Minnesota Energy Resources Corporation, Relator v. Commissioner of Revenue, Commissioner of Revenue, Relator v. Minnesota Energy Resources Corporation, A15-422

STATE OF MINNESOTA

IN SUPREME COURT

A15-0422
A15-0438

Tax Court Stras, J.
Took no part, Chutich, McKeig, JJ.

Minnesota Energy Resources Corporation,

Relator,

vs. Filed: November 9, 2016
Office of Appellate Courts
Commissioner of Revenue,

Respondent.

Commissioner of Revenue,

Relator,

vs.

Minnesota Energy Resources Corporation,

Respondent.

________________________

Michael A. Scodro, Gail H. Morse, Jenner & Block LLP, Chicago, Illinois;

Jeffery J. McNaught, Minneapolis, Minnesota; and

Ann E. Kennedy, Minneapolis, Minnesota, for Minnesota Energy Resources Corporation.

Lori Swanson, Attorney General, Michael Goodwin, Assistant Attorney General, Saint
Paul, Minnesota, for Commissioner of Revenue.
________________________

1
 SYLLABUS

1. The evidence in the record supported the tax court’s decision not to include

an additional company-specific risk factor in its calculation of the taxpayer’s cost of

equity.

2. The tax court clearly erred when it failed to explain its determination of the

beta factors used in calculating the taxpayer’s cost of equity.

3. The evidence in the record supported the tax court’s decision to reject the

build-up method of calculating the taxpayer’s cost of equity.

4. The tax court erred when it applied the standard from Eurofresh, Inc. v.

Graham County, 187 P.3d 530 (Ariz. Ct. App. 2007), rather than general evidentiary

principles, to determine whether a taxpayer’s property suffered from external

obsolescence.

5. The tax court did not clearly err when it made a deduction from the income

indicator of value to account for the taxpayer’s nontaxable intangible assets and working

capital.

6. The tax court did not clearly err when it declined to consider a prior sale

when estimating the market value of the taxpayer’s tangible personal property in

Minnesota.

Affirmed in part, reversed in part, and remanded.

2
 OPINION

STRAS, Justice.

In a proceeding before the Minnesota Tax Court, Minnesota Energy Resources

Corporation (MERC) challenged the Commissioner of Revenue’s valuation of its natural-

gas pipeline distribution system for the years 2008 through 2012. With the exception of

2012, the lone year in which it increased the assessed value of the pipeline distribution

system, the tax court reduced the Commissioner’s valuation and ordered the

Commissioner to recalculate MERC’s tax liability. Both parties appeal from the tax

court’s order and raise a variety of challenges to the tax court’s findings and conclusions.

For the reasons that follow, we affirm the tax court’s decision in part, reverse it in part,

and remand to the tax court for further explanation of the beta factors it used to calculate

MERC’s cost of equity and to reconsider whether external obsolescence impacted the

pipeline distribution system’s market value.

I.

MERC, a wholly owned subsidiary of Integrys Energy Group, Inc. (Integrys),

owns a natural-gas pipeline distribution system in Minnesota. During the tax years at

issue, 2008 through 2012, MERC delivered natural gas over 3,600 miles of pipeline to

approximately 205,000 customers in 50 Minnesota counties. As a regulated utility,

MERC’s pipeline distribution system is taxable personal property under Minn. Stat.

§ 273.33 (2014).

MERC’s pipeline distribution system stretches south from Canada across several

states, including Minnesota. Each year, the Commissioner of Revenue determines a

3
market value for MERC’s pipeline distribution system, which includes distribution pipes,

gas mains, gate stations, gas meters, distribution-regulation stations, gas valves, and

odorizing equipment. See Minn. Stat. § 273.33, subd. 2. The Commissioner uses

information provided by MERC to make her calculations. See Minn. Stat. § 273.371,

subd. 1 (2014). After calculating the total market value of MERC’s pipeline distribution

system within Minnesota, the Commissioner apportions the value among the taxing

districts through which it passes. See Minn. Stat. § 273.33, subd. 2; see also Minn. R.

8100.0200 (2015) (“[B]y the process of apportionment, the portion allocated to

Minnesota is distributed to the various taxing districts within the state.”). Each district

then assesses MERC’s personal property based on the share allocated to it by the

Commissioner. See Minn. Stat. § 273.062 (2014). MERC’s real property, by contrast, is

assessed separately by the county or taxing district in which each parcel is located. See

Minn. Stat. § 273.17, subd. 1 (2014).

Before the tax court, MERC challenged the Commissioner’s 2008 to 2012

valuation of the pipeline distribution system. In support of its position that the

Commissioner’s valuation was excessive, MERC presented an expert report and

testimony from Kevin Reilly of American Appraisal Associates, Inc. The Commissioner

relied on the expert opinion of Brent Eyre, an independent accredited senior appraiser

with a background in property-tax valuation, to support an even higher valuation of

MERC’s pipeline distribution system than the amount originally calculated by the

Commissioner.

