Cost Containment Advisors

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November 2017 Newsletter

November 13, 2017 | Newsletter

CALIFORNIA – Airlines’ failure to challenge assessments on their commercial aircraft before local boards of equalization precluded claims that assessments were void because Counties had deviated from mandatory statutory formula.

Airtran Airways Inc.; American Airlines, Inc.; Envoy Air Inc.; Jetblue Airways Corporation; Skywest Airlines, Inc.; Southwest Airlines Co.; and United Airlines, Inc., filed 44 separate but identical suits for tax refunds and declaratory relief, challenging the imposition of property tax assessments on their commercial aircraft. The airlines claimed that the Counties in which they were taxed deviated from the mandatory statutory formula to calculate property taxes and that the assessments were void as a result.

According to the complaints filed by the airlines, the Counties were required to assess the aircraft according to a statutory formula set out in California Revenue and Taxation Code § 401. The airlines alleged that the County assessors failed to correctly apply the provisions of § 401.17 in calculating economic obsolescence, resulting in excessive assessments, and that the taxes charged were void. Section 401.17 sets out a detailed, multi-step formula for assessing commercial aircraft. Among the many components of the formula, the section provides for calculation of economic obsolescence and various factors to be used in doing so. The airlines argued that the Counties were required to determine the original cost of the aircraft, adjust that cost to account for depreciation, and then further adjust that cost to account for economic obsolescence. They claimed that the last part of the economic obsolescence formula required use of a 10-year benchmark but that the Counties used a calendar year benchmark instead, resulting in less than 10 percent economic obsolescence rather than the 70 percent the airlines claimed was correct.

The airlines sought a refund for the excess taxes they paid, and claimed that they had exhausted their administrative remedies by filing refund claims with their respective Counties. They did not, however, first challenge the allegedly incorrect assessments with the local Boards of Adjustment, contending that they were not required to do so because there is only one way to apply the formula set out in § 401.17 and the Boards have no “special competence to decide” valuation. The Counties defended on the grounds that the airlines failed to exhaust their administrative remedies by appealing the allegedly incorrect assessments to the Boards before seeking refunds. The trial court agreed with the Counties.

On appeal, the Court of Appeals rejected the airlines’ argument the assessments were void, thus eliminating the necessity that they first apply to the Boards of Adjustment for a reduction in assessment. The airlines cited no case law in support of their position, and the so-called “void assessment exception” to the exhaustion requirement was generally limited to cases where the County had failed to give required notice or where the taxpayer challenged the constitutionality of a statutory section. There were also factual issues which should have been reviewed first by the local Boards. These included allegations regarding the complex calculations, the claim that the assessors’ computations had “no logical or mathematical relation” to those set out in § 401.17, and whether the schedules and “data sets” in the statute and those allegedly used were “comparable.” The Court of Appeals affirmed the trial court’s judgment in favor of the counties.

In re 2009 Aircraft Tax Refund Cases, (Court of Appeal, Fourth District, Division 3, California April 13, 2017) 2017 WL 1366941.

MINNESOTA – Supreme Court rejects Tax Court’s use of Eurofresh standard, holding that to prove a property suffers from external obsolescence; utility taxpayers need not identify the specific causes of external obsolescence and precisely calculate the contribution of each asset to decreased revenues or profit margins.

Minnesota Energy Resources Corp. (MERC) owns a natural gas pipeline distribution system in Minnesota. During the tax years at issue, 2008 through 2012, MERC delivered natural gas over 3,600 miles of pipeline to approximately 205,000 customers in 50 Minnesota counties. As MERC is a regulated utility, its pipeline distribution system is taxable personal property. The system stretches south from Canada across several states, including Minnesota. Using information provided by MERC, each year, the Minnesota Commissioner of Revenue determines a market value for MERC’s pipeline distribution system, which includes distribution pipes, gas mains, gate stations, gas meters, distribution-regulation stations, gas valves, and odorizing equipment. After calculating the total market value of MERC’s pipeline distribution system within Minnesota, the Commissioner apportions the value among the taxing districts through which it passes, and each district then assesses MERC’s personal property based on the share allocated to it by the Commissioner.

