A power plant operator was required to purchase emission reduction credits (“ERCs”) to comply with the permitting process to build a power plant. Over the course of several years, the State Board of Equalization (“Board”) made a site-specific adjustment to the plant’s property tax valuation to add the value of the ERCs in connection with a replacement cost approach to value appraisal. The Board also did an income approach to value appraisal for some of the years in question, but did not separately determine and deduct the value of the ERC’s. The operator sued the Board in state superior court for a refund of property taxes paid on the plant, arguing that the site-specific adjustment was a direct, illegal tax on the ERCs because the ERCs were nontaxable intangible assets and that the failure to deduct a value for the ERC’s from the Board’s income approach also resulted in the taxation of intangible assets.
The trial court ruled against the operator, finding that ERCs were taxable “intangible attributes of real property.” On appeal, the appellate court affirmed the decision on a different ground. The appellate court found that Revenue and Taxation Code section 110(e), which allows assessors to assume the presence of intangible rights, applied to the ERCs and was mutually exclusive of section 110(d), which states that unit valuation should exclude fair market value of intangible rights. The California Supreme Court reversed the appellate decision, holding that the Board directly and illegally taxed the ERCs, by adding an incremental value in the Board’s replacement cost appraisal; that sections 110(d) and 110(e) are not mutually exclusive and should be applied together; and that the Board properly prepared an income approach appraisal without deduction for the ERC’s, as they merely permitted the use of the property for beneficial purposes. (Elk Hills Power, LLC v. Board of Equalization (--- P.3d ----, Cal., August 12, 2013).
Elk Hills Power, LLC (“Elk Hills”) operates an electric power plant in Kern County. In 1999, as part of the state Clean Air Act permitting process for construction of the plant, Elk Hills purchased emission reduction credits (“ERCs”) to comply with local, state, and federal air quality standards. The credits were purchased through the emission offset system in which existing pollution sources that reduce their emissions can sell credits, which may then be purchased by new polluters to offset future emissions.
The State Board of Equalization (“Board”) analyzed the valuation of the power plant for property taxes using the unit taxation system. Unit taxation aims to calculate the entire value of a property by evaluating together all of the property’s component parts. The Board utilized two different approaches in valuing the plant as a unit. Between 2004-2008, the Board used the replacement cost approach, which involved estimating the cost of replacing the plant’s assets. During these years, the Board added a site-specific adjustment based on the average replacement cost of the plant's ERCs.
From 2006-2008, the Board also used an income approach to assess the plant’s value. This approach estimates the amount of income the property may generate over its lifetime, then calculates the value of that amount in today’s dollars, in doing so the Board did not deduct or carve out a separate amount of value for the ERC’s.
Elk Hills sued the Board in state superior court for a refund of property taxes paid on the plant, arguing that the site-specific adjustment for the replacement cost approach was a direct and illegal tax on the ERCs because the ERCs were intangible assets, nontaxable by law. Elk Hills also claimed that the Board improperly taxed the ERCs under the income approach because the Board allegedly failed to deduct the value of the ERCs from the plant’s projected income. Elk Hills and the Board agreed in court that ERCs are intangible rights. The trial court ruled against Elk Hills and granted a motion for summary judgment for the Board, finding that ERCs are “intangible attributes of real property.” Because Revenue and Taxation Code section 110(f) allows these intangible attributes to be reflected in the valuation of a real property’s fair market value, the trial court reasoned that the ERCs were properly subjected to assessment.
The Fourth District Court of Appeal affirmed the trial court decision, but on a different ground: It pointed to Revenue and Taxation Code section 110(e), which allows assessors to assume the presence of intangible rights that are “necessary to put the taxable property to beneficial or productive use.” The court of appeal found that section 110(e) was mutually exclusive of section 110(d), which states that in unit valuation, the fair market value of the unit should exclude “fair market value of the intangible assets and rights contained within the unit.” Elk Hills sought review by the California Supreme Court.
