INSIGHT: Maximizing Benefits Under Texas’ Most Valuable (and Complex) Tax Incentive Program

Overview

The most significant tax incentive program in Texas—the limitation of appraised value for school district property tax under Texas Tax Code Chapter 313—is also its most complex. Project developers who understand and navigate these complexities can maximize Chapter 313’s benefits. This article outlines the key financial components of a Chapter 313 incentive agreement and identifies ways in which a developer can optimize benefits of the agreement in negotiating and administering these financial components.

Chapter 313 Background

Texas property tax rates are some of the highest in the country. In many Texas locales, the combined annual school district, county, city, and special district property tax exceeds 2.5 percent of a property’s market value. This expense can be a major factor in a business’ decision to locate a capital-intensive project in Texas. School district property taxes alone are often well over 1 percent of market value. Chapter 313 was enacted in 2001 to help attract large-scale capital investment in the face of this school district tax burden, and over 375 Chapter 313 agreements have since been implemented.

Chapter 313 allows school districts to target certain categories of new capital investment (including projects involving manufacturing, renewable and clean energy, R&D, as well as capital investments of any type in excess of $1 billion) by placing a 10-year “value limitation” on the investment’s appraised value for school district property tax purposes. Only the portion of a district’s tax rate used for debt service payments is excluded from the appraised value limitation. Each district is assigned its own value limitation amount based on the size and other characteristics of the school district (e.g., urban v. rural). These value limitation amounts range from $10 million for the smallest rural districts to $100 million for the largest urban districts and can generate substantial reductions in a project’s school district property tax burden. For example, a $7 billion liquefied natural gas facility that enters into a Chapter 313 agreement capping the project’s appraised value at $20 million for 10 years can save more than $700 million in tax payments over the life of the agreement—simultaneously improving the project’s viability and Texas’ attractiveness as a location for the project.

This tax reduction will not discourage a school district from entering into a Chapter 313 agreement because under Texas’ school finance system (as explained below) the cost of these tax savings is borne by the state, not the school district. In fact, the typical Chapter 313 agreement will create a revenue windfall for the school district in addition to benefiting the project developer. Moreover, because Chapter 313 agreements do not abate the school district’s debt service taxes, large projects can help districts quickly pay down their debt and decrease future debt payment taxes for all district taxpayers.

However, the same school finance rules that allow both developer and district to benefit from a Chapter 313 agreement are complex enough that many developers fail to optimally apply them in negotiating Chapter 313 agreements. Rather, developers will often accept the initial financial terms offered by the school district (and its financial consultants) in lieu of maximizing tax benefits. A project developer who understands (i) the extent to which Chapter 313 financial terms are negotiable, and (ii) the project’s multiyear impact on the district’s finances under the Texas school finance regime, will be positioned to optimize the benefits available to the project under Chapter 313 while ensuring that the school district is adequately incentivized to enter into the Chapter 313 agreement.

Chapter 313 Agreement Financial Terms

Although many elements of a Chapter 313 agreement are not negotiable, key financial terms are. When the Texas Legislature enacted Chapter 313, it charged the Texas Comptroller with administering the program and promulgating rules and policies. Prior to 2015, Comptroller rules prescribed a number of elements that a Chapter 313 agreement was required to contain, but did not require a standardized agreement form. Responding to calls for simplification, the Comptroller promulgated a Chapter 313 agreement form in 2015 that standardizes language regarding many elements of the program, including minimum investment and job creation thresholds, compliance reporting requirements, and material breach provisions. But the most economically important provisions of an agreement—those governing the financial commitments of the applicant to the school district—are left to be negotiated by the parties. The two types of financial commitments most commonly included in a Chapter 313 agreement are payments in lieu of tax (PILOTs) and revenue protection amounts (RPAs).

