Union Pacific Railroad Co. v. State Bd. of Equalization

• Decision Date: 27 June 1991
• Docket Number: No. A042894,A042894
• Court: California Court of Appeals Court of Appeals
• Parties: UNION PACIFIC RAILROAD COMPANY, et al., Plaintiffs and Appellants, v. STATE BOARD OF EQUALIZATION, et al., Defendants and Appellants.

Page 745

282 Cal.Rptr. 745

231 Cal.App.3d 983

UNION PACIFIC RAILROAD COMPANY, et al., Plaintiffs and Appellants, v. STATE BOARD OF EQUALIZATION, et al., Defendants and Appellants.

No. A042894.

Court of Appeal, First District, Division 5, California.

June 27, 1991.

Review Denied Sept. 26, 1991.

Jay R. Martin, Peter W. Davis, John E. Carne, M. Reed Hunter, Crosby, Heafey, Roach & May, Oakland, for plaintiffs and appellants.

John K. Van de Kamp, Former Atty. Gen., Daniel E. Lungren, Atty. Gen., Robert F. Tyler, James B. Cuneo, Supervising Deputy Attys. Gen., Edward P. Hollingshead, Robert D. Milam, Deputy Attys. Gen., Sacramento, Louise H. Renne, City Atty., John J. Doherty, Deputy City Atty., San Francisco, Steven M. Woodside, County Counsel, Karen E. Heggie, Deputy County Counsel, Santa Clara County Counsel, San Jose, for defendants and appellants.

LOW, Presiding Justice.

In this case we review the methods used by the State Board of Equalization (the Board) to assess railroad operating assets. We conclude, as did the superior court, that the Board's "composite life" model cannot legally be applied to railroad operating property. We also hold, however, that the superior court erred in finding illegal certain Board techniques for estimating current railroad income.

Several railroad companies (the Railroads) ¹ brought these consolidated actions for refund of property taxes paid in 1978, 1979, and 1980. (Cal.Const., art. XIII, § 32; Rev. & Tax.Code, §§ 5140-5148.) ² Defendants are the Board, which assessed the property, and numerous counties and cities which collected taxes on it. ³ The trial court found the Board had employed an invalid method of valuation and that certain Board procedures had deprived the Railroads of due process. The court remanded for the Board to recalculate the values, employing changes in methodology specified by the court. After a return by the Board the court ordered refunds in amounts drawn from the Railroads' petitions for reassessment, claims for refund and complaints, because those refunds were smaller than those calculated by the Board on remand.

Procedural Background

After the tax lien date, March 1 of each year, the Board's valuation staff prepares and presents to the Board an "appraisal data report" for each taxpayer. For this report the staff calculates several different "value indicators" and makes a value estimate on the basis of those indicators. The Board also meets with taxpayers for the presentation of the taxpayers' views on valuation. In late May the Board, in a public meeting, sets the values for each taxpayer's property. A valuation notice is sent to the taxpayer; the staff report is usually attached to this notice. The Railroads, in each year at issue here, then petitioned for reassessment. After hearings, if requested by the Railroads, those petitions were denied with appropriate findings by the Board. The Railroads then paid the taxes, filed claims for refunds, and on their denial brought these actions.

The Board's Valuation Method

The Board's primary approach to valuation of these properties was the "income" or "capitalized earnings ability" approach. The income approach estimates current fair market value of a property by attempting to determine the amount that an investor would be willing to pay for the right to receive the future income the property is projected to produce. (Cal.Code Regs., tit. 18, § 3, subd. (e).) It is frequently summarized by the formula V = I/R, where V is the estimated value of the property, I is the projected future income, and R is a capitalization rate by which the present value of the income stream is determined. The Railroads agree that this is the best general approach for valuing railroad operating assets. The central disputes between the Railroads and the Board concern the size of the income stream, in particular, whether the costs of replacing track and rolling stock should be deducted as expenses, and the length of the stream, i.e., whether it should be projected as a perpetuity or a limited lifetime.

