This article was originally published and presented at the 2002 IPT Property Tax Symposium. The article was authored by Judith Ross, Senior Manager, Ryan & Company, Atlanta Office. Ms. Ross is a Certified Member of the Institute (CMI), Institute for Professionals in Taxation.
Substantiating obsolescence claims in the assessment process is a difficult task for tax practitioners. It has typically been a challenge to convince assessment officials that the standard cost approach methodology used by their jurisdiction may not necessarily reflect depreciation from all source sand therefore may not result in fair market value.
The tragic terrorist attacks of September 11, 2001 focused considerable attention on the airline industry. While airline tax managers have long attempted to educate assessment officials about the risks and uncertainties inherent in the airline business, the terrorist attacks brought these problems to the forefront.
The events of September 11 fit the textbook definition of external obsolescence. External obsolescence is defined as a loss in value arising from factors outside of the property itself. The terrorist attacks heightened the awareness of problems impacting the airline industry, making the need for obsolescence adjustments more visible and compelling than ever. Although several industries have been adversely impacted by 9/11, the airline industry has been among the hardest hit, particularly passenger carriers where residual fears, security delays and perceived indignations have affected passenger air travel.
This presentation will focus on several strategies for addressing external obsolescence. Although the comments herein are based upon my experience as an airline tax manager, they are not intended to represent the viewpoint of the airline industry or any particular air carrier.
Before we consider specific ways to measure obsolescence, it might be helpful to review some background information about the industry. Airline industry observers have long noted that being in the airline industry is difficult, even in the best of times. Since deregulation in 1978, airline earnings have been extremely cyclical and highly dependent upon general economic conditions.
Source: Air Transport Association
It is important to note that even before 9/11, calendar year 2001 was shaping up to be a very poor year for the industry. Prior to 9/11, industry analysts forecast that the industry would lose $1.5-2.5 billion for the 2001 calendar year. As the result of the terrorist attacks, the loss estimates increased to the $5-10 billion range. Recent estimates peg the actual losses at just over $7 billion.
Rates of return for airlines have long lagged far below that of other industries. For example, according to the Air Transport Association (ATA), the net profit margin for U.S. industry over the last twenty or so years has been in the range of 5-6%. Airlines, on the other hand, have had many years of negative returns during this period, with returns averaging less than 2%.
Source: Air Transport Association
Air carriers, like other "public service" companies such as railroads, pipelines, telecommunications carriers, electric companies, etc., are generally centrally assessed by state agencies rather than locally assessed by county or city assessors. In a number of states, airlines are assessed on a unit value basis, which means that the operating unit is assessed using a business valuation model. Most states in which commercial aircraft taxable use a "summation" approach to value airlines, which means that the assets are individually valued in a manner similar to locally assessed property. Summation methodologies may take two forms, either "cost based" using a depreciation schedule applied against historical cost or "market based" using various published aircraft "price guides". Accordingly, obsolescence arguments must be tailored to fit with each of these three valuation models- unit valuation, cost less depreciation or price guides.
Even before 9/11, a variety of adverse economic conditions had converged to create the "perfect storm" for the airline industry. The primary factors that were causing airlines to lose money during the first half of 2001 include:
- The recession caused a severe cutback in business travel, which is the economic driver of airline profitability
- Fuel costs remained high
- Labor contracts had been settled at wage increases that many observers thought would undermine future profitability
- Intense competition was causing yields to decline
In the aftermath of 9/11, airlines were further burdened with increased security costs and drastically higher insurance premiums.
The airline industry is fortunate to have an industry trade group- the Air Transport Association (ATA). All of the major air carriers are ATA members. The ATA Tax Director is responsible for encouraging consensus among the member carriers regarding positions on tax issues. Over the years, the airlines have engaged in a number of cooperative initiatives to address obsolescence and other valuation issues with state and local assessment officials. Many of these efforts were successful because the airlines were able to "speak with one voice."
Most centrally assessed industries were at one time considered to be "natural monopolies" whose earnings were strictly regulated on their "rate-base". Under rate-base regulation, assets and earning power were clearly linked. Unit valuation models are closely tied to regulatory concepts. Most unit value models consider the three approaches to value- cost, income and market. Unit valuation models utilize historical cost less depreciation as the cost approach indicator, with the implication that the net book value of the asset base is equal to fair market value. In the regulatory framework, public utilities were allowed to earn a "fair return" upon their rate base, which was essentially historical cost less depreciation with certain adjustments. Therefore, it has been long standing practice for unit value states to treat historical cost less depreciation as one indicator of fair market value. States have generally been reluctant to adjust net book value to account for obsolescence even though for unregulated companies, such as airlines, there may be little or no relationship between asset cost and earning power.