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 Following a 4-day trial, the tax court issued findings of fact and conclusions of

law, in which it found that Reilly’s report and testimony were sufficient to overcome the

presumptive validity of the Commissioner’s valuation. See Minn. Stat. 272.06 (2014). It

then conducted its own valuation of MERC’s property, based on the relevant law and its

consideration of the testimony of both experts. For each of the years from 2008 to 2011,

the court determined that the market value of MERC’s property was lower than the

Commissioner’s valuation. For 2012, it reached the contrary conclusion, deciding that

the Commissioner had undervalued MERC’s pipeline distribution system by

approximately $13 million. In valuing MERC’s property, the court used a combination

of two of the three approaches to valuing property, the cost and income approaches, and

rejected the third approach, the market approach, after determining that it would not lead

to an accurate assessment of market value. The court also deducted the value of

nontaxable intangible assets and working capital on the basis that neither is taxable under

Minnesota law, a point on which the parties disagree. The following table summarizes

the Commissioner’s original valuation, the valuations proposed by both experts, and the

market-value determination of the tax court, for each taxable year:

Taxable Commissioner’s Eyre’s Reilly’s Tax Court’s
Year Apportionable Apportionable Apportionable Apportionable
Value Value Value Value
2008 $118,247,871 $199,951,677 $51,461,168 $94,732,200
2009 $112,627,661 $231,954,372 $65,250,150 $102,981,800
2010 $144,628,839 $258,799,869 $99,360,276 $131,233,100
2011 $155,934,300 $271,870,280 $106,518,546 $144,747,800
2012 $161,525,900 $273,892,276 $120,510,785 $174,125,500

5
 Both MERC and the Commissioner appeal from the tax court’s decision. MERC

challenges four decisions made by the tax court: its failure to adopt a company-specific

risk factor, its rejection of the build-up method, its lack of explanation of the beta factors

it applied, and its adoption of the Eurofresh standard for proving external obsolescence.

Eurofresh, Inc. v. Graham Cty., 187 P.3d 530, 535, 538 (Ariz. Ct. App. 2007). We will

explain the background principles underlying each of these challenges in more detail

below.

The Commissioner, by contrast, challenges only two aspects of the tax court’s

decision. She objects to the deductions for intangible assets and working capital and

asserts that the tax court clearly erred by rejecting the market approach in its entirety

without at least considering the price paid by Integrys when it purchased MERC in a

2006 arms-length sale. We consolidated the two appeals, designating MERC as the

appellant for briefing and oral argument. We now address the challenges to the tax

court’s decision, beginning with those raised by MERC and then turning to the

Commissioner’s arguments.

II.

Our review of the tax court’s decision is limited and deferential. Cont’l Retail,

LLC v. Cty. of Hennepin, 801 N.W.2d 395, 398 (Minn. 2011). Specifically, “[w]e review

tax court decisions to determine whether the tax court lacked subject matter jurisdiction,

whether the tax court’s decision is supported by the evidence in the record, and whether

the tax court made an error of law.” Hohmann v. Comm’r of Revenue, 781 N.W.2d 156,

157 (Minn. 2010). More generally, we review the tax court’s legal determinations

6
de novo and its factual findings for clear error. Cont’l Retail, 801 N.W.2d at 398. With

respect to the tax court’s valuation of the property, we defer to the tax court’s

determination unless it clearly misvalued the property or failed to explain its reasoning.

Id. at 399.

A.

MERC’s first challenge is to the tax court’s decision to reject the application of a

company-specific risk factor to MERC’s cost of equity. The cost of equity is one of the

components each expert used to calculate the value of MERC’s pipeline distribution

system under the income approach. The court, as well as both experts, estimated value

using direct capitalization, one of two methods of determining value under the income

approach. The direct-capitalization approach “convert[s] a single year’s income

expectancy into” an indication of market value by dividing the estimate of a single year’s

net operating income by a capitalization rate. Appraisal Institute, The Appraisal of Real

Estate 491 (14th ed. 2013); see also Eden Prairie Mall, LLC v. Cty. of Hennepin, 797

N.W.2d 186, 195 (Minn. 2011) (explaining the direct-capitalization approach).

The parties’ disagreement in this case focuses on the capitalization rates applied

by the tax court, and in particular, the cost of equity it used to determine each year’s rate.

The tax court calculated the capitalization rates by estimating both the cost of debt and

the cost of equity for each taxable year, based on the straightforward principle that most

businesses, including utilities, finance the purchase of property through a combination of

debt and equity. See In re Minn. Power & Light Co., 435 N.W.2d 550, 559 (Minn. 1989).

Applying this principle, the tax court multiplied the percentage of equity by the cost of

7
equity and the percentage of debt by the cost of debt using the figures submitted by Eyre,

the Commissioner’s expert. It then added those two figures together to generate a

capitalization rate, which the court then used in combination with the yearly estimates of

MERC’s net operating income to calculate the value of MERC’s pipeline distribution

system. Several of MERC’s challenges, including its argument about the allegedly

erroneous exclusion of a company-specific risk factor, suggest that a single component of

the calculation, the cost of equity, is unrealistically low in light of the risks involved in

MERC’s business.

Specifically, MERC argues that the tax court erred when it failed to apply a

company-specific risk factor to account for the increased risk of a utility business that

operates largely within a single state—Minnesota—and distributes only a single

product—natural gas—to its customers. This circumscribed portfolio of business,

according to MERC, raises the risk for equity investors and necessarily creates a higher

cost of equity. MERC argues that an additional, company-specific risk factor in the cost-

of-equity formula would account for this risk.

Both experts used the standard capital-asset-pricing model to estimate the cost of

equity:

cost of equity = risk-free rate + (beta*market-risk premium) + additional
risk factor.

However, only MERC’s expert, Reilly, applied an additional risk factor of 3 percent.

Eyre, by contrast, used the same model and formula but simply concluded that an

additional company-specific risk factor was unwarranted. The tax court’s decision to

8
exclude the risk factor had a substantial impact on MERC’s cost of equity: with the 3

percent additional risk factor proposed by Reilly, the cost of equity would have increased

from about 8 percent to about 11 percent, which in turn would have substantially

decreased the estimated market value of MERC’s pipeline distribution system under the

income approach.