MERC filed suit challenging the Commissioner’s 2008 to 2012 valuation of its pipeline distribution system. Following a trial, the Tax Court found that the report of MERC’s expert was sufficient to overcome the presumptive validity of the Commissioner’s valuation, and then conducted its own valuation of MERC’s property. The Court used a combination of two of the three approaches to valuing property, the cost and income approaches, and rejected the third approach, the market approach, after determining that it would not lead to an accurate assessment of market value. MERC challenged three decisions made by the Tax Court in its use of the direct capitalization method of the income approach: its failure to adopt a company-specific risk factor, its lack of explanation of the beta factors it applied, and its rejection of the build-up method. MERC also challenged the Tax Court’s adoption of the Eurofresh standard for proving external obsolescence in its cost approach analysis. The Tax Court reduced the assessments in question, and both parties appealed.

The parties’ disagreement regarding the income approach focused on the capitalization rates applied by the Tax Court, and in particular, the cost of equity it used to determine each year’s rate. The Tax Court calculated the capitalization rates by estimating both the cost of debt and the cost of equity for each taxable year, based on the straightforward principle that most businesses, including utilities, finance the purchase of property through a combination of debt and equity. MERC argued on appeal that the Tax Court erred when it failed to apply a company-specific risk factor to account for the increased risk of a utility business that operates largely within a single state—Minnesota—and distributes only a single product—natural gas—to its customers. This circumscribed portfolio of business, according to MERC, raises the risk for equity investors and necessarily creates a higher cost of equity. MERC argued that an additional, company-specific risk factor in the cost-of-equity formula would account for this risk. The Tax Court excluded a company-specific risk factor from its calculation of MERC’s cost of equity based on a lack of evidence for the proposition that MERC’s business was riskier than the market, not because it determined, as a matter of law, that a regulated entity’s cost of equity can never be augmented to account for additional risk. The Supreme Court affirmed the Tax Court on this issue, because the factual finding was not clearly erroneous.

MERC’s second challenge relating to the income approach was to the Tax Court’s explanation of the so-called “beta factors” it used to calculate MERC’s cost of equity. The beta factor, a concept unique to corporate finance, accounts for the relative volatility of a specific investment compared to the volatility of the market as a whole. The Tax Court’s adoption of a beta factor that was less than 1 for each taxable year indicated that it believed that MERC’s volatility, likely due to its status as a highly regulated entity, was lower than the market’s risk, which resulted in a lower cost of equity for MERC than a similar investment with a higher beta factor. Other than stating that the beta factor was less than 1 for each of the years in question, the Tax Court’s order did not specify the value of the beta factors it used for each year; much less explain how or why it selected them. Because this lack of explanation precluded the Supreme Court from determining whether the record supported the beta factors adopted by the Tax Court, it reversed and remanded to the Tax Court on this issue for further explanation.

Finally, the Supreme Court rejected MERC’s claim that the Tax Court should have used the build-up method as an alternative technique for calculating MERC’s cost of equity in its income approach analysis. The Tax Court instead used the capital-asset-pricing model to calculate MERC’s cost of equity. The build-up method used by MERC’s appraiser, much like the capital-asset-pricing model, begins with a risk-free rate, but rather than using a beta factor it adds a market premium for equity investments and a size premium to reflect the higher expected rate of return for investments in smaller companies. The Supreme Court affirmed with the Tax Court on this issue, because the disagreement between the appraisers was best left to the Tax Court’s determination and was not clearly erroneous.

MERC’s final challenge was to the Tax Court’s use of the cost approach. The Tax Court determined that MERC’s pipeline distribution system did not suffer from external obsolescence during the years in question. The Supreme Court began its analysis by observing that the cost approach, which estimates market value on the basis of the current cost to construct new or substitute property, is particularly useful when trying to determine the market value of “special-purpose property” such as pipelines and specialized equipment. It is also clear that “[e]xternal obsolescence often relates to the business enterprise that operates at the special-purpose property, such that a change in industry conditions could cause the taxpayer to incur a reduction in revenue, profit margin, or return on investment metrics.” The Tax Court correctly defined external obsolescence as “a loss in value caused by negative externalities that is almost always incurable,” but then found that MERC’s evidence insufficiently demonstrated that MERC’s pipeline distribution system was externally obsolete.

