Burlington Northern Railroad v. Bair (648 F. Supp. 91, 1986)

ORDER

STUART, Senior District Judge.

The above-entitled matter is before this Court upon remand from the Eighth Circuit Court of Appeals.

Plaintiff filed this action March 2, 1983, contending that the property tax system of the State of Iowa discriminated against it three ways in violation of section 306 of the Railroad Revitalization and Regulatory Reform Act of 1976, Pub.L. No. 94-210, 90 Stat., 31, 54 (codified at 49 U.S.C. § 11503). This Court found in favor of plaintiff on one issue holding that fifty percent of the plaintiffs property was personal and should be taxed in the same manner as all other personal property in Iowa. 584 F.Supp. 1229 (S.D. Iowa 1984). The claim that in certain years Iowa assessed all of Burlington Northern’s property well in excess of its true market value was dismissed. On March 15, 1985, the Court, in an unreported ruling and order, by applying the arbitrary and capricious standard, held in favor of the defendant on plaintiff’s claim that Iowa assessed most other commercial and industrial property at a much lower percentage than Burlington Northern’s property.

In Burlington Northern Railroad Company v. Bair, 766 F.2d 1222, 1226 (8th Cir.1985) the Court of Appeals held that this Court erred:

(1) in aggregating Burlington Northern’s real and personal property in its section 306 (l)(a) analysis; (2) by imposing an improper burden of proof; and (3) in failing to make findings of fact on assessment values and true market values.

On remand, no additional evidence was taken, briefing has been completed and the case came on for oral arguments June 23, 1986. Before the Court is Burlington Northern’s claim under section 306(l)(a), 49 U.S.C. 11503(b)(1), (c), for proper equalization asserting that the ratio of assessed value to true market value of Burlington Northern’s real property exceeds the ratio of assessed value to true market value of all other commercial and industrial real property by at least five percent. This claim is based on de facto discrimination. Iowa law does not contain different assessment rates, but Burlington Northern claims that the tax system operates in such a manner as to discriminate against it.

Defendant’s original brief on remand quoted a considerable portion of this Court’s March 15, 1985, Ruling and Order and argued that the court had previously made the factual findings required by the Eighth Circuit Court of Appeals and that nothing in the circuit opinion required alteration. The Court does not agree. In reviewing the same seven errors urged here, the Court merely found that the Department did not act arbitrarily or capriciously in using the methodology it did. The Court did make some further findings of fact. The Court will not treat them as the law of the case, but will reconsider such findings in the light of further argument and the change in the burden of proof to be used. A closer examination is called for when the Court must determine the preponderance of the evidence, rather than decide whether the conduct of the defendant was arbitrary or capricious.

In order to make the comparison for equalization purposes under section 306(l)(a), the district court must make findings of fact on: (1) the assessed value of plaintiff’s property; (2) the true market value of plaintiff’s property; (3) the assessed value of all other commercial and industrial property in the same assessment jurisdiction; and (4) the true market value of all such other commercial and industrial property. The district court must calculate the two ratios and determine whether they vary by at least five percent.

Burlington Northern Railroad Company v. Bair, 766 F.2d 1222, 1226 (8th Cir.1985).

Because of the unique nature of railroad operating property, Iowa, like most states, values it for ad valorum tax purposes as a unit. The unit concept is based on the principle that the operating property derives its true value, not from the sum of its parts, but from the integrated use of all of such property to carry traffic, generate income and render public service. As railroads are rarely sold as operating units, comparable sales are unavailable and other methods must be used to attempt to arrive at the value of the operating property of the railroad. Accepted methods are (1) the capitalized earnings method (income method); (2) the stock and debt method; and (3) the depreciated cost method.

The parties do not quarrel about the use of the unit concept nor is there disagreement over the percentage of railroad operating property allocated to Iowa. They also agree on the above methods of evaluation, but differ over the way each method should be applied in attempting to value railroad operating property.

The Court will begin its analysis by considering the most difficult and complex of the four factors upon which findings of fact must be made.

TRUE MARKET VALUE OF PLAINTIFF’S PROPERTY

Burlington Northern contends the Department has made seven significant errors in its valuation process as follows:

A. In weighting the three accepted methods of determining market value.

B. In the income method:

1. in forecasting earnings,

2. in its treatment of current deferred federal income taxes,

3. in its treatment of current liabilities.

C. In the stock and debt method:

1. in the determination of common equity,

2. in the treatment of current liabilities,

3. in the treatment of accumulated deferred federal income taxes.

In attempting to arrive at the true market value of Burlington Northern’s real property, the Court will use as a starting point, The Appraisal Report of the Operating Properties of Burlington Northern Railroad by the Iowa Department of Revenue for January 1, 1981 and January 1, 1982 (exhibits CC and DD) The Court will then discuss each of the claimed errors and arrive at the principles to govern the determination of market value of the plaintiff’s operating property for the years in issue.

