Law360 recently published an article by Baker Botts Partner Matt Larsen and Senior Associate Bucky Brannen highlighting why Texas developers should monitor school tax changes.
To read the article in Law360, please click here.
Texas property tax rates are among the highest in the country, often exceeding 2.5%. School districts collect the largest share of this tax, with many districts collecting more than half of the total rate.
In 2019, the Texas Legislature's H.B. 3 made major changes to the school finance system, with one of the primary objectives being to lower school district property taxes. Last month, the Texas Education Agency released estimates of how H.B. 3 will affect each school district's 2020 tax rates.1
For many districts, these rate reductions are significant. Moreover, H.B. 3's tax rate compression is a permanent, one-way street — once down, rates stay down.
Large Texas taxpayers — and future taxpayers considering building a large capital-intensive project in Texas — have monitored these school district tax developments carefully, because these rate and other school finance changes will have long-term impacts on large projects, including those with property tax incentive agreements with school districts under Chapter 313 of the Texas Tax Code — Texas' most valuable economic development program.
This article will discuss these impacts, which are continuing to manifest as elements of the new school finance regime are applied for the first time, and will, in the process, highlight issues that large projects should consider, particularly when applying for, negotiating and operating under a Chapter 313 incentive agreement.
Tax Rate Compression
The Texas Education Agency's recent estimates show that the 2020 maintenance and operation tax rates of many school districts have compressed by over 10%.
Under H.B. 3, if districtwide property values increase by more than 2.5%, including new property, then the district's tax rate must compress by a corresponding amount — with a goal of limiting tax collections to 2.5% annual growth — importantly, without affecting school funding, as explained below.
And even if districtwide property values subsequently decline, the maintenance and operation rate remains compressed. H.B. 3 contains no mechanism for increasing the district's maintenance and operation rate back to its previous level — meaning a one-time jump in district values can compress the district's rate for the foreseeable future.
This is particularly important for new facilities, as such projects' new value may dramatically and permanently compress a small school district's tax rate.
Chapter 313 is a critical part of the property tax analysis for large projects considering a Texas location. Since its inception in 2002, the program has attracted nearly 400 projects to Texas. While it is not new, even those familiar with the program will need to consider issues newly raised by H.B. 3 in order to most effectively negotiate and operate under a Chapter 313 agreement.
Chapter 313 Overview
Chapter 313 allows school districts to grant 10 years' tax savings in the form of a value limitation agreement, which limits the school district property tax valuation of a qualifying facility — including manufacturing, renewable energy and certain other projects — to a fixed, lower value for 10 years.
For example, a $1 billion manufacturing facility that enters into a Chapter 313 agreement capping the facility's appraised value at $20 million for 10 years can save more than $100 million in taxes over the life of the agreement — simultaneously improving the project's viability and Texas' attractiveness as a location for the project.
Importantly, school districts do not bear the lost tax collections. Under Texas' Robin Hood school finance system, school district funding is mostly independent of local tax collections. The state ensures that all districts have roughly similar levels of funding per student by making state aid payments to districts with lower tax collections and recapturing revenue from districts with higher collections.
Accordingly, any lost tax collections under a Chapter 313 agreement are replaced by an increase in state aid or decrease in recapture payments. In addition, Chapter 313 agreements typically provide for payments in lieu of tax, or PILOTs, that are independent of state aid and recapture payments, and which thus create a unique revenue opportunity for the district.
With revenue protection payments, or RPPs, preventing downside, and PILOTs ensuring upside, districts have been highly incentivized to use Chapter 313 to help attract large investments to Texas.
H.B. 3's Impact on Chapter 313
H.B. 3 was primarily hailed for increasing school funding, raising teacher compensation and reducing recapture payments from the state's wealthiest districts — all while reducing property tax rates statewide.
But H.B. 3 also brought changes to Chapter 313 agreements, some of which are continuing to be discovered.
Most notably, H.B. 3 (1) fundamentally changed the calculation of, and rationale for, the revenue protection payments described below; (2) compressed tax rates, complicating developers' decision on when to begin the 10-year value limit period; (3) changed the dynamics of negotiations between developers and districts; and (4) introduced new variables into the process of planning for and reviewing revenue protection payments.
In short, H.B. 3 made Chapter 313 agreements even more beneficial for Texas school districts while changing the economics of the agreements for developers.
Effect on Revenue Protection Payments
Chapter 313 agreements generally contain two significant economic incentives for the school district: (1) PILOTs — up to $100 per student, per year for up to 16 years — to induce the district to enter into the agreement; and (2) RPPs, which have historically been indemnity payments that ensure the district will not lose funding under Texas' Robin Hood system because of the Chapter 313 agreement.
As explained above, Texas' Robin Hood system sends state aid to districts with lower tax collections per student, and vice versa recaptures revenue from districts with higher collections. Prior to H.B. 3, these equalizing state aid and recapture calculations were based on the district's tax collections in the prior year.
So, if a district attracted a large facility and experienced significant property growth from Year 1 to Year 2, it would collect more taxes in Year 2 than it would lose from adjustments to state aid or recapture, because state aid or recapture would be calculated based on the smaller Year 1 values.
When a Chapter 313 agreement prevented the district from collecting tax on the facility's full value in Year 2, the district would lose that one year of revenue surplus. So developers would pay RPPs to districts equal to the amount of surplus.