Before addressing the merits of the parties’ competing positions, we first address

the applicable standard of review. In defending the tax court’s decision, the

Commissioner argues that the court’s refusal to apply a company-specific risk factor was

a factual determination subject to clear-error review because the tax court’s decision

reflected its acceptance of the testimony of one party’s expert (Eyre) and the rejection of

the testimony of the other expert (Reilly). In contrast, MERC suggests that a de novo

standard governs because, in its view, the court adopted two bright-line legal rules,

neither of which allegedly finds support in the record: (1) regulated entities cannot have

their cost of equity adjusted based on company-specific risk; and (2) mathematical

precision is required before applying a company-specific risk factor. We agree with the

Commissioner that the tax court’s rejection of the additional risk factor was a factual

determination subject to clear-error review. See Kohl’s Dep’t. Stores, Inc. v. Cty. of

Washington, 834 N.W.2d 731, 735 (Minn. 2013) (applying the clear-error standard of

review to the tax court’s capitalization-rate calculations).

The tax court excluded a company-specific risk factor from its calculation of

MERC’s cost of equity based on a lack of evidentiary support in the record for the

proposition that MERC’s business was riskier than the market, not because it determined,

9
as a matter of law, that a regulated entity’s cost of equity can never be augmented to

account for additional risk. As the tax court found, there was “no creditable evidence in

the record to support [Reilly’s] claim that MERC, as a rate-regulated entity, experiences

more risk (even if considered a standalone company) than Reilly’s diversified guideline

companies.” The tax court further found that “Reilly provided no support” for choosing

3 percent as the applicable risk factor rather than some other figure. Accordingly,

because the tax court’s decision to exclude a company-specific risk factor from its

calculation of the cost of equity was a factual determination, not a legal conclusion, we

review it for clear error.

Faced with conflicting testimony by competing experts, the tax court agreed with

Eyre’s position that “[p]roperty specific risk or nonsystematic risk should not be

accounted for in the cost of equity, but rather should be accounted in the forecast of

expected cash flows.” Eyre also testified about a study that showed that “there is no

conclusive empirical evidence to support the general practice of adding a small firm risk

premium to the discount rate when valuing small firms.” Another witness, Jon Van

Nurden, an employee of the Department of Revenue, largely agreed with Eyre, stating

that he had not seen support for the application of an additional risk factor in any source

other than the one relied upon by Reilly.

To be sure, MERC accurately observes that Reilly’s report, relying on a multi-

volume publication on business valuation, supports the addition of a company-specific

risk factor to the cost of equity for small, undiversified firms. See 1 Jay E. Fishman et al.,

Guide to Business Valuations 5-21 (5th ed. 1995). Even so, the tax court, as the finder of

10
fact, was entitled to resolve the conflicts in the record and determine how much weight to

give each expert report. See City of New Prague v. Hendricks, 286 N.W.2d 696, 702

(Minn. 1979). The tax court, in other words, was in the best position to weigh the

conflicting opinions, and based on our review of the record, we cannot say that the tax

court clearly erred when it decided to adopt the expert opinions of Eyre and Van Nurden

over Reilly’s opinion. 1

B.

MERC’s second challenge is to the tax court’s explanation of the beta factors it

used to calculate MERC’s cost of equity, which again requires us to examine the capital-

asset-pricing model. Once the court decided to exclude the company-specific risk factor

from the cost-of-equity calculation, it condensed the calculation to the following formula:

cost of equity = risk-free rate + (beta*market-risk premium).

The risk-free rate adopted by the court was the yield on long-term United States Treasury

securities, long viewed by investors as a safe investment. See Appraisal Institute, supra,

at 145; Fishman et al., supra, at 5-15; see also United States v. Doud, 869 F.2d 1144,

1145 (8th Cir. 1989) (discussing “a ‘riskless’ rate, usually commensurate with the interest

paid on government issue bonds and bills”). The market-risk premium, which represents

the additional return required by investors to own an equity security rather than a bond,

was the difference between the return on large-company stocks and long-term

1
Because the tax court did not clearly err when it excluded the additional risk factor
from the cost-of-equity calculation, we need not resolve whether a 3 percent risk factor
would have been appropriate to account for MERC’s company-specific risk.

11
government bonds. See Steiner Corp. v. Benninghoff, 5 F. Supp. 2d 1117, 1134 (D. Nev.

1998) (“The market risk premium is a measure of the additional return needed, on

average, to convince investors to invest in the stock market rather than in risk-free

Treasury Notes.”). Finally, the beta factor, a concept unique to corporate finance,

accounts for the relative volatility of a specific investment compared to the volatility of

the market as a whole. See P.R. Tel. Co. v. Telecomm. Regulatory Bd., 665 F.3d 309, 327

(1st Cir. 2011) (explaining the “ ‘beta’ factor, which estimates the risk of investing in a

particular company by measuring the volatility of its stock as compared to the market as a

whole”); Steiner Corp., 5 F. Supp. 2d at 1134 (“[A] beta is the covariance of a company’s

rate of return against the market rate.”). The tax court’s adoption of a beta factor that was

less than 1 for each taxable year indicated that MERC’s volatility, likely due to its status

as a highly regulated entity, was lower than the market’s risk, 2 which resulted in a lower

cost of equity for MERC than a similar investment with a higher beta factor.

Other than stating that the beta factor was less than 1 for each of the years in

question, the tax court’s order does not specify the value of the beta factors it used for

each year, much less explain how or why it selected them. MERC argues that this

omission by the tax court requires us to remand the case for further explanation so that

we can meaningfully review the tax court’s decision. The Commissioner’s position is

2
An example illustrates beta’s operation. Suppose that a security has a beta factor
of 2 and then the market’s overall value increases by 5 percent. The individual security
with a beta factor of 2 can be expected, on average, to increase in value by 2*.05, or 10
percent, because the individual security moves in the same direction as the market but
with twice the volatility, based on its beta. See Richard A. Brealey et al., Fundamentals
of Corporate Finance 346-48 (7th ed. 2012).