PILOTs

PILOTs are discretionary but included in most 313 agreements. PILOTs are annual supplemental cash payments made by the developer to the school district. Chapter 313 caps PILOTs at the greater of $50,000 or $100 per student. This means that PILOTs made to Texas’ smallest school districts are capped at $50,000 per year, while the largest district, Houston ISD, could legally collect nearly $20 million per year in PILOTs. Because these payments are discretionary, they can be freely negotiated up to the statutory cap. A project developer could agree to pay the statutory maximum each year or a lesser amount (e.g., a percentage of tax savings or a fixed amount). A savvy developer who knows what PILOTs other, comparable projects are paying and can calculate the overall financial impact of the project on the district, including likely RPAs (as discussed below), will be in the best position to negotiate optimal PILOTs.

RPAs

Chapter 313 agreements must include provisions “for the protection of future school district revenues through . . . the payment of revenue offsets,” but neither the statute nor Comptroller rules provide further guidance about this requirement. The standard response to this requirement has been for agreements to provide for indemnity payments, commonly known as RPAs, from the developer to the school district guaranteeing that the net tax and school finance revenue received by the district after the 10-year value limitation period begins will not drop below a certain threshold. School districts will often request that this threshold be set by formula as the amount of tax and school finance revenue the district would have received in the absence of a Chapter 313 agreement. There is, however, no authority mandating this formula. The following high-level overview of Texas’ school finance regime explains why that formula is commonly used, but also suggests that there could be alternative ways of satisfying the revenue offset requirement and “protecting school district revenues” that might be preferable to a project developer.

Texas’ school finance system is designed to equalize school district funding such that every Texas school district receives roughly the same level of funding on a dollar-per-student basis (with many exceptions that are beyond the scope of this article). Property-wealthy districts with tax collections that exceed their dollar-per-student allotment will send some tax collections back to the state (these transfers are known as “recapture” payments), which the state redistributes as aid payments to property-poor districts whose collections fall short of their dollar-per-student allotment. Because of this “Robin Hood” system, school district funding is largely unaffected by property wealth, meaning district funding should not be greatly affected by a Chapter 313 value limitation agreement—with a significant exception. School district tax collections are based on current-year property values. But the formulas that govern Robin Hood state aid payments (for property-poor districts) and recapture costs (for property-wealthy districts) are calculated based on prior year tax collections. As a result, an increase in district-wide property values and tax collections results in a one-year windfall to the district (i.e., total revenue greater than its target per-student funding level). Texas doesn’t adjust the district’s state aid payments or recapture costs to reflect the increased tax collections until the following year, at which point the increased collections cause the district to collect less in state aid or pay more in recapture costs to roughly offset these collections. Conversely, drops in district-wide property values can result in a one-year shortfall (total revenue less than its target per-student funding level).

Accordingly, a Chapter 313 value limitation can result in a significant one-year drop in district funding. Consider a new investment with an appraised value of $1 billion in 2018 and a $20 million value limitation that begins in 2019. The district collects taxes on $20 million of property value in 2019, but its state aid/recapture formulas assume the district collected tax on $1 billion of property value—resulting in a significant one-year funding shortfall. An RPA formula could (and arguably should) indemnify the district for the resulting loss.

The RPA formula commonly requested by school districts guarantees the district the amount of revenue it would have received had there been no Chapter 313 agreement. While this formula indemnifies against the type of loss described in the previous paragraph, it can also produce a large one-year windfall RPA payment despite no real loss by the district. For example, if the above facility is valued at $0 for 2018 and $1 billion in 2019, with the $20 million value limitation beginning in 2019, then the district would collect state aid or pay recapture based on $0 of property value, but collect tax on $20 million of property value—there would be no funding shortfall. But despite the lack of a shortfall, the commonly requested RPA formula would guarantee the district the amount of taxes it would have collected in 2019 without the Chapter 313 agreement (i.e., taxes on $1 billion), with no reduction for decreased state aid/increased recapture because there was no project value in the prior year. A developer might argue that this RPA windfall is excessive and negotiate for an alternative calculation formula.

