United States: Unit Valuation – Fundamental Valuation Principles, Not Administrative Rules, Prevail

Last Updated: August 24 2018
Article by Mark Lansing

In Enbridge Energy, Limited Partnership v. Commissioner of Revenue,1 The Minnesota Tax Court recently rejected the Minnesota Commissioner of Revenue's ("State") attempt to artificially increase an interstate pipeline's value to exceed market value, here, applying unit valuation. It rejected the State's numerous inconsistent positions and its attempt to assert its own administrative rule as a limitation on the Court's ability to determine fair market value.2

The Tax Court started with two fundamental principles: (1) it was required to determine the fair market value of the pipeline, and to do so, (2) it had to consider the three traditional approaches to value: sales comparison, cost, and income.3  Like most states, Minnesota requires all property "be valued at its market value."4 The Court agreed with the Taxpayer that the sales comparison approach was not applicable, noting the "very limited amount of actual sales data to be used as an evidence of value."5 The Court rejected the State's stock-and-debt approach,6 finding the Taxpayer's partnership interests were not publicly traded, and thereby, the State's reliance on the partnership interests of the parent partnership, as a proxy, was baseless. The partnership interests of the parent reflected about a dozen other entities.7

For the cost approach, after deriving the current cost of constructing the existing improvements on the property, the appraiser then computes and deducts depreciation for each of the following three forms: (1) physical deterioration – wear and tear from regular use, the impact of the elements, or damage, or; (2) functional obsolescence  – a change or flaw in the structure, materials, or design that affects the function, utility, and value of the improvement; and (3) external or economic obsolescence  – an impairment of the utility or salability of the property due to influences outside the property. While each form of depreciation is determined independently, the appraiser must assure itself that there is no overlap or double-counting.8

To derive the current cost of constructing, the appraiser applies either the reproduction cost or, more commonly, replacement cost.9 The Court rejected both parties' application of their respective variant of original cost less depreciation. The Court found that a pipeline's rate base value (noting sales of pipelines exceeded their rate base) was not fair market value. It also noted that interstate pipelines were not a regulated utility (thus, rate base was erroneous).10

That left the income approach to value the Taxpayer's entire pipeline under unit valuation. From the income generated by the property, the appraiser deducts operational expenses.11 The Court accepted (with modification) the Company's yield capitalization approach that converted cash flow into present value by discounting the expected future benefits at an appropriate discount rate (synonymous with the property's overall yield rate or cost of capital). The Court rejected the State's reliance on historic income and expenses, agreeing that a buyer would base value on the income projected (including such income amount projected to be earned from construction work in progress ("CWIP")). The Court rejected the State expert's contention for the inclusion of the total amount of the CWIP investment. To compute operation expenses, the Court also rejected the inclusion of oil spill clean-up costs, but included imputed income taxes in the cash flow.

The Court then derived a discount or capitalization rate for each year recognizing "capitalization rates attributable to components of a capital investment (debt and equity) are weighted and combined to derive a weighted-average rate attributable to the total investment."12 Thus, the Court estimated the cost of debt and the cost of equity as of each valuation date, determined an appropriate market capital structure and, then, calculated a weighted average cost of capital.

The Court first determined the expected cost of debt. Finding it could not replicate the Company's calculations and that there were numerous problems with the State's calculations, the Court derived its own cost-of-debt focusing on master limited partnerships. Thereafter, the Court analyzed the cost of equity. The Court rejected the capital asset pricing model (CAPM), finding it understated the cost of equity capital during the years at issue because: (1) beta understated the risk of investing in master limited partnerships,13 and (2) the Federal Reserve's massive purchases of Treasury bonds kept the risk-free rate (typically the yield on long-term Treasury bonds) artificially low.14

The Court also rejected the use of a risk premium, finding that historic risk premiums "substantially overstate the risk premium that should be used in estimating the cost of equity" as a result of such things as "survivorship bias" and "[t]he constancy of differences in risk between treasury bonds and stocks."15 The effect of overstating the risk premium is to overstate the cost of equity capital, and thereby, understate the pipeline's value. As the Court lacked information from either party regarding specific time period over which the risk premium was more appropriately calculated, the Court could not estimate the appropriate reduction in historical risk premiums to reflect current risk premiums.

As both parties estimated the cost of equity capital by the dividend growth model, the Court used that model (as it does not rely on a risk-free rate of return, risk premium, or beta). The dividend growth model assumes "that the current stock price is equal to the expected future returns discounted to a present value at a discount rate that represents the equity cost of capital for that company."16. If the current stock price is known, the formula can be applied to solve for the cost of capital.17 The dividend growth model estimated the cost of equity as the current dividend yield (that is, dividends as a percentage of the current stock price) plus the expected growth in either dividends or earning:

Kc= (D1 /Po)+ g

where Kc is the cost of equity; D1 is the expected dividend in year I; Po is the current stock price; and g is the expected growth in dividends or earnings.  To derive the cost of capital, the Court, again, integrated data from master limited partnerships.

Finally, the Court determined the appropriate overall capital structure, i.e., the relative proportion of debt and equity that a prospective buyer would adopt at each valuation date. The Court recognized that the capital structure of a limited partnership, such as the Taxpayer, differed from that of a corporation. Recognizing that a buyer would most likely organize as a master limited partnership, the Court primarily relied on the capital structure of other petroleum and pipeline companies organized as master limited partnerships, finding 30% debt and 70% equity.18

Having determined net operating income, expected costs of both debt and equity capital as of each valuation date, and the expected capital structure, the Court found that State's valuation of the Taxpayer was grossly overstated to the tune of $1 to 3 billion dollars, depending on the year in question.