A. In weighting the three accepted methods of determining market value.

In arriving at their opinions as to the unit value of plaintiff’s transportation property, the parties gave the three methods referred to above the following weight:

Method Plaintiff Defendant

Income 50% 30%

Stock and Debt 50% 60%

Depreciated cost 0% 10%

The depreciated cost method presumes that the value of railroad system property is equal to its original cost less recorded depreciation and estimated obsolescence. It is primarily an accounting procedure. Any relationship between depreciated cost and value would be coincidental. Mr. Nicholson, the Supervisor for Central Assessment for the State of Iowa, testified that “the cost approach in no way or in very little respects would indicate market value.” The Court holds that the Department erred in giving the depreciated cost method any weight under the circumstances of this case.

The income approach attempts to arrive at the fair market value of the railroad’s transportation property by capitalizing the income generated by the railroad as an operating unit. Here the parties have agreed as to the appropriate rate of capitalization but have substantial differences as to the proper stream of income to be used in the computation.

The stock and debt method utilizes the railroad’s outstanding debt and the equity in all of its securities. The theory is that the true market value of the asset side of the balance sheet is arrived at by properly valuing the debt and equity side of the balance sheet. The parties have significantly different opinions as to the proper way to use the stock and debt method.

Both methods require the exercise of considerable judgment on the part of the appraisers. The Court does not believe that either is preferable. The Department erred in giving more weight to the stock and debt method than the income method. The income method is the most direct measure of the investor’s or buyer’s interest. Prospective buyers of stock or the system are not interested in the railroad property as such, but in the income that an investment in that property will generate.

The Court holds that the plaintiff has established by a preponderance of the evidence that in determining the unit value of plaintiff’s operating property, the income method and the stock and debt method should be weighted equally and that the cost method should not be used.

B. In the use of the income method.

B-l. In forecasting earnings.

In the income approach, plaintiff used the average of its computation of the operating income of Burlington Northern for the last five years on the theory that this method leveled out the extra-ordinary large items in the income stream and minimized the distortions associated with investment tax credits. The Department uses plaintiff’s current year’s income from operations to forecast plaintiff’s income for the next year. Although the Department’s use of current earnings may cause the projected income to fluctuate more from year to year, there was no showing that over the years plaintiff would be prejudiced. Very few railroad appraisers use the five year income average. The evidence has shown that the operating income of Burlington Northern has risen substantially over the last several years and its president expects the trend to continue. This evidence, coupled with the general long term inflationary trend, persuades the Court that the use of the current year’s operating income to forecast the next year’s income is more appropriate. Use of the five year average would result in a consistent under estimation of plaintiff’s earnings for the next year, and consequently undervalue plaintiff’s transportation property. If the trend should reverse and the operating income decrease, the plaintiff would have the immediate advantage of the effect of that decrease on the next years evaluation.

Plaintiff has failed to establish by a preponderance of the evidence that the defendant erred in using the current year’s operating income to forecast the income to be capitalized under the income method.

B-2. In treating deferred taxes.

For book and financial reporting purposes railroads use the straight-line method of computing depreciation prescribed by the I.C.C. However, in order to stimulate investment in new assets, federal tax laws permit taxpayers to depreciate certain asset’s for tax purposes at a faster rate in the early years of an assets life and at a slower rate in the later years. Regardless of whether accelerated or straight-line depreciation is used, total depreciation cannot exceed the cost of the asset. Conceptually, the use of accelerated depreciation for federal income tax purposes simply defers payment of a portion of a taxpayer’s ultimate federal income tax liability. Publically held companies, including railroads, are required to report the total tax expense attributable to pre-tax earnings, but divide the total tax between that which is currently payable under federal law and that which is deferred.

In arriving at its forecast of plaintiff’s operating income, the Department allowed only the taxes currently paid as a deduction and did not consider 50 million dollars of deferred taxes as an expense. This method increases the market value of the transportation property by 250 million dollars. The plaintiff treats deferred taxes as they are treated under Generally Accepted Accounting Principles (GAAP) and ICC Regulatory Accounting and does not add the deferred tax expense back into the amount of income to be capitalized. Plaintiff’s position is supported by the only three reported cases, In re Southern Railway Co., 328 S.E.2d 235 (N.C.1985); Southern Railway Co. v. State Board of Equalization, 682 S.W.2d 196 (Tenn.1984); Pacific Power & Light Co. v. Department of Revenue, 596 P.2d 912 (Ore.1979). This Court takes a different view.

Mr. Nicholson, the Supervisor of Central Assessment for the State of Iowa testified that studies show that deferred taxes are not paid back because for capital-intensive companies, they either grow or are constant. See Davidson, Kirsch & Palast, What Others Think, Utilities Accelerated Depreciation and Income Tax Allocation: An Empirical Study. Public Utilities For-nightly — July 2, 1981. He concluded that investors are aware of this additional source of capital and therefore he included deferred taxes in arriving at the railroad’s income stream. (Tr. 648-649)

The Court is of the opinion that the assumption that deferred taxes will continue to grow and actually will never be paid back is supported by the studies and logic. If deferred taxes are not added into the income stream, the plaintiff would have an increased flow of capital that would not be capitalized. On the other hand, if investments would be less than the depreciation, a negative deferred tax situation would develop where more taxes were actually being paid than would have been paid under the straight-line method, plaintiffs income would be reduced by that amount and the property value lowered accordingly. As it appears that a consistent underestimation of operating income will probably develop if it is not determined by taxes actually paid, and as there would be no prejudice over the long run to plaintiff if deferred taxes are not treated as an expense in arriving at income, the Court believes that the plaintiff has failed to establish by a preponderance of the evidence that the defendant erred in computing operating income by using taxes actually paid and not treating deferred taxes as an expense.