For most major airlines, there is a sizeable disparity between the income approach and cost approach as reflected in the various state unit value models. The disparity is caused by the fact that the airline industry operates in a highly competitive, unregulated environment, which is extremely price sensitive. The pricing structure resulting from these conditions generally precludes airline assets from earning a market required return on net book value. A number of low-cost carriers have been able to offer fares below those of major carriers, whose unionized workforces and hub and spoke operations cause the cost structure of major airlines to be considerably higher than that of discount carriers. In recent months, there has been speculation that the business model used by the major airlines is "broken" and not viable in today's economic climate.
As previously stated, airline fare structures have nothing whatever to do with the cost of the airline's assets. Most major airlines have been in the midst of a fleet replacement program for several years. Consequently, although new aircraft are replacing old aircraft and the new aircraft have a much higher book cost, the new aircraft do not enhance the earning power of the air carriers. Although it is true that new aircraft provide efficiencies that lower certain operating costs such as fuel, other costs for new aircraft types, such as labor and insurance, tend to increase. Airlines are not able to charge higher fares on flights using new aircraft as compared to older models. While rate-base regulated companies have the opportunity to pass along the higher cost of their new assets through rate increases, airlines do not enjoy this benefit, as fares are driven by competition and supply and demand- not by asset cost. Thus, for most airlines, asset cost has been continually increasing while income has been relatively flat or declining.
Methods to Measure Obsolescence
Unit Value States
Because the cost approach for airlines is generally much higher than the income approach, reflecting obsolescence in the cost approach can be a significant valuation issue. There are several methods that historically have been used in the context of unit valuation to quantify obsolescence. These are:
|Income or rate shortfall (similar to the "capitalization of rent loss" appraisal technique)
|The "blue chip" method which compares operating efficiencies among companies in an industry to the best indices for each selected statistic
|Inutility or underutilization measures, such as capacity used versus available capacity
Acceptance of these methods to quantify and measure obsolescence in unit value states has been limited. While some states have applied a specific computation of obsolescence using one or more of the above referenced methodologies, most states claim that they account for obsolescence by the correlation process. That is, if a state's unit value model uses three approaches to value, the three value indicators must be correlated into an overall unit value for the operating unit. Because it is common for the income indicator to be substantially below the cost indicator and usually also below the market indicator, which is known as the stock & debt approach, it is not unusual for states to maintain that they account for obsolescence by putting more weight on the income approach.
In arguing for obsolescence prior to 9/11, airline tax managers focused on the cyclical earnings pattern of their companies to support a conservative projection of a normalized income stream. Historically, tax administrators have tended to view positive earnings as indicative of an ever-increasing trend, while they have tended to dismiss poor earnings as an aberration that should have little impact on future value. During the early 1990's,the airline industry experienced staggering losses. In the mid-1990's, the economic climate improved significantly and airlines had the best earnings in their history. During the mid to late 1990's, most major airlines managed to string together 4 or 5 years of positive earnings, which was the longest period of prosperity that the industry had experienced in a deregulated environment. Prior to 9/11, some assessment officials had viewed the earnings performance over the last several years as evidence that the airline industry had overcome past problems and would therefore experience sustained future earnings growth. However, the events of 9/11 proved that airline earnings will always be highly dependent upon economic conditions and external events.
In addition to the traditional methods to measure obsolescence, the events of 9/11 provided the ability to compare asset values and business values in the pre-9/11 environment and the post-9/11 environment. For example, the published aircraft price guides, which will be discussed shortly in more detail, provide evidence of the magnitude of change in aircraft prices, even if one takes issue with the absolute dollar value indicated for the various aircraft types. Similarly, the magnitude of change in a unit value fee appraisal done for 1-1-02 as compared to 1-1-01 may indicate the magnitude of the decline in value, even if one disagrees with the absolute value conclusion presented in the appraisal report.