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that, even though the tax court’s order does not reveal the beta factors it used to calculate

MERC’s cost of equity, we can reverse engineer the beta factors by plugging each of the

other figures identified in the tax court’s order into the cost-of-equity formula.

Moreover, the Commissioner says that she independently calculated each of the beta

factors and that they are similar, though not identical, to the beta factors used in Reilly’s

report. The Commissioner’s assertion finds support in the tax court’s statement that its

beta factors were “adapted [from] Reilly’s [b]eta figures.”

Even though the Commissioner is correct that we can isolate the beta factor in the

formula and determine each year’s beta factor arithmetically, the Commissioner’s

suggestion does not resolve the problem with the tax court’s lack of explanation.

Calculating the beta factor for each year would still leave us in the dark about why the tax

court selected any specific beta factor for a particular year, which itself necessitates a

remand. See Westling v. Cty. of Mille Lacs, 512 N.W.2d 863, 866 (Minn. 1994).

Therefore, because we simply cannot determine whether the record supports the beta

factors adopted by the tax court, we reverse the portion of the tax court’s order discussing

MERC’s cost of equity and remand to the tax court for further explanation.

C.

MERC’s third challenge is to the tax court’s decision to reject the build-up method

as an alternative technique for calculating MERC’s cost of equity. The tax court, as well

as both expert witnesses, used the capital-asset-pricing model to calculate MERC’s cost

of equity. Reilly supplemented his valuation of MERC’s pipeline distribution system

with another technique, the build-up method, to determine MERC’s average cost of

13
equity. The build-up method, much like the capital-asset-pricing model, begins with a

risk-free rate, but rather than using a beta factor, it adds a market premium for equity

investments and a size premium to reflect the higher expected rate of return for

investments in smaller companies. See Shannon P. Pratt & Roger J. Grabowski, Cost of

Capital 177 (5th ed. 2012). Reilly’s report deviated slightly from the typical

methodology of the build-up method by substituting the company-specific risk factor for

the size premium. He then used MERC’s average cost of equity, which he derived from

averaging the cost of equities calculated from both the build-up method and the capital-

asset-pricing model, to estimate the market value of MERC’s pipeline distribution system

using the direct-capitalization technique.

The tax court declined to incorporate the build-up method into its calculations, but

the parties disagree on the reason for the court’s decision. The Commissioner suggests

that the court’s decision simply reflects its choice between competing expert opinions,

with the court adopting Eyre’s position that the build-up method would not accurately

estimate MERC’s cost of equity. MERC once again asserts that the court adopted a

bright-line rule that categorically prohibits using the build-up method in the valuation of

regulated entities such as utilities. We agree with the Commissioner’s reading of the

court’s decision.

At trial, Eyre identified problems with Reilly’s use of the build-up method. First,

Eyre explained that the build-up method is traditionally used in situations in which there

are “no comparables out there from which to derive betas,” which was not the case with

MERC. Second, Eyre testified that neither Minnesota Administrative Rule 8100 nor

14
“corporate finance tax” theory requires application of the build-up method. Third, Eyre

criticized Reilly’s decision to use a corporate-bond rate as the risk-free rate, because

corporate bonds are a riskier investment than United States Treasury securities. The tax

court echoed Eyre’s final point, stating in its order that “a government bond rate would

represent a less risky investment than a corporate bond rate.” The court was also

“troubled by Reilly’s failure to use a specific risk premium related to the gas distribution

industry” in calculating MERC’s cost of equity under the build-up method.

MERC responds with a general assertion that each of these reasons for rejecting

the build-up method is unpersuasive. Yet MERC references little testimony, evidence, or

authority to support its position. Rather, one of the few sources it cites says only that the

build-up method is “commonly used,” not that it must be used to value business property

or that it would be particularly useful under these circumstances. See Robert F. Reilly &

Robert P. Schweihs, Guide to Property Tax Valuation 166 (2008). Indeed, nothing relied

on by MERC contradicts Eyre’s testimony that the build-up method is commonly used

only when there are no comparable firms from which to draw reliable beta factors.

The tax court’s decision to reject the build-up method is similar to the situation it

faced with respect to the company-specific risk factor: a disagreement between two

competing expert opinions. Reilly and Eyre had differing opinions about the value of the

build-up method, with Eyre opining that its use in this case was inappropriate and Reilly

advocating for its inclusion. The tax court was in the best position to judge the credibility

of these two experts and to assign weight to their testimony. See City of New Prague,

286 N.W.2d at 702. We defer to its decision to adopt Eyre’s view. We therefore

15
conclude that the tax court did not clearly err when it declined to incorporate the build-up

method into its own calculation of MERC’s cost of equity.

III.

Each of MERC’s first three challenges addressed the tax court’s calculation of the

cost of equity, which was one of the variables it used to estimate the market value of

MERC’s pipeline distribution system under the income approach. MERC’s final

challenge, which involves the court’s determination that MERC’s pipeline distribution

system did not suffer from external obsolescence during the years in question, affects the

court’s estimate of market value under the cost approach.

