special report The Riddle of Fee Versus Tax Solved: California's Proposition 26 by Thomas H. Steele, Andres Vallejo, and Scott M.

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1 special report The Riddle of Fee Versus Tax Solved: California's Proposition 26 by Thomas H. Steele, Andres Vallejo, and Scott M. Reiber Thomas H. Steele is a partner, Andres Vallejo is special counsel, and Scott M. Reiber is a tax associate with Morrison & Foerster LLp, San Francisco. One of the authors of this artic;le, Thomas H. Stee.le, served as trial counsel for Equilon in Equilon Enterprises LLC v. Board of Equalization. The onerous requirements that California state and local governments must meet to impose new taxes under propositions 13 and 218 provide substantial incentives for state and local governments to generate increased revenue through the use of fees rather than taxes. Many of the fees imposed resemble what one would typically consider a fee in that they cover the costs of providing a particular benefit sought out by a taxpayer (fees for hunting or fishing licenses, admission fees to enter government parks, and so on), or the costs ofburdens created by particular taxpayers (emissions fees, fees charged to regulate public utilities, and so on). However, the appetite ofstate and local governments for increased revenues, coupled with the public's reluctance to support any increase in taxes, has led state and local governments to impose "fees" that bear no direct relationship to the benefits inuring to, or the burdens caused by, particular taxpayers. This article explores the evolution ofthe legal test in California for determining when a fee is actually a tax. It begins with a brief description of the relevance of the tax versus fee distinction and the test supplied by the California Supreme Court in Sinclair Paint Co. u. State Board ofequalization, for making that distinction. l It then compares the application of the legal standard in Sinclair Paint in two recent cases: California Farm Bureau Federation u. State Water Resources Control Board and ISee Sinclair Paint, 15 Cal. 4th at 866 (1997). (For the decision, see Doc or 97 STN ) Equilon Enterprises LLC u. Board ofequalization. 2 Finally, it describes how Proposition 26, enacted by the voters in November, should accomplish what the California courts have been unable to: bring clarity to the distinction between taxes and fees. A The Relevance of the Tax Versus Fee Distinction and the Test Provided in Sinclair Paint In 1978 the California electorate added Article XIII A, commonly referred to as Proposition 13, to the California Constitution. Section 3 ofarticle XIII A requires any increase in state taxes to "be imposed by an Act passed by not less than two thirds of all members elected to each of the two houses of the Legislature." Similarly, section 4 of Article XIII A requires approval by two-thirds of the electorate before the imposition of any local special tax. In 1996 the voters added to the California Constitution Article XIII C, commonly referred to as Proposition 218, which essentially extended Proposition 13 to local governments. Article XIII C, section 2 prohibits local governments from passing general or special taxes without a majority or two-thirds vote of the electorate, respectively. Because of the "close, 'interlocking' relationship between the various sections of article XIII A," courts have applied the same standards at the state and local level in determining whether an imposition is a tax or fee. 3 The California Supreme Court addressed the distinction between taxes and fees in Sinclair Paint. Sinclair Paint involved a challenge to a levy imposed to fund a program designed to: evaluate, screen, and provide case management for children at risk of lead poisoning; 2California Farm Bureau Federation v. State Water Resources Control Board, No (Cal.,Jan. 31, 2011), and Equilon Enterprises LLC v. Board of Equalization, 189 Cal. App. 4th 865 (2010). (For the decision in California Farm Bureau Federation, see Doc or 2011 STT 22-3; for the decision in Equilon, see Doc or 2010 STT ) 3See Sinclair Paint, 15 Cal. 4th at 873 (1997). State Tax Notes, March /4, 20// 793

2 Special ReporT identify sources of lead contamination responsible for that poisoning; identity and use programs providing adequate case management for children found to have lead poisoning; and provide education on lead poisoning detection and case management to state healthcare professionals_ 4 The levy was imposed on entities that significantly contributed or currently contribute to environmental lead contamination. 5 In describing the tax versus fee distinction, the court in Sinclair Paint stated that "[t]he cases recognize that 'tax' has no fixed meaning, and that the distinction between taxes and fees is frequently 'blurred,' taking on different meanings in different contexts."6 The court stated that in general, taxes are imposed for revenue purposes, as opposed to in return for a specific benefit, and that taxes are typically compulsory, rather than being imposed in response to a voluntary decision to seek government privileges. 