Savings Opportunities for the Knowledgeable

While this oversimplified explanation of Texas’ school finance system provides a high-level understanding of how a Chapter 313 agreement might impact district finances, the impact of a project will vary for every district based on the district’s student count, property wealth, and a number of other district-specific demographic data points. Knowledgeably negotiating the revenue protection payment formula, and predicting/budgeting for future RPAs once the agreement is in place, requires the ability to calculate how various changes in the project investment schedule and district demographics can impact the district’s tax revenues and financial aid payments (both incoming and outgoing).

Many developers rely entirely on school district consultants to set the RPA formula, estimate RPAs during the application process, and calculate the actual RPA due each year. But there are a number of 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 under its agreement, such as:

• Negotiating a favorable RPA formula
• Determining the value limitation period start date that provides maximum tax and RPA savings
• Determining whether multiple 313 agreements could be used to provide greater benefits
• Deferring revenue protection and PILOT payments for years in which these payments offset an atypically large percentage of tax savings
• Ensuring that value losses caused by other 313 agreements do not distort the RPA
• Challenging incorrect RPA calculations performed by school district consultants

Developers seeking nonstandard RPA formulas negotiate in peril if they don’t understand how proposed changes will affect the developer’s RPA obligations. Similarly, many developers will build a project without understanding the degree of variance inherent in an estimated RPA. In smaller school districts, subtle changes to district demographics can result in significant changes to the district’s funding levels. These changes can cause an RPA to be as much as 10 times more than the initial estimate. Developers should be aware of, and attempt to quantify, such risks in budgeting for RPA payments.

School districts are often wary of any attempt to deviate from the Chapter 313 agreement terms their advisors originally propose, but developers with a mastery of Texas school finance and experience with RPA formulas can often identify alternative approaches in which both sides benefit, and can educate the district on these approaches.

Auditing and Disputing Assessments Under Financial Provisions

Annual RPA and PILOT assessments can be large—eight figure invoices are not uncommon. Project developers often pay these invoices without review or challenge, but knowledgeable, well-advised developers have significant opportunities to correct calculation errors or misapplications of agreement financial provisions at the invoicing stage. An invoicing challenge requires the ability to perform the same school finance modeling and RPA formula calculations that the school district’s financial consultants perform when preparing the invoice. Texas’ school finance formulas are sufficiently complex that errors by school district consultants can cause six or even seven figure overcharges. And, as discussed above, school district calculations often fail to take into account the impact of other Chapter 313 projects, leading to RPA assessments that exceed the district’s actual losses.

If a dispute over an RPA calculation or the meaning of financial language in the Chapter 313 agreement cannot be resolved informally, the Chapter 313 agreement commonly requires mediation, with the right to litigate in district court any issues that cannot be resolved by mediation. Litigation costs for such disputes are not typically recoverable from the school districts. As such, it will benefit a developer to handle disputes efficiently, and to engage an advisor who (i) is experienced with business disputes and mediations, (ii) has experience with issues of sovereign immunity, and (iii) can effectively present Chapter 313 and school finance concepts to a mediator or court. Litigation experience can also be important in limiting any inherent advantage the school districts may possess in their own judicial district, where a dispute is likely to be brought.

Conclusion

Chapter 313 offers developers of capital-intensive projects in Texas significant property tax relief. Maximizing this relief, however, requires an understanding of the financial issues discussed in this article and a consistent focus on these issues in negotiating, complying with, and (when necessary) disputing charges under the Chapter 313 agreement.

Author Information

Matt Larsen is a partner, and Bucky Brannen is an associate, in Baker Botts LLP’s Dallas office. Ben Geslison is an associate in Baker Botts LLP’s Houston office. All are members of the firm’s State and Local Tax Section. Mr. Larsen and Mr. Brannen regularly assist clients with all elements of the Chapter 313 process and annually audit (disputing when necessary) RPA and PILOT calculations for developers across Texas. Mr. Geslison is an experienced litigator with significant mediation and litigation expertise disputing complex property tax issues in Texas courts.