Tax Revenue Sharing: Down But Not Out! The Supreme Court Weighs in on the CityNorth Case.
February 2010


Over a year ago, the Arizona Court of Appeals, Division I, invalidated an economic development agreement (EDA) between the City of Phoenix and NPP CityNorth, L.L.C. that authorized the sharing of 50% of the sales tax proceeds generated by the CityNorth development. Adopting a new test, the appellate court concluded that almost all of the $97.4 million tax revenue sharing offered to the developer, NPP CityNorth, L.L.C., violated the Arizona Constitution’s “Gift Clause” prohibition against donations or subsidies of public funds to private persons. Of the benefits the City of Phoenix derived from the CityNorth EDA—a new private parking garage offering 2,980 free non-exclusive parking spaces and 200 City-exclusive Park & Ride spaces, increased economic development, new retail uses, additional employment, an new urban core, and increased tax revenues—the appellate court held that only the 200 parking spaces exclusively set aside for City Park & Ride users satisfied the Gift Clause analysis. Both the City of Phoenix and the developer appealed the appellate decision to the Arizona Supreme Court.

On January 25, 2010, the Arizona Supreme Court issued its decision. The Supreme Court vacated the appellate court decision, affirmed the trial court decision upholding the constitutionality of the CityNorth EDA, and then changed the “consideration” for all future economic development agreements. For CityNorth and current holders of EDAs around the state, this is a terrific result—they “won” the first round. For the future, however, this decision constrains but does not eliminate the use of tax revenue sharing as an economic development tool.

What Did the Supreme Court Decide?

The Supreme Court overturned the appellate test. The Court set aside the three-prong test established in the appellate decision. Instead, it reaffirmed the 1984 Wistuber v. Paradise Valley Unified Sch. Dist. two-pronged test that requires a government expenditure to: (1) satisfy a public purpose; and (2) provide consideration from the private entity that is not “’far exceeded by the consideration being paid by the public.’”

The Supreme Court clarified the Wistuber test. The Court clarified and applied Wistuber to the CityNorth EDA. Analyzing the public purpose prong, the Court emphasized the legislative branch’s primary role in determining public purpose, ruling that public purpose will be absent “only in those rare cases in which the governmental body’s discretion has been ‘unquestionably abused.’” This interpretation is consistent with prior Arizona Gift Clause cases explaining public purpose. Applying the public purpose prong to the CityNorth EDA, the Supreme Court determined that the Phoenix City Council did not unquestionably abuse its discretion in deciding the CityNorth agreement had a public purpose.

The Court went a new direction, however, in analyzing Wistuber’s consideration prong. It held that indirect benefits are relevant only in determining public purpose unless such indirect benefits are bargained for as part of the private party’s contractual performance and are not otherwise required by law. For Gift Clause purposes, the consideration prong “focuses instead on the objective fair market value of what the private party has promised to provide in return for the public entity’s payment.” If the public entity’s payments “are grossly disproportionate to the objective value” of what the private party promised to provide in return, the deal fails Wistuber’s consideration prong.

Based on the objective value of the exchange, the CityNorth EDA failed the Court’s clarified consideration analysis. The Court rejected the premise that the un-quantified, indirect benefits relied on by the Phoenix City Council and the developer—projected sales tax revenues, increased employment opportunities, denser development and decreased pollution—constituted consideration for the $97.4 million tax rebate. The Court concluded that the only “relevant” consideration in the CityNorth EDA was the 200 Park & Ride spaces. The Court then “intuited” that the $97.4 million total tax rebate the City of Phoenix promised to pay CityNorth likely “far exceeds” the objective fair market value of the exclusive use of 200 parking spaces and the nonexclusive use of another 2,980 parking spaces.

The Supreme Court applied the clarified Wistuber test prospectively. Rather than using the clarified consideration analysis to invalidate the CityNorth EDA or remanding the case back to the trial court to apply the clarified consideration analysis, the Supreme Court decided to apply Wistuber’s clarified consideration prong to “transactions occurring after the date of this opinion;” in other words, prospectively. This should exempt EDAs that were effective before January 25, 2010.

What Does This Mean?

The Supreme Court’s decision both clarifies and constrains. The Court’s prospective application of its clarified consideration prong means that the clarified analysis cannot be used to challenge existing EDAs. Additionally, given the Court’s deference to the legislature and history, most existing EDAs are probably safe from challenge unless the existing agreement does not serve a public purpose and/or provides blatantly inequitable and unreasonable consideration.

Going forward, however, the clarified consideration prong will require more quantifiable consideration from private parties. At least two big questions remain. First, what amount of public consideration will the Court consider “grossly disproportionate” and therefore an unconstitutional subsidy? On the one hand, the Court tells us that paying $5 million to repair a sewer line that could be fixed for $5,000 is grossly disproportionate (even accounting for the risk of disease, death and significant public health costs if the repair is not made). The Court also suspects that the $97.4 million CityNorth tax rebate for 200 exclusive and 2980 non-exclusive parking spaces is grossly disproportionate. On the other hand, an EDA that offers a tax rebate in an amount equal to the cost of the public infrastructure constructed to support a new shopping center appears proportionate and should pass constitutional muster. But, will consideration include the cost of public infrastructure “required” by a rezoning case? Will a tax rebate that is twice or three times the public infrastructure cost be “far more than the fair market value”? These critical questions will have to be decided on a case-by-case basis.

Second, can (or how can) traditionally indirect benefits meet the clarified consideration prong? The Supreme Court’s consideration analysis suggests we focus on the value of the bargained for exchange, including traditionally indirect benefits. For example, will an EDA withstand challenge if a private entity promises that a project will generate a specific amount of new tax revenue, add a specified number of new jobs, or reduce vehicle miles traveled by a specified amount? We can quantify the value of sales taxes and new jobs; we may even be able to quantify the value of reduced vehicle miles traveled. But, will sales taxes constitute consideration if they are already required by law, while jobs are not? If the value of the bargained for indirect benefits is not grossly disproportionate to the tax rebate and the EDA contains remedies for incomplete performance (i.e. pro rata reduction in the tax revenue share), the deal may satisfy the clarified consideration prong.

Where Do We Go from Here?

The Supreme Court’s clarified consideration prong raises the bar for EDAs, but does not eliminate their usefulness to economic development. A direct dollar-for-dollar exchange will work; un-quantified or grossly disproportionate benefits will not. The challenge lies in public-private transactions that fall in-between, in a grey area where the private party bears the greater risk if the adequacy of consideration is challenged.

This Client Alert has been prepared by Lewis and Roca LLP for informational purposes only and is not legal advice. Readers should seek professional legal advice on matters involving these issues.

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