After H.B. 3, state aid and recapture calculations are based on current-year values, so a large year-over-year increase in district property value from a new facility will no longer create a revenue surplus. This change would have largely wiped out any RPPs under Chapter 313 agreements.
But H.B. 3 includes a provision that requires RPPs to continue to be calculated as if the one-year lookback remains in place. Accordingly, RPPs no longer indemnify districts against actual losses. Rather, RPPs are now essentially just another form of PILOT.
In addition to this shift from indemnifying real losses under prior law to indemnifying hypothetical losses under new law, the school finance formulas that form the basis of the calculation have changed.
Developers generally relied on RPP estimates — calculated under old law — when they made their investment decisions. They may have even negotiated specific PILOTs in reliance on those RPP estimates. But those RPP estimates are now outdated.
H.B. 3 may cause higher or lower RPPs and in different years than predicted under prior law. And some developers have discovered that H.B. 3's hypothetical-loss framework will, under certain facts, inflate RPPs when the same school district is party to multiple Chapter 313 agreements.
Tax Rate Compression and Chapter 313 Agreement Structure
As discussed above, H.B. 3 requires school districts to automatically and permanently compress their maintenance and operation tax rate in any year in which school districtwide property values increase by more than 2.5%. This important component of H.B. 3 may cause certain developers and school districts to elect to begin the 10-year value limitation period one year later than they might have under prior law.
For the developer, while this later value limit period may not maximize tax savings during the 10-year agreement, it might achieve greater long-term tax savings over the life of the project by allowing the facility's full value to hit the appraisal rolls before the start of the value limitation and thus achieving indefinite tax rate compression. And for the district, this beneficially reduces property taxes for all constituents without affecting district funding.
Other Effects on Chapter 313 Agreement Negotiations
Following H.B. 3, developers and districts arguably have more flexibility to negotiate RPPs than under prior law. Chapter 313 requires the agreement to include provisions for the protection of future school district revenues only "to the extent necessary" and "through the adjustment of the minimum valuations, the payment of revenue offsets, and other mechanisms agreed to by the property owner and the school district."
Accordingly, the parties might negotiate nontraditional RPP calculation mechanisms under the logic that while H.B. 3 requires RPPs to be based on prior law, the resulting hypothetical losses calculated under pre-H.B. 3 RPP formulas are not necessary to protect school district revenues.
Under old law, RPPs were intended to indemnify district losses, such that districts were hesitant to agree to anything but minor deferral of the RPP. Now that RPPs no longer relate to losses, developers might request to pay an RPP over multiple installments to avoid adding to potential cash-flow issues that frequently arise during the construction period of the project.
Planning For and Auditing Chapter 313 Agreement Assessments
Annual RPP assessments can be large — not uncommonly eight figures. Developers and school districts typically base their budgets on RPP estimates prepared by school finance consultants at the inception of the project.
Following H.B. 3, any estimates based on old law are outdated and likely inaccurate. And projects with Chapter 313 agreements for which RPP estimates are based on H.B. 3 will nonetheless want to periodically update these estimates to account for changes to districtwide property values, tax rates — including maintenance and operation tax rate compression, or the project's construction schedule.
In districts with multiple Chapter 313 agreements, the beginning or ending of one project's value limitation period can significantly inflate another project's RPP — in some cases by millions of dollars. There are reasonable arguments that the RPP should be adjusted to remove this inflation, particularly now that the RPP no longer relates to an actual school district revenue loss.
2021 Legislative Session
While we are just now seeing the first instances of tax rate compression in 2020, H.B. 3 makes this an annual event. Later this year, the comptroller will estimate Texas' statewide property tax growth for the next biennium.
The Texas Education Agency and Legislative Budget Board will use these estimates to set the maximum school district maintenance and operation tax rate for the next two tax years, which will determine the maximum amount by which school district maintenance and operation rates may compress over that time.
Finally, the Chapter 313 program is set to expire on Dec. 31, 2022, meaning the Legislature is expected to review the program in the upcoming 2021 legislative session and determine whether to extend it and whether to make any significant changes to the economic terms described above, or to the types of developers targeted under the program.
Following H.B. 3, it is critical for a large project developer to have a solid understanding of how school district tax rates and school finance law will impact the project, particularly under a Chapter 313 agreement.
Many developers rely on the school district's consultants to estimate these tax rate and Chapter 313 impacts, set the RPP formula and calculate the RPP due each year. But there are several ways in which a developer whose adviser is experienced with school finance law and financial modeling can take a more active role to maximize benefits for both the developer and district under a Chapter 313 agreement, including:
- Negotiating a favorable RPP formula;
- Determining the value limitation period start date that provides maximum tax and RPP savings;
- Determining whether multiple Chapter 313 agreements could be used to provide greater benefits;
- Deferring and/or reducing RPPs and PILOTs for years in which these payments nullify any tax savings;
- Ensuring that other Chapter 313 projects' value limits do not improperly distort the RPP;
- Updating RPP estimates as facts or legal interpretations change; and
- Challenging incorrect RPP calculations performed by school district consultants.
A savvy developer that can calculate the overall tax rate impacts and school finance consequences of a project will be in the best position to reduce property tax exposure and negotiate an optimal Chapter 313 agreement that serves as a win-win to the developer and district.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of approximately 700 lawyers practicing throughout a network of 12 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy, technology, and life sciences sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.