Rather than treating external obsolescence in the same manner as other forms of depreciation, the Tax Court adopted a special standard for evaluating MERC’s claims of external obsolescence. This standard, borrowed from the Arizona Court of Appeals, requires “a taxpayer claiming external obsolescence [to] offer probative evidence of the cause of the claimed obsolescence, the quantity of such obsolescence, and that the asserted cause of the obsolescence actually affects the subject property.” (Eurofresh, Inc. v. Graham Cty., 218 Ariz. 382, 187 P.3d 530, 538 [Ariz.Ct.App.2007]). Attempting to satisfy this standard, MERC presented five witnesses who testified as to “regulation and rate lags, mild weather, the economic crisis in 2008, and an increase in the use of energy efficient appliances” as contributing to MERC’s decreased revenues and profit margins. The Tax Court concluded that MERC’s evidence was insufficient to warrant an adjustment to the market value of MERC’s property under the cost approach.

The Supreme Court rejected the Tax Court’s use of the Eurofresh standard. The Court observed that the fact that the taxpayer cannot identify the specific causes of external obsolescence and precisely calculate the contribution of each to decreased revenues or profit margins does not mean that a property does not suffer from external obsolescence. External obsolescence can exist when its cause is difficult to quantify, resulting in variation among experts in their estimation of the impact of external factors on the fair market value of certain properties. The Court held that the Tax Court evaluated MERC’s evidence of external obsolescence under the wrong legal standard by relying on Eurofresh, and that MERC’s evidence was at least sufficient to make out a prima facie case of external obsolescence. On remand, the Tax Court was directed to consider all of the evidence presented to determine whether the evidence of external obsolescence is sufficient to support a downward adjustment to the estimated market value of MERC’s property under the cost approach.

Minnesota Energy Resources Corp. v. Commissioner of Revenue, 886 N.W.2d 786 (November 9, 2016).

SOUTH CAROLINA – Fourth Circuit Court of Appeals holds that South Carolina statute which singles out railroad property by excluding it from 15 percent assessment increase cap afforded other commercial and industrial property violates Railroad Revitalization and Regulatory Reform Act.

All property subject to taxation in South Carolina is appraised for assessment purposes at its “fair market value.” The methods used for such appraisals vary. South Carolina law specifically provides that railroads are assessed under the “unit valuation” method, by which the operating properties of an interstate company as an integrated whole are valued without regard to the value of its component parts. South Carolina generally calculates railroad system values based on the income the property is earning. Once the total value of all of a railroad’s real and personal property throughout the United States is determined in this fashion, the next step in the unit valuation process is to allocate the portion of the system value that represents the value of the railroad’s property in South Carolina. Finally, property that has already been taxed or that is tax-exempt is subtracted, yielding an “appraised value.”

Once South Carolina has determined the appraised value of a taxpayer’s property in the state, the next step in the tax-calculation process is the application of a statutory assessment ratio. The South Carolina General Assembly has established statutory assessment ratios that apply to various types of property, and for railroad property, the ratio is 9.5 percent. Applying the statutory assessment ratio to the appraised value of a taxpayer’s property yields the “assessed value,” against which the property tax rate is generally applied and property taxes are levied and collected. In the case of property owned or leased by transportation companies for hire, including railroads, there is an additional step that precedes the application of the property tax rate. To the assessed value of such property, South Carolina applies an “equalization factor,” which is a reduction that these companies receive to help negate disparities between the fair market valuation of their properties and those of other commercial/industrial and manufacturing properties. Once the appropriate equalization factor is applied, the resulting assessed value is distributed to the various South Carolina counties and cities in which the company operates, and these entities in turn apply their local tax rates to determine the taxes the railroad must pay.

The primary focus of this appeal is the South Carolina Real Property Valuation Reform Act, or SCVA, which generally limits increases in appraised values of commercial and industrial real properties to 15 percent within a particular five-year period. The SCVA does not apply, however, to “[r]eal property valued by the unit valuation concept,” and since railroad property is valued by that method, railroads do not benefit from the 15 percent cap.