7 That said, in some situations fees also may be compulsory.8 Following those parameters, the court in Sinclair Paint enumerated three categories into which fees may be classified: special assessments, based on the value ofbenefits conferred on property; development fees, exacted in return for permits or other government privileges; and regulatory fees, imposed in accordance with the state's police power. 9 The levy in Sinclair Paint was clearly not a special assessment or development fee. Also, the plaintiff in Sinclair Paint argued that the levy at issue in Sinclair Paint could not be a valid regulatory fee because the statute at issue was not regulatory in that it was aimed primarily at producing revenue. lo The court held that as a fundamental matter, under the police power, the state may enact regulatory fees despite having revenue-raising as a primary purpose. In so holding, the court in Sinclair Paint cited San Diego Gas & Electric Co. v. San Diego County Air Pollution Control District (SDG&E),ll a case involving a challenge to a locally assessed levy, for the requirements for a valid regulatory fee: [T]o show a fee is a regulatory fee and not a special tax, the government should prove (1) the estimated costs ofthe service or regulatory activity, and (2) the basis for determining the manner in which the costs are apportioned, so 41d. at 87l. 51d. at d. at 874 (citations omitted). 71d. 8Id. 9Id. lold. at Cal. App. 3d 1132 (1988). that the charges allocated to a payor bear a fair or reasonable relationship to the payor's burdens on or benefits from the regulatory activity.12 Based on this formulation, the court in Sinclair Paint found that the levy is a legitimate fee as long as the revenue from the levy does not exceed the costs of the regulatory activity and the levy is not imposed for an unrelated revenue purpose, and the levy allocated to the payer bears a fair or reasonable relationship to the payer's burdens on or benefits from the regulatory activity.i:\ The court held that the levy was a valid regulatory fce, but indicated that the payer would have the opportunity on remand to prove that the amount of the levy exceeded the costs of the program, that the levy was imposed for unrelated revenue purposes, and that the levy lacked the requisite relationship between the burdens generated by the payer and the amount of the levy charged to the payer. The Court in Sinclair Paint stated that 'the cases recognize that "tax" has no fixed meaning, and that the distinction between taxes and fees is frequently blurred, ' taking on different meanings in different contexts. Showing that the revenue from a regulatory fce does not exceed the costs of the associated regulatory activity and that the charges are not imposed for unrelated revenue purposes is typically straightforward_ The more complex question is often whether the charges allocated to the payer bear a fair or reasonable relationship to the payer's burdens on or benefits from the regulatory activity. In general, the cases addressing this issue have held that the relationship between the amount charged to a payer and the burdens from or benefits to that payer need only be reasonable. For example, in SDG&E the local taxing district allocated a portion of its permit charges, which funded its regulation of stationary sources of pollution, based on the emissions of the permit holder. 14 In finding that the permit charges were fees and not special taxes under Article XIII A, section 4 of the California Constitution, the court stated that a precise showing of how greater emissions increased the burdens on the agency was not required, because "ft]he purpose l2sinclair Paint, 15 Cal. 4th at 878. nld. at San Di {{o Gas & Electric Co. lj. San Diego Air Pollution Control District, 203 Cal. App. 3d at SWle Tax Notes, M{lrch 14, 2011

3 for the district's existence is to achieve and maintain air quality standards... land] thus from an overall perspective it is reasonable to allocate costs based on a premise that the more emissions generated by a pollution source, the ~'Teater the ref,'lllatory job of the district."j5 B. The California Supreme Court's Decision in California Farm Bureau Sinclair Paint's analytical framework for distinguishing between a tax and a fee was recently interpreted by the California Supreme Court in Cal. Farm BureauJ6 At issue in Cal. Farm Bureau were annual fees that the State Water Resources Control Board's Division ofwater Rights imposed on holders of water rights permits and licenses. The division lacked the authority to impose permit and license fees on some holders ofwater rights, including those with riparian or pueblo rights, those who had acquired rights before 1914, and the federal government. Despite not having authority to license those parties, the division's activities benefited those parties by protecting their water rights from all post 1914 applications and permits regarding water appropriations, providing complaint resolution services, and adjudicating their water rights. The water rights held by the parties not subject to the annual permit or license fees represented approximately 60 percent of the water subject to water rights. Because the division was not permitted to impose a fee on 60 percent of the water rights holders, 40 percent of the water rights holders paid fees to support the costs of the entire program. Permit holders filed suit against the division alleging, in part, that the license fees were actually unconstitutional taxes that were not passed by a supermajority of the electorate. 