The property tax assessment on a natural gas pipeline was more than 50% too high, an appeals court said in August.

Transwestern owns a 2,500-mile gas pipeline that crosses five states, including seven counties in Arizona.

The state assessed the part of the pipeline that passes through Arizona at $639.7 million in 2016 and $614.4 million in 2017, but then tried to increase the value to more than $700 million each year after Transwestern challenged the assessments.

After an eight-day trial and more than 1,000 pages of testimony, the Arizona tax court decided the proper assessment was $402.9 million in 2016 and $392.3 million in 2017.

The state appealed.

The appeals court focused on three issues.

One is the weighted average cost of capital used to discount the projected net revenue stream from use of the pipeline in Arizona. The Transwestern appraisal expert said to use discount rates of 10.2% in 2016 and 9.8% in 2017. The state’s expert said 7.11% and 7.8% were more appropriate.

The Transwestern expert included a company-specific risk premium of 3% on grounds that the company has only 10 customers and limited liquidity as a private company. He added another 1.8% in 2016 and 2% in 2017 as a “small-company risk premium.” The court said neither factor justifies these premiums. It sent the case back to the tax court to determine the appropriate weighted average cost of capital.

Transwestern reduced the projected revenue stream by 39% to cover federal and state income taxes, even though Transwestern is not subject to entity-level income taxes. It is a wholly owned subsidiary of Energy Transfer Partners, which is a master limited partnership, or MLP. An MLP is a large partnership whose units are traded on a stock exchange or over-the-counter market. 

The appeals court said it would not second guess the tax court, which allowed the subtraction.

The Arizona tax department conceded that the MLP partners would have to pay income taxes on the income. The appeals court said other states have allowed taxes to be deducted in this situation, citing 2019 and 2020 court decisions in Minnesota involving Enbridge Energy, a diversified energy company that owns oil and gas pipelines and is organized as a partnership.

The last issue is whether it is appropriate to reduce the valuation as Transwestern’s expert did by 59% in 2016 and 60% in 2017 on grounds that the pipeline is economically obsolescent.

Transwestern said the drop in demand during the 2008-to-2009 recession, falling prices for natural gas and competition from green energy have made the pipeline less valuable.

The state said any economic obsolescence is already taken into account in depreciation, and the fact that Transwestern made an additional investment in a lateral to serve Phoenix undermines the claim of economic obsolescence.

The appeals court declined to overrule the tax court. It said poor economic conditions are a recognized source of economic obsolescence.

The Transwestern expert arrived at his economic obsolescence percentages by comparing Transwestern’s current rate of return to its historic return and to the rates of returns of six other pipelines serving the same region.

The case is Transwestern Pipeline Company v. Arizona Department of Revenue. The court released its decision in August.