CSX Transportation, Inc., challenged the way South Carolina law treats railroad property differently from other commercial and industrial property, alleging that the South Carolina’s property tax system discriminated against railroads in violation of the Railroad Revitalization and Regulatory Reform Act. The United States District Court for the District of South Carolina entered judgment in favor of Department of Revenue, and CSX appealed.

The Railroad Revitalization and Regulatory Reform Act targets state and local taxation schemes that discriminate against railroads. The portion at issue in this action, 49 U.S.C. § 11501 (b) (4), bars states from imposing a “tax that discriminates against a rail carrier providing transportation subject to the jurisdiction of the Board.” CSX claimed that South Carolina’s tax system explicitly and unjustifiably singles out railroads—as part of an isolated group—for less favorable treatment than other similarly situated taxpayers. CSX argued that the basis for its challenge was not that the State’s regime had produced the result that the railroad property is assessed at a higher percentage of its true value than is other commercial and industrial property, but rather that the South Carolina tax scheme on its face singles out railroad property for less favorable treatment than other commercial and industrial property. Thus, CSX argued that (b) (4), which prohibits discrimination, was the proper vehicle for its challenge.

The Court of Appeals rejected the District Court’s holding that CSX had not shown that it was challenging the imposition of a “tax,” within the meaning of (b) (4). The District Court had reasoned that CSX was challenging the SCVA, which does not impose a tax but only caps “increases in appraised values” within the context of “an already-existing tax scheme.” The Court of Appeals held that the railroad’s action was plainly a challenge to a tax, vacated the District Court’s judgment, and remanded for further proceedings.

CSX Transportation, Incorporated v. South Carolina Department of Revenue, 851 F.3d 320 (March 17, 2017).

COLORADO – Supreme Court allows retroactive taxation where gas company underreported oil and gas selling price at the wellhead.

Kinder Morgan CO2 Company, L.P., operates oil and gas leaseholds in Montezuma County, Colorado. In 2009, the assessor for Montezuma County issued a corrective tax assessment on these leaseholds for the previous tax year, retroactively assessing over $2 million in property taxes, after an auditor concluded that Kinder Morgan underreported the value of gas produced at the leaseholds. Kinder Morgan appealed, arguing that the assessor lacked authority to retroactively assess these taxes because the statutory scheme for property taxation of oil and gas leaseholds—which authorizes retroactive assessments when “taxable property has been omitted from the assessment roll”—does not authorize a retroactive assessment when an operator has correctly reported the volume of oil and gas sold but has underreported the selling price at the wellhead.

Oil and gas leaseholds are subject to taxation in Colorado as real property. Unlike most real property interests, however, the value of an oil and gas leasehold interest comes not from the physical space or land the leasehold occupies, but rather, from the quantity and value of oil and gas underground. Under the Colorado property tax code, the holder of an oil and gas lease must submit an annual statement, from which the county assessor determines the property’s value and the leaseholder’s property tax liability. The annual statement must include, among other information, the volume of gas or oil sold and the selling price of the gas or oil “at the wellhead”—a term that refers to “the physical location where the extracted material emerges from the ground.” The sale of unprocessed oil or gas, however, rarely occurs at the wellhead; instead, the oil or gas is typically gathered from multiple wells, processed, and transported away from the wellsite before sale. As a result, an operator typically must estimate its “selling price at the wellhead” for purposes of the property tax by deducting from its final, downstream selling price the costs of gathering, processing, and transporting the extracted material. This calculation—that is, the deduction of gathering, processing, and transportation costs from the final, downstream selling price—is known as a “netback” method of calculating wellhead selling price.

An operator’s netback calculation depends on whether the operator contracts with a related or an unrelated party to perform these gathering, processing, and transportation services. If the operator enters into a bona fide, arm’s-length transaction with an unrelated party to perform these services, then the operator may deduct the full amount paid for these services from its final, downstream sales price in its netback calculation (the “unrelated-parties netback method”). If the operator instead enters into a transaction with a related party (such as another subsidiary of the same parent company) to perform these services, then it may deduct only a portion of the amount paid for these services (the “related-parties netback method”). The operator need not disclose the methodology or details of its netback calculation in its annual statement, although an assessor may elect to require this information to be submitted separately, and the assessor may rely on this information if it conducts a review or an audit.