17 The court of appeal held that although the fees were facially constitutional, they were illegal taxes as applied by the division's regulations because the fees did not bear a reasonable relationship to the plaintiffs' burdens on or benefits from the regulatory activity. The division appealed to the California Supreme Court. 15Id. at ; see also Cal. Ass'n. ofprofl Scientists v. Dep't offish and Game, 79 Cal. App. 4th 935 (2000) (upholding a flat fi.~e for conducting environmental reviews on the ground that the flat fee allocation was a reasonable basis for distributing the cost among payers, even though there may not be an exact correlation between each payer and the benefits received or burdens imposed by the payer's activity). 16Both sides have petitioned for rehearing in the case, although none of the grounds for the rehearing appear to affect the portions (}f the opinion relevant to the analysis herein. 17The plaintiffs also raised an issue regarding the fees charged to federal contractors. As an initial matter, the Calif()rnia Supreme Court placed the burden on the fee payers to "establish a prima facie case showing that the fee is invalid."ih The court also held that the fee payers had the burden of producing evidenceyl However, the court said: IO]nce plaintiffs have made their prima facie case, the state bears the burden of production and must show "'(1) the estimated costs of the service or regulatory activity, and (2) the basis for determining the manner in which the costs are apportioned, so that the charges allocated to a payor bear a fair or reasonable relationship to the payor's burdens on or benefits from the regulatory activity."'20 Thus, the fee payers bear the initial burden to establish a prima facie case regarding the costs of the regulatory activity and to establish that those costs do not bear a reasonable relationship to the burdens on or benefits from the regulatory activity. Thereafter, the burden shifts back to the state to show that the requirements of a valid fee are met. In determining whether the challenged levy was a fee or a tax, the court in Cal. Farm Bureau first said that "[t]he question of proportionality is not measured on an individual basis. Rather, it is measured collectively, considering all rate payors."21,22 The state supreme court agreed with the court of appeal that the fees were not facially unconstitutional because the statutes imposing the fees did not require J8Cal. Farm Bureau, No , slip op. at 13 (Cal. Jan. 31,2011). 19Id. at 14. 2oId. at (citations omitted). 21We understand this to mean that a fee need not be directly proportional to the costs that each individual fee payer imposes on the program. Rather, the requirement of proportionality is determined by looking at how the fee is apportioned to various classes of fee payers. Because in the Cal. Farm Bureau case there was a single class of fee payers - permit holders - t.he question on remand is whether the costs (burdens) creat.ed by those fee payers are reasonably reflected in the fees charged to them. In contrast, if there is more than one class of fee payers, the test presumably is proportionality (once it is established that the fees are not used for purposes other than the program costs). For example, if instead of charging no fees to non-permit-holders the division in Cal. Farm Bureau charged the non-permit-holders a total fee of $1, the relevant question would not simply be whether the total fees charged to all holders of water rights (permitted and non-permitted) were reasonably related to the total costs that all water rights holders imposed on the program. The relevant inquiry would also involve whether the fee charged to the permit holders was reasonably related to the costs those permit holders imposed on the program, and whether the $1 fee charged to the non-permit-holders was reasonably related to the costs those non-permit-holders imposed on the program. 221d. at State Tax Notes. March 14,