However, for the period of time involved, there is an extraordinary item of deferred taxes that does not fit within the above analysis. Beginning in 1981, the Internal Revenue Service (IRS) permitted railroads to write off the undepreciated base in their track accounts over a five year period. Burlington Northern elected to use an accelerated depreciation method. In 1981, this IRS regulation created a deduction of $400,000,000 and reduced income taxes by over $192,000,000. No additional money was invested. The IRS just permitted a shorter period to write off investments previously made. Deferred taxes were created by the difference between the deduction allowable under the double declining balance method and the straight-line method. These deferred taxes are not within the courts justification for the use of taxes actually paid. The railroad did not invest any additional capital. It just accelerated the depreciation on previous investments in track and roadbed. The deferred taxes on this item should not be added back into the income stream.

The Court holds that the plaintiff has not shown by a preponderance of the evidence that the Department erred in its treatment of deferred taxes except to the extent that it included therein the extra ordinary item discussed above.

B-3. In treating current liabilities.

One of the Department’s expert witnesses, Dr. Martin Gruber, added current liabilities into the value arrived at under the income method. Neither Dr. Schoenwald nor Mr. Nicholson did so. Current liabilities were not used in the final calculations of the Department under the income method. As the Court has used such calculations as a starting point and examined them with respect to the errors urged by plaintiff, the Court need not determine whether Dr. Gruber’s add-on of current liabilities is improper. Defendant does not urge that this add-on should be made. If a determination were required, the Court would find that current liabilities should not be added.

Plaintiff has established by a preponderance of the evidence that it is not proper to adjust the income stream to reflect current liabilities.

C. In the stock and debt method.

The stock and debt approach to value is based upon the premise that the aggregate market value of a company’s outstanding stock and debt reflects the market value of the company’s assets. Plaintiff challenges the Department’s (1) determination of the value of Burlington Northern’s common equity; (2) treatment of current liabilities; and (3) treatment of deferred taxes.

C-l. Valuation of the railroad’s common equity.

As Burlington Northern Railroad is a subsidiary of a holding company, Burlington Northern Inc (BNI), which also includes companies engaged in oil and gas exploration and production, forest products, coal and other minerals, land, trucking and air freight, there is no public trading in the stock of Burlington Northern Railroad as such. Only BNI’s stock is publicly traded. In attempting to determine the market value which investors purchasing BNI’s stock have placed on the operating railroad properties, one must separate the railroad stock from that of the other subsidiaries. An investor would, in purchasing BNI stock consider the income streams and risks attributable to each of these major affiliates and the potential of each in terms of dividends or growth, quality of earnings, the industry involved, the risk of such a company and its relationship to the total assets of the holding company.

In its final computations, the Department arrived at the market value of the equity in Burlington Northern by multiplying the market value of the equity in BNI — a known figure — by the ratio of the book value of investment in the railroad operating property to the book value of the investments in BNI. (89.42%). The Department’s expert Dr. Gruber arrived at the market value of the equity in Burlington Northern by multiplying the total equity of BNI “by the ratio of total income available to equity of the rail subsidiary to the income available to the equity of the holding company.” (EE p. 7)

The most that can be said for these techniques is that they are simple and objective. The Court has already stated that depreciated cost has little or no relationship with value. Book value as used here is equally worthless. As pointed out above an investor takes many factors in addition to income into consideration in determining the market value of a stock. Reliance on one factor could seriously distort the market value an investor would place on the stock of the railroad subsidiary. For instance, BNI owns the largest coal reserves in the United States except for the government. Those reserves would contribute significantly more to the equity value of BNI than the limited income from the coal properties. The Court believes the simplistic methods urged by the Department fail to properly account for the fundamental variances among BNI’s various holdings, and fails to consider other factors that can influence an investor’s opinion as to the market value of stock.

The price/earnings (P/E) multiple used by Dr. Schoenwald and Mr. Batkin, expert witnesses for plaintiff, reflects an investor’s total interest in a stock including risk, growth, earnings, as well as other factors that may apply to a particular industry and a specific company. Lehman Brothers, of which Mr. Batkin is a managing director, was asked to “determine the average market value which investors would have placed on the net assets of the non-rail properties of Burlington Northern Inc. during the calendar year 1981.” Lehman used indices of companies that it determined were in comparable businesses with each of the various BNI subsidiaries. With the exception of the coal and mineral business, Lehman used the average price/earnings multiple for 1981 for the companies selected as comparable. The estimated market value for the coal and mineral business was valued at 2