Payment in Lieu of Taxes Increased After the Adoption of Proposition 26 is not Grandfathered-In

A city’s annual budget transfer from its electric utility to its general fund, referred to as a payment in lieu of taxes (PILOT), is a tax under Proposition 26 — unless the city can demonstrate the amount collected does not exceed the reasonable costs to the city of providing electric service, the California Court of Appeal has decided. The court rejected the City of Redding’s argument that the PILOT is grandfathered-in because the practice of imposing it preceded the adoption of Proposition 26.

Redding operates an electric utility. The City’s electric utility revenues are accounted for separately from the City’s general fund revenues. Because the electric utility is municipally owned, its real property is not subject to a 1 percent ad valorem tax. The City makes an annual budget transfer from its electric utility fund to its general fund. The annual transfer (i.e., the PILOT) is established at a rate to equate as nearly as practicable to the tax a private utility would have to pay the City in ad valorem taxes. The PILOT is not established by ordinance, but is part of the City’s biennial budget.

Approved by the voters in November 2010, Proposition 26 amended provisions of article XIII C of the California Constitution governing the imposition of local government taxes by providing a new definition of the term “tax.” For local governments, this narrow definition defines “tax” to mean any levy, charge or exaction of any kind imposed by a local government, except for seven specifically identified exceptions. As a consequence, fees and charges that do not fall within one of the seven exceptions are redefined as taxes and subject to voter approval. Proposition 26 shifted to local agencies the burden of demonstrating by a preponderance of the evidence (i.e., that it is more likely than not) that a fee is not a tax.

In December 2010, the City approved a rate increase to its electric service fees and the PILOT. A group of citizens challenged the City’s PILOT as a tax. They asserted that, because the PILOT is not attributable to any costs incurred by the utility or the City for providing electric service, it exceeded the cost of providing the service and is a tax within the meaning of Proposition 26. The City argued that: (1) Proposition 26 was not retroactive and therefore did not apply to the PILOT; (2) the electric service fees are not fees “imposed” by the City because any customer was free to provide their own service and (3) an electric utility charge is not a tax within the meaning of Government Code sections 53720-53730 (approved by voters by Proposition 62) requiring a two-thirds voter approval.

The trial court held that: (1) the PILOT predated Proposition 26 and therefore was immune from a Proposition 26 challenge as a tax and (2) even if the PILOT fell within Proposition 26’s ambit, it could reasonably be argued the PILOT reflected a reasonable cost of service.

The Court of Appeal found that, because the PILOT was calculated as a flat percentage of the utility’s assets, it was not designed to approximate the reasonable costs of providing electric service. While the City may recover costs that its general fund incurs on behalf of the utility, the court found that there was no showing that the PILOT coincides with those costs. The appellate court also rejected the City’s argument that the electric service fees are not imposed, finding that a tax does not lose its revenue-generating character because there is a theoretical, but unrealistic way, to escape the tax. The court held that PILOT is a tax within the meaning of Proposition 26 unless the City can prove the amount collected is necessary to cover the reasonable costs to the City of providing electric service. Because the trial court concluded that the PILOT does not exceed the reasonable cost of providing electric service, the Court of Appeal remanded the case back to the trial court for an evidentiary hearing in which Redding may prove that the PILOT does not exceed the reasonable costs to the City.

In addressing whether the PILOT was grandfathered-in by Proposition 26, the court took particular note of the fact that the PILOT was not adopted prior to Proposition 26 by a separate ordinance or law, but was calculated with each biennial budget according to a formula approved by the City Council. As a budget line item, the PILOT is subject to annual discretionary reauthorization by each City Council. Consequently, the court concluded that the PILOT cannot be deemed grandfathered-in as preceding the adoption of Proposition 26. Because it was not grandfathered-in, it must be cost justified.