On February 19, the Third District Court of Appeal issued an order denying requests by both parties for a rehearing of its recent decision, Citizens for Fair REU Rates v. City of Redding. This decision held that a municipal utility’s recurring budget transfer of a payment in lieu of taxes (PILOT) to the City’s general fund constitutes a tax under Proposition 26 unless the City can show on remand that the amount collected is necessary to cover the reasonable costs of providing electric service.1 The order denying requests for rehearing also included limited modifications that do not impact the court’s original judgment.2  

Citizens for Fair REU Rates has serious implications for local governments and the many municipal utilities that currently employ similar PILOT transfers. The ratings agency, Fitch, already indicated that the ruling may impact city ratings, as the PILOT transfers often account for a substantial portion of government inflows and help fund important city services.

The decision, published on January 20, 2015, reversed a trial court order and remanded for an evidentiary hearing to determine whether the City of Redding can show by a preponderance of the evidence that the funds transferred (i.e., the PILOT) are exempt from Proposition 26’s definition of a tax because the PILOT charge reflects “the reasonable costs” of providing electricity to its customers.3 The City’s PILOT is designed to replicate a 1% ad valorem tax that is imposed on privately owned utilities (and passed on to customers through rates). Municipal utilities are exempt from this tax under the California Constitution.4 In 1988, REU adopted a PILOT to collect the same amount that would be charged if it were subject to the ad valorem tax.5 The amount collected is transferred to the City of Redding’s general fund as part of the biennial budget, and the methodology used to calculate the PILOT is occasionally adjusted.6  

A group of citizens challenged REU’s PILOT, contending that because the charge did not reflect an actual cost incurred by the municipal utility, it constitutes a tax under Proposition 26 and requires voter approval. The City made three arguments in response: (1) the PILOT is not a tax pursuant to a specific exemption for charges which are “imposed for a specific government service” and which reflect the true cost of providing this service,7 (2) the PILOT is not a tax “imposed” by the City because any customer may seek alternative means of electric service and thus would not be subject to the charge, and (3) even if it were deemed a tax, the PILOT is “grandfathered-in” because its implementation predated Proposition 26.8  

The trial court accepted the City’s third argument that the PILOT was grandfathered-in and stated that even if it were subject to Proposition 26, it could reasonably be seen to constitute a cost of service. The trial court rejected the City’s second contention, noting that while it was technically possible for a customer to opt out and provide its own electricity, this option is not realistic.9  

On appeal, the court agreed with the trial court only on this last issue, noting that “[a] tax does not lose its revenue-generating character because there is a theoretical but unrealistic way to escape from the tax’s purview.”10 The court rejected the trial court’s finding that the PILOT was grandfathered-in, reasoning instead that because the PILOT is subject to biennial budgetary review (each of which constitutes a distinct discretionary act by the city council), and because the methodology used to calculate the PILOT is periodically adjusted, any revenue collected under the PILOT subsequent to 2010 is subject to Proposition 26.11While the court expressed its inclination that the PILOT does not constitute a true cost of service (noting that the lack of any particular purpose for the transferred funds provided “additional support for the conclusion that the [PILOT] constitutes a revenue-generating tax” rather than a reflection of the true cost of service), it remanded to the lower court for further findings on this issue. The court concluded that the City had not carried its burden of proof to show that the PILOT does not exceed a reasonable cost of service.12  

In a dissenting opinion, Justice Duarte argued that any PILOT, regardless of when it was adopted, "is reasonable as a matter of law" so long as it comports with Proposition 13, and is not subject to Proposition 26’s requirement of voter approval.13 Justice Duarte reasoned that "a fair or reasonable relationship" to cost of service does not require a municipal utility to charge "the least possible amount for municipal services, nor to charge customers the least possible amount for electricity," and that a city may exercise its legislative discretion to find that reasonable utility costs “include an amount equal to what the city would collect in taxes from an equivalent private utility."14  

The parties will likely seek review by the California Supreme Court. Local governments with similar PILOT arrangements should take note and consult with legal counsel to determine the ruling’s impact on their agency.