4 the division to collect fees in excess of the costs incurred in carrying out the division's permit functions.2: 1 The court then addressed whether the fees were unconstitutional as applied to the fee payers because the charges allocated to payers under the division's regulations did not bear a fair or reasonable relationship to the payers' burdens on or benefits from the regulatory activity. The plaintiffs argued that the proportionality had to be measured by the benefits conferred by the division, and that because 40 percent of those benefiting were paying 100 percent of the fees, the fees did not bear a fair relationship to the benefits from the regulatory activity.24 The division, on the other hand, argued that the relevant focus was not on the "broad benefits ofthe program" but rather on the costs incurred by the division. 25 Because the division claimed that "some 95 percent of its time and expense are directed toward servicing and regulating those licensees and permittees against whom the challenged fees were assessed," the 100 percent allocation ofthe fees to the license and permit holders was reasonable. 26 The court agreed with the division that "central to the resolution of this issue is an understanding of the extent and costs of the Division's regulatory 'activity.'"27 Indeed, the court said that Sinclair Paint "directed courts to examine the costs of the regulatory activity and determine if there was a reasonable relationship between the fees assessed and the costs of the regulatory activity."28 Because the trial court did not make adequate factual findings regarding the costs of the regulatory activity, the court remanded the case to the trial court "to make detailed findings focusing on the Board's evidentiary showing that the associated costs of the regulatory activity were reasonably related to the fees assessed on the payors."29 The court said that the trial court "must determine whether the statu- 23Id. at Id. at Id. at d. 27Id. at 19 (citing section 1525(d)(3)). 281d. at 21 (citing Sinclair Paint at pp. 870 and 878). 291d. at 22 (citing Sinclair Paint at p. 870).Justice Moreno's concurring opinion, joined by Justice Werdegar, clarified the issue on remand as follows: In the present case, the State Water Resources Control Board claims that "some 95 percent of its time and expense are directed toward servicing and regulating those licensees and permittees against whom the challenged fees were assessed." (Maj. opn., ante, at p. 20) The support for this contention stems primarily from a document produced by the board on April 15, 2004, shortly after the present litigation commenced. Because of the uncertain reliability of this document, as well as the trial court's lack of findings, remand is (Footnote continued in next column.) 796 tory scheme and its implementing regulations provide a fair, reasonable, and substantially proportionate assessment of all costs related to the regulation of affected payors."30 C. The Court ofappeal's Decision in Equilon Three months before the decision in Cal. Farm Bureau, the Third District Court ofappeal issued its decision in Equilon>ll Equilon involved the same statutes and regulations at issue in Sinclair Paint, but addressed issues that the court in Sinclair Paint did not decide, including whether the fees imposed were reasonably related to the payers' benefits from or burdens on the regulatory program. The fee in Equilon was allocated approximately 85 percent to the gasoline industry based OIl its alleged contribution to "environmental lead contamination," while evidence showed that the majority ofthe costs ofthe program at issue in Equilon were tied to cases of lead poisoning, which the court of appeal acknowledged do not correspond directly to environmental lead contamination.32 The fee payer in Equilon, Equilon Enterprises LLC, argued, similar to the California Supreme Court's holding in Cal. Farm Bureau, that the "feepayers' 'burdens on' the 'regulatory activity' should be determined by looking at the burdens actually addressed by the regulatory program, as evidenced by the program's activities and expenditures."33 Because there was evidence that the program spent the vast majority of its resources on cases of childhood lead poisoning, and because there was evidence that that the gasoline industry was not primarily responsible for cases of childhood lead poisoning, Equilon argued that the fees allocated to the gasoline industry were not reasonably related to the industry's burdens on the program.34 Relying primarily on San Diego County Air Pollution Control District and Cal. Ass'n. of Prof'l. Scientists u. Dep't of Fish and Game, the court of appeal in Equilon rejected the arguments of the fee payer. Rather, the court of appeal held: While we certainly agree that identifying and addressing cases of lead poisoning in children is at the core of the lead program, it does not follow that in allocating the fee imposed to fund the program's activities the department was appropriate to determine whether the board's decisions regarding who would be subject to the fee were reasonable. Cal. Farm Bureau, No , slip op. concurrence at 2 (Cal.,Jan. :n, 2(11). :loid. at 2:1. 3lEquiloll, 189 Cal. App. 4th at 865. :12Id. at Eqlliloft, 189 Cal. App. 4th at 883. :J4Id. State Tax Notes. March 14, 20JJ \

