. 4, at 4 (Apr. 1961).

[23] David Cooper, $73 Million Bill: Assembly Groups Okay Tax Plan, The News and Observer (May 26, 1961), at 1.  The Greensboro Daily News separately but similarly reported that the “purpose” of the levy and refund was to “close loopholes in the present law.”  Guy Munger, Revenue Plan Moves Ahead in Assembly: Food Tax Included in Proposal Passed by Finance Subcommittees, Greensboro Daily News (May 26, 1961), at 1.

[24] Senate Journal at 488 (June 7, 1961).