The moral of the story is not new. Whether by the misuse of unit valuation or asset valuation, taxing jurisdictions (and their special consultants) continue to find ways to overstate the value of utility, pipeline, generation and other forms of energy-related property (including renewable energy property). Diligence and challenges of assessments remain necessary to stay ahead of any present negative cash flow implications and those that might arise from an economic downturn.


1 2018 WL 2325404 (Minn. Tax Ct. May 15, 2018).

2 As anticipated, the Commissioner sought discretionary review and the Minnesota Supreme Court granted discretionary review of this otherwise non-appealable order on July 17, 2018. The Commissioner argues that Minnesota Energy Res. Corp. v. Comm'r of Revenue, 886 N.W.2d 786 (Minn 2016) supports its position that an administrative rule trumps Minnesota's statutory prescription that all property must be valued at market value. It is noteworthy that other states having mass appraisal administrative rules and processes (e.g., Maryland, New York) to value utility and energy property that such administrative rules and processes are subject to the State's statutory prescription of determining fair market value when reviewed de novo. It will be interesting whether Minnesota puts an administrative rule over statutory prescription. It is also noteworthy that Rule 8100 permits discretion, so much so, that the Minnesota Supreme Court could both find in favor of the Commissioner and affirm the Tax Court's decision.

3 See Equitable Life Assurance Soc'y of U.S. v. Cty. of Ramsey, 530 N.W.2d 544,552 (Minn. 1995).

4 Minn. Stat. § 273.11, subd. I.

5 The sales comparison approach assumes "that the value of property tends to be set by the cost of acquiring a substitute or alternative property of similar utility and desirability within a reasonable amount of time." Appraisal Institute, Appraisal of Real Estate (14th ed, 2013), 379. The cost approach is that "an informed buyer would pay no more for the property than the cost of constructing new property having the same utility." Equitable Life Assurance Soc'y, 530 N.W.2d at 552.The income approach is the present value of future rights to income generated by a property, determined by capitalizing anticipated rents generated by the property at market rates, less expenses of the property at market rates. Macy's Retail Hldgs., Inc. v. Cty. of Hennepin, 2011 WL 6117899, at *9 (Minn. T.C. Nov. 28, 2011) (citing Space Ctrs. Enters., Inc. v. Cty. of Ramsey, 1999 WL 1018098 (Minn. Tax Ct. Nov. 4, 1999)).

6 "The stock and debt approach to value, which is a substitute for a market-sales approach, is based upon the premise that the value of assets is equal to total liabilities plus equity. Thus, the stock and debt approach assumes that the market value of a company's assets can be imputed from the market value of its equity and debt." Delta Air Lines, Inc. v. Dep't of Rev., 984 P.2d 836, 842-43 (Or. 1999); see also Long Island Lighting Co. v. Assessor for Town of Brookhaven, 202 A.D.2d 32, 38-39 (N.Y. App. Div. 1994) (noting that the stock and debt approach produces "an estimate of what it would cost to acquire all the stock and assume all the debt of [the taxpayer] as of the valuation date").

7 See Union Pac. R.R. v. Dep 't of Rev., 843 P.2d 864, 883 (Or. 1992) (describing as "a formidable task" the determination of the portion of a parent company's stock and debt values attributable to one subsidiary, when other subsidiaries are engaged in other types of businesses).

8 Appraisal Institute, The Appraisal of Real Estate  (14th ed. 2013), 576.

9 Appraisal of Real Estate 569. "Reproduction cost is the estimated cost to construct, as of the effective appraisal date, an exact duplicate or replica" of the improvements, "using the same materials, construction standards, design, layout, and quality of workmanship," including any defects in the existing improvements.  Id. at 569-70.  In contrast, "[r]eplacement cost is the estimated cost to construct, as of the effective appraisal date, a substitute for the [improvements] being appraised using contemporary materials, standards, design, and layout."  Id. at 570

10 The Court also rejected the State's contention it was bound by Minn. R. 8100 (2017) in determining market value, finding that only applied to the State for its mass appraisal of pipelines.

11 Appraisal of Real Estate 703.

12 Appraisal of Real Estate 495.

13 Regarding beta, the Court lacked information on how much it understated the risk of investing in master limited partnerships, as opposed to corporate stocks.

14 It lacked information on the amount by which the Federal Reserve depressed yields on long-term Treasury bonds during the years at issue. No dispute that yields on 20-year U.S. government bonds fell sharply in December 2008 and remained low thereafter. See Shannon P. Pratt & Roger J. Grabowski, Cost of Capital: Application & Examples 103 (chart), 102 (noting "the dramatic decreases in yields during the 2008 Crisis" and that "(t]he intent of these nontraditional quantitative easing (QE) measures was not only to support the economy, but also to drive down long-term interest rates ..."  (5th ed. 2014).

15 Starting in 1942, the U.S. Treasury kept interest rates on U.S. government bonds artificially low to reduce the cost of borrowing during and after World War II. Pratt & Grabowski, Cost of Capital 119-20. Excluding the period between 1942 and 1951 (when the practice ended) from the calculation of historical risk premiums between 1926 and 2012 lowers the ex post risk premium by nearly 1.2 percentage points (from 6.70% to 5.53%). Id. at 120.

16 Pratt & Grabowski, Cost of Capital 458.

17 Id.

18 Notwithstanding the State flip flopped on the issue, the Court found no precedent or basis to include "flotation cost", and thus, rejected those costs in the derivation of the capitalization rate.

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