5 .. ~.. ( constrained to an allocation method based only on responsibility fi)r actual cases of lead poisoning in order for the fee to be a legitimate regulatory fee rather than ataxy" The Equilon court noted that despite the program's expenditures, the State Legislature had determined that the broad focus of the program was to address "the consequences of childhood lead exposure resulting from lead contamination in the environment and not simply cases of lead poisoning."36 In other words, the court of appeal determined that the relevant focus was on the broad purposes of the program as defined by the Legislature and not on the costs ofthe activities actually undertaken by the program. Because the decision in Equilon appears to conflict with the more recent decision of the California Supreme Court in Cal. Farm Bureau, Equilon may no longer be good law. Certainly, it is difficult to reconcile the court of appeal's holding in Equilon (that the "burdens" to which the fee allocation must bear a reasonable relationship are the broad purposes of the regulatory program as defined by the Legislature) with the supreme court's holding in Cal. Farm Bureau (that the relevant "burdens"were the costs actually incurred by the regulatory program as a result of the fee payers). Indeed, these conclusions appear to be directly at odds with one another since the Equilon test essentially relates the fees to a legal finding while the Cal. Farm Bureau test looks to a correlation with the program as it actually exists.: 17 Had the court of appeal in Equilon applied the test from Cal. Farm Bureau, it may have reached a different result given its finding that "identifying and addressing cases of lead poisoning in children is at the core ofthe lead program," and the court's conclusion that environmental lead contamination, on which basis the fee was allocated, was not proportional to childhood lead poisoning. 3s D. Proposition 26 Given the ambiguity with which the California courts have addressed the tax versus fee distinction, and given the propensity of state and local governments to overreach in situations in which the legal restrictions on thf~ir authority is unclear, taxpayers :l5equilon, 189 Cal. App. 4th at R85. :l6equi!on, 189 Cal. App. 4th at 884. :17Although one may argue that the cases may be reconciled based on the fact that the Legislature as interpreted in Cal. Farm Bureau appears to have intended that the fees be allocated based on cost, while the Legislature as interpreted in Equi!on appears to have intended that the fees be allocated based on the broad purpose of the program, it seems illogical that the findings of the Legislature would modify the legal standard for determining whether the actions of the Legislature are constitutional. 38See Equilon, 189 Cal. App. 4th at 885, should welcome the clarity that Proposition 26 brings to the tax versus fce distinction. Proposition 26, passed by the California electorate in November 2010, amends the California Constitution to provide a detailed definition ofthe term "tax" as used at both the state and local levels. It also definitively places the burden of proving that a levy is a fee and not a tax on the state or local agency. The amendment says that every levy, charge, or other exaction imposed by the state is deemed to be a tax except for: (1) A charge imposed for a specific benefit conferred or privilege granted directly to the payor that is not provided to those not charged, and which does not exceed the reasonable costs to the State of conferring the benefit or granting the privilege to the payor. (2) A charge imposed for a specific government service or product provided directly to the payor that is not provided to those not charged, and which does not exceed the reasonable costs to the State ofproviding the service or product to the payor. (3) A charge imposed for the reasonable regulatory costs to the State incident to issuing licenses and permits, performing investigations, inspections, and audits, enforcing agricultural marketing orders, and the administrative enforcement and adjudication thereof. (4) A charge imposed for entrance to or use of state property, or the purchase, rental, or lease of state property, except charges governed by Section 15 ofarticle XI. (5) A fine, penalty, or other monetary charge imposed by the judicial branch of government or the State, as a result of a violation of law. 39 The definition of "tax" at the local level is similar, although it also excepts from the definition of tax charges imposed as a condition of property development and assessments and property-related fees imposed in accordance with Article III D of the California Constitution. The burden of proving "that a levy, charge, or other exaction is not a tax, that the amount is no more than necessary to cover the reasonable costs of the government activity, and that the manner in which those costs are allocated to a payor bear a fair or reasonable relationship to the payor's burdens on, or benefits received from, the governmental activity" falls squarely on the state and local government entities. 40 Although the levy in Cal. Farm Bureau may meet the strict requirements of Proposition 26 so that it 1. 3!)Cal. Const. art. XIII A, section 3. 40Cal. Const. arts. XIII A, section 3(d), and XIII C, section State Tax Notes, March 14, 20ll 797