The California Supreme Court reversed the appellate decision, holding that the Board directly taxed the ERCs when using the replacement cost approach and that section 110(d) and 110(e) are not mutually exclusive and should be applied together. The Court found that, under the income approach, the ERCs did not have a quantifiable fair market value to be deducted from the plant’s projected income.
Examining legislative history and case law on California’s tax treatment of intangible rights, the Court stated that these sources reflected that “although intangible rights and assets are not directly taxable, much of the value of taxable assets can be intangible in nature.” For example, the value of vacant property has value related to its ability to “serve another purpose” such as being the site of a future structure. The Court found that Revenue and Taxation Code sections 110(d) and 110(e) were enacted to codify this principle and were not mutually exclusive (as the court of appeal had ruled) but instead should be read together. The Court held that this meant that assessors are allowed to assume the “presence of intangible assets when valuing taxable property put to beneficial or productive use” as stated in section 110(e). However, in determining the property’s value, an assessor must not actually include the value of the intangible right itself in the property’s valuation, as required by section 110(d).
Examining the Board’s use of the replacement cost approach in assessing the plant’s value, the Supreme Court stated that the site-specific adjustment for the value of the ERC’s that the Board used in calculating the replacement cost of the plant was an improper tax. The Court noted that section 110(d)(2) requires the fair market value of intangible assets to be removed from the value of the taxable unit prior to assessment to avoid direct taxation of the intangible assets.
The Court rejected the Board’s argument that the site-specific adjustment was a permissible assessment of the ERCs and other “soft costs” of the plant, not an illegal direct tax. The Court observed “there is a meaningful difference between assuming the presence of an intangible asset and adding value to the unit whole to account for the presence of that intangible asset.” The Court pointed out that the Board’s assessment manual states that the Revenue and Taxation Code does not authorize “adding an increment to the value of taxable property to reflect the value of intangible assets.” The Court held that although section 110(e) allowed the Board to assume the presence of intangible rights such as the ERCs when assessing the plant’s value, the Board went too far by including the fair market value of the ERCs in the assessment.
The Court rejected the Board’s contention that Revenue and Taxation Code section 110(f) provided an alternative justification for the Board’s replacement cost valuation of the plant. The trial court had ruled that section 110(f) applied to ERCs. Section 110(f) states that “intangible attributes of real property” such as “zoning, location, and other attributes that relate directly to the real property involved” should “be reflected in the value of the real property.” The Supreme Court stated that the types of intangible attributes covered by section 110(f) are those that relate directly to the characteristics of a property such as the location of the property, zoning, architecture, or an ocean view. Section 110(f) does not apply to “intangibles, such as ERCs, that ‘relate to the real property only in their connection with the business using it.’”
Additionally, the Court held that even if section 110(f) did apply to ERCs, the section should be considered along with Revenue and Taxation Code section 212(c), which states that intangible rights such as ERCs are exempt from direct taxation.
However, the Court found that the Board correctly performed the plant assessment under the income approach. The Court disagreed with Elk Hills’ argument that the Board should have calculated how much of the plant’s income was attributable to the ERCs and then deducted that amount from the plant’s income stream. The Court stated that intangible rights like ERCs that contribute to the income stream only indirectly by simply allowing the property to generate income do not have a “quantifiable fair market value that must be deducted from an income stream analysis prior to taxation.” In contrast, other intangible assets, such as goodwill, customer base, and favorable franchise or contract terms, do “make a direct contribution to the going concern value of the business as reflected in an income stream analysis.” When considering these latter types of intangible assets, assessors should quantify their fair market value and deduct that from the income stream estimate before applying a tax under the income approach. Accordingly, the Court upheld the Board’s income approach to value appraisal.
This Legal Alert updates our previous alert on this case entitled, “Value Of Emission Reduction Credits Could Be Included In The Assessment Of Power Plant For Property Tax Purposes,” June 8, 2011.