The Colorado Supreme Court affirmed the judgment of the Court of Appeals and held that because Colorado has established a self-reporting scheme for property taxation of oil and gas leaseholds, and because the legislature’s amendments to that scheme describe the “underreporting of the selling price or the quantity of oil and gas sold from a leasehold” as a form of omitted property, the statutory scheme authorized the retroactive Kinder Morgan tax assessment. The Court further concluded that the Board of Assessment Appeals did not err in determining that Kinder Morgan underreported the selling price by claiming excess transportation deductions, given Kinder Morgan’s relationship to the owner of the pipeline through which the gas was transported.

Kinder Morgan CO2 Co., L.P. v. Montezuma County Board of Commissioners, 396 P.3d 657 (Co., June 19, 2017).

OHIO – Case remanded to Board of Tax Appeals to consider whether property owner established that initially reported value was not accurate reflection of parcel’s value and to independently determine parcel’s true value.

Buckeye Terminals, LLC, acquired a 37-acre parcel of real property improved with eight buildings, 22 fuel-storage tanks, and other tangible personal property located in the city of Columbus, Ohio, as part of the purchase of 32 other facilities across several states. A schedule attached to the purchase agreement stated that the fair market value of the Columbus facility, including both equipment and real-property interests, was $13,981,000. In June 2011, when recording the deed to the real property, Buckeye filed a conveyance-fee statement with the Franklin County auditor, reporting $8,492,911 as the purchase price. The Franklin County auditor valued the property at $1,825,700 for tax year 2011.

In February 2012, the Board of Education (BOE) of the South-Western City School District filed a complaint with the Franklin County Board of Revision challenging the auditor’s valuation and alleging that the June 2011 sale established a higher true value for the property. Based on the June 2011 deed and conveyance-fee statement, the BOE requested that the property’s value be increased to $8,493,000. Shortly before the hearing on the BOE’s valuation complaint, Buckeye filed an amended deed and conveyance-fee statement, which altered Buckeye’s allocation of the bulk-purchase price of the Columbus real property from $8,492,911 to $1,921,084 in order to “correct purchase price erroneously noted on prior conveyance.”

At the Board of Revision hearing in October 2014, the BOE offered no evidence other than the June 2011 conveyance-fee statement and deed in support of its complaint. Buckeye responded that the June 2011 conveyance-fee statement listed an incorrect sale price for the Columbus property because it erroneously included not just the value of the real estate but also the value of tangible personal property transferred as part of the Columbus facility. In support, Buckeye offered the amended conveyance-fee statement and deed, as well as testimony from its property-tax manager and two employees of Ernst & Young, L.L.P., who were involved in the allocation of the $166 million purchase price of the assets transferred in the June 2011 transaction. The Board of Revision increased the value of the real property to $8,493,000 for tax years 2011, 2012, and 2013, but it retained the auditor’s valuation of $1,825,700 for tax year 2014.

Buckeye appealed the Board of Revision’s valuation increase for tax years 2011, 2012, and 2013 to the Board of Tax Appeals. Buckeye again relied on the amended conveyance-fee statement and deed, but it also presented testimony to support the value reported on the amended conveyance-fee statement from a former employee of the Ohio Department of Taxation, and from an appraiser. The Board of Tax Appeals affirmed the Board of Revision’s valuation of the real property for tax years 2011, 2012, and 2013, based on the original conveyance-fee statement and deed, and Buckeye appealed.

On appeal, the BOE argued to the Court that the Board of Appeals correctly determined that Buckeye’s initial allocation of $8,492,911 on the June 2011 conveyance-fee statement was the best evidence of the property’s value. The Court rejected this argument. In light of the evidence presented by Buckeye, the Court held that it was unreasonable and unlawful for the Board of Tax Appeals simply to adopt the valuation reported on the conveyance-fee statement. Once Buckeye had demonstrated that the originally reported allocated value did not accurately reflect the value of the real property, the Board of Tax Appeals was required to determine true value based on the evidence in the record. The Court remanded the case to the Board to determine the true value of the property for the 2011–2013 tax years.

Buckeye Terminals, L.L.C. v. Franklin Cty. Bd. of Revision, Slip Opinion No. 2017-Ohio-7664 (September 21, 2017)