The cost approach is “founded on the proposition that an informed buyer would

pay no more for the property than the cost of constructing new property having the same

utility as the subject property.” Equitable Life Assurance Soc’y of the U.S. v. Cty. of

Ramsey, 530 N.W.2d 544, 552 (Minn. 1995). As we have recognized, the cost approach,

which estimates market value based on the current cost to construct new or substitute

property, is particularly useful when trying to determine the market value of “special

purpose property” such as pipelines and specialized equipment. S. Minn. Beet Sugar

Coop v. Cty. of Renville, 737 N.W.2d 545, 555-56 (Minn. 2007).

It is clear that MERC’s pipeline distribution system qualifies as “special purpose

property” because “it was designed and built for a special purpose.” Fed. Reserve Bank

of Minneapolis v. State, 313 N.W.2d 619, 612 (Minn. 1981). It is also clear that

“[e]xternal obsolescence often relates to the business enterprise that operates at the

special-purpose property, such that a change in industry conditions could cause the

16
taxpayer to incur a reduction in revenue, profit margin, or return on investment metrics.”

Guardian Energy, LLC v. Cty. of Waseca, 868 N.W.2d 253, 263 (Minn. 2015) (citation

omitted) (internal quotation marks omitted). The tax court correctly defined external

obsolescence, but then found that MERC’s evidence insufficiently demonstrated that

MERC’s pipeline distribution system was externally obsolete.

External obsolescence “is a loss in value caused by negative externalities” that is

“almost always incurable.” Appraisal Institute, supra, at 632. It is one of three forms of

depreciation—functional obsolescence and physical depreciation being the others—that

can decrease the market value of a property under the cost approach. Id. at 576, 633; see

Guardian Energy, 868 N.W.2d at 262. Yet rather than treating external obsolescence in

the same manner as these other forms of depreciation, the tax court has adopted a special

standard for evaluating taxpayer claims of external obsolescence. This standard,

borrowed from the Arizona Court of Appeals, requires “a taxpayer claiming external

obsolescence [to] offer probative evidence of the cause of the claimed obsolescence, the

quantity of such obsolescence, and that the asserted cause of the obsolescence actually

affects the subject property.” Eurofresh, Inc. v. Graham Cty., 187 P.3d 530, 538 (Ariz.

Ct. App. 2007) (emphasis added). In addition to this case, the tax court has applied the

Eurofresh standard in at least two other cases since 2009. See, e.g., Guardian Energy,

LLC v. Cty. of Waseca, Nos. 81-CV-10-365, 81-CV-11-348, 81-CV-11-741, 2014 WL

7476215, at *41 (Minn. T.C. Dec. 9, 2014); Am. Crystal Sugar Co. v. Cty. of Polk, Nos.

C1-05-574, C4-06-367, 2009 WL 2431376, at *25 (Minn. T.C. Aug. 5, 2009).

17
 The tax court examined MERC’s claim that it was entitled to receive a reduction

in market value for external obsolescence under the Eurofresh standard. In an attempt to

satisfy Eurofresh, MERC presented the testimony of five witnesses, including Reilly.

The witnesses pointed to “regulation and rate lags, mild weather, the economic crisis in

2008, and [an] increase [in] use of energy efficient appliances” as contributing to

MERC’s decreased revenues and profit margins. Reilly, in particular, attempted to

demonstrate the existence of external obsolescence by comparing MERC’s lower return

on equity to nine other utility companies that had collectively performed better than

MERC.

Even so, the tax court concluded that MERC’s evidence was insufficient to

warrant an adjustment to the market value of MERC’s property under the cost approach.

The court instead evaluated each of MERC’s explanations individually, rather than

viewing the evidence as a whole, to determine whether MERC’s pipeline distribution

system suffered from external obsolescence during the years in question. In the court’s

view, MERC “had failed to demonstrate that any of these factors affected the subject

property,” even though the court acknowledged “the difference between MERC’s return

on equity and the average return on equity for the gas distribution industry could indicate

that the subject property suffered from external obsolescence.” Clearly, the causal-nexus

requirement from Eurofresh played a decisive role in the court’s decision to reject

MERC’s external-obsolescence evidence. See 187 P.3d at 538.

As MERC observes, we have never adopted the Eurofresh standard as the

appropriate framework for evaluating taxpayer claims of external obsolescence. See

18
Guardian Energy, 868 N.W.2d at 264 (“Because neither party argues that the tax court

applied the incorrect analytical framework in this case, we assume, without deciding, that

[Eurofresh] is the appropriate analytical framework.”). For two reasons, we decline to

adopt the Eurofresh standard now.

First, we have never required taxpayers to make the heightened showing required

by Eurofresh. In Northwest Racquet Swim & Health Clubs, Inc. v. County of Dakota, for

example, we affirmed a decision by the tax court to accept a taxpayer’s claim of external

obsolescence based on an expert opinion that was no more specific than the evidence

presented in this case. 557 N.W.2d 582, 586, 588 (Minn. 1997). There, the taxpayer’s

expert opined that, because a health club received an actual rate of return that was half as

large as its expected rate of return, the property in question suffered from external

obsolescence of 50 percent. Id. at 586. The County’s expert, by contrast, estimated the

health club’s obsolescence based on its location to be 15 percent. Id. Rather than

requiring the taxpayer to show a specific causal nexus between the asserted cause of the

obsolescence and the subject property, the tax court simply “chose a compromise value”

of 25 percent, which was between the estimates of the two experts. Id. We affirmed the

tax court’s decision, reasoning that “a court confronted with conflicting appraisals may

conclude that a compromise in valuation is required, provided it has evidentiary support

and is not unreasonable or clearly erroneous.” Id. at 588. Nothing in Northwest Racquet

supports the imposition of heightened requirements for proving external obsolescence.

See also Am. Express Fin. Advisors, Inc. v. Cty. of Carver, 573 N.W.2d 651, 660 (Minn.