The Board projects income only for a limited lifetime, calculated as a "composite" lifetime of the existing team of tangible assets. It does not deduct from the income to be capitalized the cost of replacing those assets in kind. (General operating expenses, including "spot" maintenance of track, are deducted from the income to be capitalized.) The Board projects a level (neither rising nor falling) income over the composite life of the assets. The Board acknowledges that revenue attributable to the aging assets would actually decline over their lifetime, but, in the Board's composite life model, revenues attributable to the longer lived assets are averaged with those attributable to the shorter lived, producing a level income for the composite lifetime. The present value of that income stream is calculated, and the estimated value of the land, which has a perpetual life, is then added.

The Board computed two different values for each property, the first using as the income base the income in the past year, the second using an average of the previous five years' incomes. Before averaging the previous years' incomes, the Board, in 1979 and 1980, adjusted them to current dollars according to increases in the Consumer Price Index (CPI). Regulatory rate increases added during or after the income reporting year, and therefore not fully reflected in the reported revenues, were also added to revenues, with a proportionate adjustment to expenses.

The composite lifetime of the existing assets is an average of the remaining lifetimes of the assets, weighted by their replacement costs. A "capital recovery factor," computed from the composite life, is added to the basic capitalization rate, to account for an investor's need to recover its investment during the limited lifetime. By increasing the denominator of I/R, this has the effect of decreasing the estimated value of the property below what would be reached if the same income were projected over a perpetual life.

The Railroads claim the Board's composite life model is inherently unsuitable for appraisal of railroad properties, which they argue require constant replacement of track structure and rolling stock simply to maintain operating income. They successfully argued below that the Board should be required to use a perpetual life model and to deduct, from income to be capitalized, the costs of replacing assets in kind. The trial court ordered the Board to make the following changes in its income approach valuations:

"1. [Use] the perpetual life model and [deduct] expenditures for track replacement in kind from the income to be capitalized ...;

"2. [Deduct] from income to be capitalized the capital expenditures for replacement of rolling stock and other equipment in an amount ... equal to the book value depreciation ...;

"3. [Omit] the adjustment of income to be capitalized by the Consumer Price Index (CPI);

"4. [Omit] the adjustment to income to be capitalized for prospective rate increases;

"5. [Omit] any capital recovery factor from the capitalization rate."

I Standard of Review and Introduction of New Evidence in the Superior Court

The superior court denied the Board's motion in limine which sought exclusion of any evidence regarding application of the Board's valuation method beyond that contained in the administrative record. The court heard extensive expert testimony from both parties regarding the correctness of various valuation methods, including that employed by the Board. After trial the court concluded that the disputed issues were legal, not factual, and were therefore to be determined de novo. The Board contends that there were disputed issues of fact as to which no new evidence should have been introduced and which should have been reviewed only under a substantial evidence test.

The standard and scope of superior court review depend on the nature of the taxpayer's challenge to the assessment. When the taxpayer claims only that the assessor has erroneously applied a valid method, review is restricted to the administrative record and is limited to determining whether the assessment board's decision was supported by substantial evidence. (Bret Harte Inn, Inc. v. City and County of San Francisco (1976) 16 Cal.3d 14, 23, 127 Cal.Rptr. 154, 544 P.2d 1354.) When the challenge is to the validity of a valuation method itself, however, the question for the superior court is one of law, i.e., whether the method employed was arbitrary, in excess of discretion, or in violation of legal standards. (Ibid.) In determining this legal question, the superior court is not restricted to the administrative record but may take additional evidence as needed. (Trailer Train Co. v. State Bd. of Equalization (1986) 180 Cal.App.3d 565, 582, 225 Cal.Rptr. 717; Georgia-Pacific Corp. v. County of Butte (1974) 37 Cal.App.3d 461, 474, 112 Cal.Rptr. 327.) ⁴

A valuation method may be recognized as theoretically coherent and logical, yet be so inappropriate to the type of property being assessed as to ensure, for all properties of that general kind, that the results reached will not approximate fair market value. A claim of this kind could be termed a challenge to the "application" of the method, presenting a factual question. But where the claim is that, due to the basic undisputed characteristics shared by an entire class of properties, the challenged method will produce systematic errors if applied to properties in that class, the issue is not factual but legal. The issue is not whether the assessor misunderstood or distorted the available data, but whether he or she chose an appraisal method which by its nature was incapable of correctly estimating market value.

An example is found in Southern Pacific Transportation Co. v. State Bd. of Equalization (1987) 191 Cal.App.3d 938, 237 Cal.Rptr. 191. There the railroad contended that the Board's use of historical and reproduction...