6 could still possibly be sustained if it had been enacted after January 1,2010 (the effective date of Proposition 26), the fee in Equilon does not. The California Supreme Court remanded Cal. Farm Bureau for a determination regarding whether the levy imposed by the division fits requirements similar to those under the third exception to the definition of tax, above; namely, whether the levy is imposed for the reasonable regulatory costs to the division incident to issuing and enforcing its licenses and permits. The "fee" upheld by the court of appeal in Equilon, on the other hand, does not appear to fit within any of the above categories. Although Proposition 26, by its own terms, appears to apply only to levies adopted after January 1, 2010, such that its substantive provisions should not affect the levies at issue in Cal. Farm Bureau and Equilon, the burden of proof provisions in Proposition 26 may apply to pending and future suits involving levies adopted before January 1, "Courts have consistently recognized the principle that a new statute addressing the conduct of trials may actually be prospective in nature when applied to a trial occurring after its effective date, even though the trial deals with facts existing prior to that date,"41 the court in Murphy v. City of Alameda said. That principle does not apply, however, when the newly enacted provision, even though seemingly procedural, "[c]hanges the legal consequences of the parties' past conduct, as by imposing new and different liabilities based on that conduct" or "by imposing an evidentiary requirement with which it is impossible to comply."42 On their face, the burden of proof provisions in Proposition 26 appear procedural in nature in that they address the burden of proof of the parties at trial, and they appear to adopt the same legal standards as those enumerated in Sinclair Paint such that they do not appear to alter the substantive rights of the parties. Moreover, like the provision at issue in Murphy, the provisions in Proposition 26 require only evidence that the exaction is currently not a tax, rather than requiring evidence from the time the levy was enacted, which may be impossible to produce. 43 Thus, taxpayers appear to have a relatively strong argument that the burden of proof provisions in Proposition 26 apply to levies regardless of when they were enacted.44 The outcomes in Cal. Farm Bureau and Equilon do not appear to turn on the burden of proof applied by the courts in those cases, so the burden of proof provisions in Proposition 26 would not have affected the outcomes of these cases. The supreme court in Cal. Farm Bureau, despite initially placing the burden on the plaintiff: appears to have remanded the case for a determination of the "Board's evidentiary showing," and the court ofappeal in Equilon appears to have based its decision on its legal conclusion, rather than on whether either party had satisfied its burden ofproofunder their respective legal theories. However, because the burden of proof in lawsuits often shapes, as a practical matter, how the lawsuit proceeds, payers challenging levies as unconstitutional taxes should consider whether the burden of proof provisions in Proposition 26 would apply to their case even if the levy itself falls outside the definitional provision of Proposition 26 because the levy was enacted before January 1, Payers challenging levies as unconstitutional taxes should consider whether the burden of proof provisions in Proposition 26 would apply to their case even if the levy itself falls outside the definitional provision of Proposition 26. In short, Proposition 26 has fundamentally altered the dynamic surrounding the tax versus fee question in California. It has done so both by significantly tightening the definition of a tax and by clarifying that the burden of proof falls on the government to prove that the levy at issue is not a tax. As noted above, Proposition 26's clarification of the burden of proof may even apply to challenges to levies enacted well before the effective date ofproposition 26. -tc 41Murphy Ii. City of Alameda, 11 Cal. App. 4th 906, 911 (1992) (upholding the application of a statute that shifted the burden of proof in actions challenging the validity of some growth control ordinances to claims involving ordinances enacted before the statute that shifted the burden of prood. 42Id. at See Murphy, 11 Cal. App. 4th at 912 ("The statute directs that in any action challen!,>ing the validity of a growth control ordinance, the city or county shall bear the burden of proof that the ordinance 'is' necessary, not that it was necessary at the time it was enacted."). 41Whether the burden of proofprovisions in Proposition 26 apply to a levy will likely be a fact-specific inquiry that will have to he addressed in the context of the levy being challenged. For example, because the court of appeal found that there was no requirement for the state to periodically review the levy at issue in Equilon, it may be argued that any shifting of the burden of proof would necessarily impose an evidentiary requirement on the state with which it would be unable to comply, thereby affecting its substantive legal rights. See Murphy, 11 Cal. App. 4th at State Tax Notes, March /4, 2011