19
1998) (stating that the “the financial losses of [a conference facility]” was probative

evidence of external obsolescence).

Second, the fact that the taxpayer cannot identify the specific causes of external

obsolescence and precisely calculate the contribution of each to decreased revenues or

profit margins does not mean that a property does not suffer from external obsolescence.

As Northwest Racquet suggests, external obsolescence can exist but the cause of it can be

difficult to quantify, resulting in variation among experts in their estimation of the impact

of external factors on the fair-market value of certain properties. 557 N.W.2d at 588

(affirming the tax court’s use of a compromise figure for obsolescence because of the

lack of supporting data to ascertain a reliable figure). In fact, the precision required by

the Eurofresh standard is inconsistent with what The Appraisal of Real Estate calls the

“most persuasive measurement of the effect of negative externalities on value”: “[d]irect

comparison of similar properties with and without external obsolescence.” Appraisal

Institute, supra, at 634. This was precisely the type of evidence that MERC introduced in

this case through Reilly’s testimony, which compared MERC’s returns on equity to those

of nine other similar properties.

We do not suggest that the tax court, on remand, is required to find the existence

of external obsolescence or accept the testimony of MERC’s witnesses. Rather, we hold

that it evaluated MERC’s evidence of external obsolescence under the wrong legal

standard by relying on Eurofresh, and that MERC’s evidence was at least sufficient to

make out a prima facie case of external obsolescence. It will be the tax court’s task on

remand to consider all of the evidence presented to determine whether the evidence of

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external obsolescence is sufficient to support a downward adjustment to the estimated

market value of MERC’s property under the cost approach.

IV.

We now turn to the Commissioner’s cross-appeal, beginning with her argument

that the tax court erred as a matter of law when it deducted the value of intangible

property and working capital from its valuation of MERC’s pipeline distribution system

under the income approach. The Commissioner’s argument requires us to determine

whether these two categories of property are exempt from taxation under Minnesota law.

A.

All real and personal property in Minnesota is taxable, unless exempt by law.

Minn. Stat. § 272.01, subd. 1 (2014). Minnesota Statutes § 272.03, subd. 2(5) (2014),

specifies that taxable “personal property” includes “[a]ll gas, electric, and water mains,

pipes, conduits, subways, poles, and wires of gas, electric light, water, heat, or power

companies.” Minnesota Statutes § 273.33 specifically addresses “pipeline companies”

and grants authority to the Commissioner of Revenue to assess ad-valorem taxes on

“pipeline system[s],” which include “mains, pipes, and equipment attached thereto.” See

also Minn. R. 8100.0100, subp. 11 (2015) (defining a utility’s “operating property” as

“any tangible property that is owned or leased, except land, which is directly associated

with the generation, transmission, or distribution of electricity, natural gas, gasoline,

petroleum products, or crude oil”). The statute specifically exempts the “products

transported through the pipelines” from taxation, as well as pipelines that transport

“petroleum products” exclusively for the pipeline owner’s consumption. See Minn. Stat.

21
§ 273.33, subd. 2. Based on these statutes, the tax court concluded that MERC’s tangible

personal property was taxable, but that its intangible property, including intangible assets

and working capital, was not. Our review of the tax court’s conclusion presents a

question of statutory interpretation that we review de novo. See Cont’l Retail, LLC v.

Cty. of Hennepin, 801 N.W.2d 395, 398 (Minn. 2011).

The Commissioner disagrees with the tax court’s interpretation of these statutes,

stating that a calculation of the market value of MERC’s pipeline distribution system

must necessarily include the value of all intangible assets that affect its value. Those

intangible assets include, according to the Commissioner, MERC’s working capital and

other intangible assets, which reflect the going-concern value of MERC’s property. We

disagree.

The Commissioner’s argument fails to distinguish between tangible and intangible

property, only the former of which is taxable under the statutes and rules that apply to

pipeline companies. By focusing on “mains, pipes, and equipment attached thereto,”

Minn. Stat. § 273.33, subd. 2, allows the Commissioner to tax only a pipeline company’s

tangible property. The administrative rules make this distinction even clearer by granting

authority to the Commissioner to assess taxes on a utility’s “operating property,” which

one of the rules defines as “any tangible property that is owned or leased, except land,

which is directly associated with the generation, transmission, or distribution of

electricity, natural gas, gasoline, petroleum products, or crude oil.” Minn. R. 8100.0100,

subp. 11 (emphasis added); see also id., subps. 14, 16 (2015) (defining “system plant”

and “unit value,” both of which are used in calculating the taxes a utility owes on its

22
personal property). “Nonoperating property,” by contrast, is not taxed according to “the

formula provided . . . for the valuation of utility property.” Minn. R. 8100.0500, subp. 2

(2015).

The tax court’s analysis followed the statutes and rules that treat a pipeline

company’s intangible property as nontaxable. Critically, there is no indication that the

tax court deducted the going-concern value attributable to MERC’s tangible assets, but

rather limited the deduction to the income provided by those intangible assets that are

exempt from taxation under the relevant statutes and rules. In fact, Reilly’s analysis,

upon which the tax court relied, noted that the deduction for intangible assets did not

reduce MERC’s going-concern value. By deducting only the income provided by

MERC’s intangible assets, which are nontaxable, the tax court’s analysis is fully

consistent with the plain language of Minn. Stat. §§ 272.03 (2014), 273.33, and Minn. R.

8100.0100-.0700 (2015).

B.

In addition to its purely legal argument, the Commissioner challenges the tax

court’s specific deductions of 5 percent for working capital and 5 percent for intangible

assets, both of which the tax court adopted from Reilly’s report. The tax court stated that

its deduction for intangible assets was for an “assembled and trained management team

and workforce, computer software, and operating manuals and procedures.” The

deduction for working capital, on the other hand, was based on the “observed levels of

working capital presented by the guideline companies as of the valuation date as well as

historically and consideration of the actual levels of working capital observed by

23
MERC.” The Commissioner argues that, even if the relevant statutes and rules authorize

these deductions, the tax court made them at the wrong stage of the analysis under the

administrative rules.

The Commissioner relies on Rule 8100.0500, which addresses how to make

deductions from the unit value of taxable property for nonoperating and tax-exempt

property. Rule 8100.0500, subpart 1, requires the deductions for nontaxable property to

be made after the calculation of the property’s unit value, which is “the value of the entire

system plant of a utility company taken as a whole without any regard to the value of its

component parts.” Minn. R. 8100.0100, subp. 16. Calculating unit value requires

weighing the three indicators of value, which the rule refers to as the market, income, and

cost indicators of value. Minn. R. 8100.0300. Once the unit value is determined using

some combination of these three indicators, the unit value must then be allocated based

on “the portion of value [that] is attributable to Minnesota.” Minn. R. 8100.0400. Only

at the final stage, after calculating unit value and allocating value, does Rule 8100.0500

allow the tax court to make deductions for the value of nonoperating and tax-exempt

property.

The tax court deviated from the requirements of Rule 8100.0500 by deducting the

working capital and intangible assets from the income indicator of value, rather than

making the deduction at the end of the process, after each of the indicators of value has

been considered and weighed in calculating the property’s unit value. Relying on our

decision in Northwest Airlines, Inc. v. Commissioner of Revenue, 265 N.W.2d 825, 830

(Minn. 1978), the tax court concluded that it was not bound by the process set forth in the

24
Commissioner’s administrative rules. Northwest Airlines does not provide a basis for

ignoring the requirements of binding administrative rules.

Northwest Airlines involved an appeal from the tax court’s valuation of

Northwest’s “airflight property,” including its aircraft. Id. at 827. More specifically, the

case involved the validity of the Commissioner of Revenue’s adoption of a cost-less-

depreciation formula to value Northwest’s property. Id. at 828. In reviewing the

decision, we stated that the tax court, in an appeal from an assessment by the

Commissioner, was not required to use the Commissioner’s formula if it would result in

an inaccurate valuation of the property. Id. at 830. However, Northwest Airlines, unlike

this case, did not involve any administrative rules. In fact, the Commissioner unilaterally

adopted the formula after negotiations with Northwest Airlines had collapsed prior to the

filing of the appeal. Id. at 828.

To be sure, Northwest Airlines reflects the general principle that the tax court has

an independent obligation to determine the market value of property when the taxpayer

challenges the Commissioner’s assessment of taxes. Id. at 830. But it does not stand for

the additional proposition, contrary to the tax court’s analysis, that courts are free to

ignore administrative rules when they believe those rules will result in an inaccurate

valuation. Administrative rules have the force and effect of law, Minn. Stat. § 270C.06

(2014); U.S. W. Material Res., Inc., v. Comm’r of Revenue, 511 N.W.2d 17, 20 n.2

(Minn. 1994), and courts are free to reject them only when they conflict with the statutes

they implement, see Billion v. Comm’r of Revenue, 827 N.W.2d 773, 781 (Minn. 2013).

Mere disagreement with an administrative rule is not a valid reason to disregard it.

25
 Even though the administrative rules are binding on the tax court, the rules

themselves recognize that the Commissioner—and by extension, the tax court—can

“exercise discretion” to depart from the valuation formula “whenever the circumstances

of a valuation estimate dictate the need for it.” Minn. R. 8100.0200. “Discretion may be

used,” among other reasons, “to ensure a balance between a prescriptive rule and sound

appraisal judgment; to ensure that all relevant data pertaining to value is considered;

[and] to ensure that a reasonable estimate of market value is derived.” Id. The

administrative rules, in other words, allow for the exercise of discretion when deviating

from the formula will lead to a more accurate valuation. Accordingly, even though the

tax court was wrong to rely on Northwest Airlines to support its decision to deviate from

the Commissioner’s formula, the administrative rules recognize that it nevertheless had

the authority to do so “to ensure that a reasonable estimate of market value [was]

derived.” Minn. R. 8100.0200.

C.

The Commissioner also raises a purely factual objection to the size of the

deductions for working capital and intangible assets. She says that MERC failed to

satisfy its burden of proof to show that it was entitled to separate 5 percent deductions for

both categories of intangible property. See Minn. R. 8100.0500, subp. 5 (“The utility

company has the burden of proof to establish that the value of any property should be

excluded from the Minnesota portion of the unit value.”). Reilly deducted 5 percent of

the previous year’s income for intangible assets “based on his experience in valuing

energy properties” and stated that intangible assets for these types of properties generally

26
fall between 5 percent and 20 percent of the “total business enterprise.” The tax court

adopted Reilly’s 5 percent figure in part because it was on the low end of the range for

intangible assets for comparable businesses. Although Eyre did not directly challenge the

deduction for working capital, the tax court explained that the 5 percent deduction was

based on “observed levels of working capital” presented by comparable companies as

well as “the actual levels of working capital observed by MERC.”

Here again, the tax court was faced with conflicting expert opinions, with Reilly

opining that the 5 percent deductions for intangible assets and working capital were

supported by comparable energy companies and Eyre challenging the deductions

altogether. As with MERC’s arguments on the addition of a company-specific risk factor

and the use of the build-up method to calculate MERC’s cost of equity, the tax court was

in the best position to evaluate the credibility of each expert and to weigh the conflicting

opinions. See City of New Prague v. Hendricks, 286 N.W.2d 696, 702 (Minn. 1979). We

therefore conclude that the tax court did not clearly err when it adopted Reilly’s opinion

on the necessity of deducting the value of intangible assets and working capital from the

estimated value of MERC’s pipeline distribution system under the income approach.

V.

The final question presented by this case is whether the tax court erred when it

declined to incorporate the 2006 sale of MERC into its calculation of the market value of

MERC’s pipeline distribution system. The tax court is required to consider all relevant

evidence when determining the market value of property. See Indep. Sch. Dist. No. 99 v.

Comm’r of Taxation, 297 Minn. 378, 384, 211 N.W.2d 886, 890 (1973). We have

27
previously acknowledged that prior sales of the subject property can be important

evidence when valuing real property, even though they are “not conclusive.” Archway

Mktg. Servs. v. Cty. of Hennepin, 882 N.W.2d 890, 896 (Minn. 2016). Relying on these

principles, the Commissioner argues that MERC’s 2006 sale, which occurred just 2 years

before the first of the assessments that MERC challenges, is reliable evidence of the

market value of MERC’s pipeline distribution system during the years in question, from

2008 to 2012. For three reasons, we are not persuaded that the tax court erred.

First, MERC’s sale included all of its property, not just the pipeline distribution

system that the Commissioner assessed and the tax court valued. MERC’s purchase price

in 2006 captured the overall value of the entire enterprise—including MERC’s tangible

assets, goodwill, investments, and working capital, some of which we have already

determined is nontaxable. It also included the value of ServiceChoice, MERC’s

appliance-repair business, which is completely separate from MERC’s pipeline

distribution system. Thus, although MERC’s 2006 purchase price includes the tangible

personal property at issue in this case, it also reflects the value of other property that is

either nontaxable or not part of the valuation undertaken by the tax court.

For this reason, the cases relied on by the Commissioner are unpersuasive. The

Commissioner cites various cases for the proposition that a recent sale of the subject

property is relevant evidence that the tax court must consider. See, e.g., Minn. Entm’t

Enters., Inc. v. State, 306 Minn. 184, 188, 235 N.W.2d 390, 393 (1975); Schleiff v. Cty. of

Freeborn, 231 Minn. 389, 394-95, 43 N.W.2d 265, 268-69 (1950). But these cases

involved evidence of a recent sale involving the subject property itself, not a sale

28
involving a combination of different types of property, some of which are not even

taxable. Minn. Entm’t Enters., 306 Minn. at 184, 235 N.W.2d at 391; Schleiff, 231 Minn.

at 392, 43 N.W.2d at 267. Moreover, these cases involved real-property valuation, which

can require a different approach than the valuation of the tangible personal property of a

utility company. In fact, the Commissioner’s administrative regulations, which the tax

court was bound to follow, reflect the differences between valuing the tangible personal

property of utilities and other types of property. Minn. R. 8100.0300, subp. 1 (“Because

of the unique character of public utility companies, the traditional approaches to

valuation estimates of property (cost, capitalized income, and market) must be modified

when utility property is valued.”).

Second, the Commissioner cannot point to any statute or administrative rule that

required the tax court to consider the 2006 sale in its valuation. Instead, Rule 8100.0300,

subpart 1, requires only that the tax court must consider each of the three approaches

(cost, market, and income), but it may not use any approach that is

“not demonstrated to be reliable.” (Emphasis added.) Here, the tax court considered and

rejected application of the market approach, but only after concluding that it was

unreliable and unhelpful.

Third, the experts did not rely on the market approach or MERC’s 2006 sale in

their analyses. In fact, the Commissioner’s expert, Eyre, “placed no weight on the

[market] approach” because “sales [of utility property of this type] rarely occur.” Reilly

reached a similar conclusion, stating that it is difficult to identify “how much of the

29
purchase price [of an energy-distribution company] was paid for intangible assets,” which

precludes “an effective [market] comparison.”

Recognizing that neither expert relied on the market approach, the Commissioner

suggests that the tax court should have used MERC’s 2006 sale as a “benchmark”

showing “that its valuations [of MERC’s property] were far too low.” But without

evidence allowing the court to disaggregate MERC’s purchase price into the component

parts of MERC’s business, the Commissioner does not show how the court could have

derived a reliable value for MERC’s pipeline distribution system from only the 2006

purchase price of MERC’s entire business. 3 We accordingly conclude that the tax court

did not err when it declined to incorporate MERC’s 2006 purchase price into its

calculation of the estimated value of MERC’s pipeline distribution system under the

market approach.

VI.

For the foregoing reasons, we affirm the tax court’s decision in part, reverse in

part, and remand to the tax court for further proceedings consistent with this opinion.

Affirmed in part, reversed in part, and remanded.

3
The Commissioner criticizes the tax court for failing to consider MERC’s internal
documents, including the annual goodwill-impairment studies conducted by Ernst &
Young and the purchase-price allocation done at the time of the sale, in its valuation
analysis. However, the Commissioner does not show how MERC’s 2006 purchase price
necessarily reflected the value of its tangible assets more than 2 years later in 2008 or, for
that matter, in any subsequent year. Nor does the Commissioner indicate how the tax
court could have used these documents to calculate the value of MERC’s tangible
personal property under any of the three approaches mentioned in the administrative rules
in light of the failure of the parties’ experts to do so.

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 CHUTICH, J., not having been a member of this court at the time of submission,

took no part in the consideration or decision of this case.

MCKEIG, J., not having been a member of this court at the time of submission,

took no part in the consideration or decision of this case.

31