At the writing of this paper, it is still too early to tell how receptive the unit value states will be to reflecting obsolescence in the valuation judgments that they make. Preliminary indications are that the states are being somewhat more flexible and are not dismissing the negative earnings picture as readily as they had in the early 1990's. Although most states are still not calculating an explicit obsolescence adjustment, state assessment officials appear to be considering the airline industry's grim earnings outlook in the development of an income stream to capitalize.
States using Cost Less Depreciation
States using this valuation methodology generally apply a depreciation table to the historical costs of airline assets. The annual depreciation rates and residual floors used by the various states vary widely, with some being quite favorable and others being less so.
Prior to 9/11, the effort to obtain obsolescence adjustments focused on four issues:
|Recognition of lower values for "Stage 2" aircraft which did not meet Federal noise reduction requirements prior to December 31, 1999
|Application of a different depreciation schedule for "out-of-production aircraft' as compared to "in-production" aircraft models
|Special obsolescence for "troubled" aircraft models, such as B727's and L1011's, which are being removed from airline fleets and disposed of for scrap value
|Adjustments for capitalized airframe and engine modifications that were "replacements" rather than "improvements"
Generally speaking, airlines have had reasonable success with these positions. Prior to 12/31/99, which was the deadline for aircraft operating in the United States to meet specified noise standards, airlines had been able to negotiate more rapid depreciation schedules with lower residual values for the Stage 2 aircraft which did not meet the Federal noise level requirements and thus had to be retrofitted with hush-kits or retired from US operations by 12/31/99. Similarly, various states have been willing to apply more favorable depreciation schedules to older aircraft models that have been out-of-production. In states that would not agree to a separate depreciation schedule for out-of-production aircraft, it was not uncommon for assessing officials to allow a special obsolescence adjustment for aircraft that were in the process of being phased out of domestic airline fleets. With regard to the exclusion of capitalized replacement expenditures, the airlines have had mixed success with acceptance of the position that only "substantial" modifications which add new functionality or extend economic life should be included in the assessable base.
States Using Aircraft Price Guides
There are several states that assess commercial aircraft based upon published price guides. The airline industry has expressed a variety of concerns with the data in these guides. Accordingly, there has been a continuing dialogue regarding appropriate adjustments for using the price guides in the assessment process.
Some assessment officials believe that the various price guides contain valid, recent sales and purchase transactions and are therefore reliable indicators of either a "market" approach or a "replacement cost" approach. Unfortunately, there is misunderstanding as to what the data in these guides truly represents.
The airlines have pointed out numerous problems with respect to using the guides for property assessment purposes. Issues include:
|The guides are not a "blue book for aircraft". In fact, there are relatively few secondary market transactions of commercial aircraft each year. Thus the guides do not in fact represent recent transactions. Consequently, the values appearing in the guides are based primarily upon proprietary trend models that each of the guide publishers has developed rather than upon recent market transactions.
|The few sales that do occur are generally from one lessor to another and are often sales of aircraft sold subject to an existing lease. Therefore, the price paid reflects the value of the anticipated income stream as well as the value for the physical asset.
|Airlines have compiled information showing that actual aircraft acquisition costs are on average 23% below the estimated "price new" in one of the more widely utilized guides. Because most of the published prices are based upon trend models whose starting point is the estimated price new, airlines contend that if the starting point is wrong, the resulting value estimate will also be wrong.
|The few transactions that do occur are typically "one-off" transactions of one or two aircraft to a corporation or lessor. These transactions do not reflect the way airlines buy and sell aircraft. Commercial airlines are not generally participants in the secondary aircraft market, as airlines tend to buy new aircraft and sell old aircraft only at the end of the aircraft's useful life. The price of one aircraft as a stand-alone transaction is not indicative of the value of aircraft operating as a fleet.
|Aircraft sales often include more than just the aircraft itself. In addition to the fact that most sales are of an aircraft sold subject to an existing lease, transactions also tend to include spare parts, spare engines, maintenance and training agreements. Because of the confidentiality provisions specified in most contracts, price guide publishers do not have access to the terms of most transactions.
|When airlines do engage in secondary market activity, airline managers responsible for aircraft acquisitions and dispositions utilize the various price guide publications more in the context of gauging the range of asking prices than as an indication of the market value of any particular aircraft type.
While airlines take issue with the notion that the prices in these guides are indicative of the value of commercial aircraft fleets, the guides have been useful in establishing the magnitude of the value decline as the result of 9/11. As previously stated, even when there is strong demand for aircraft, there are relatively few sales that take place each year. In the wake of9/11, market activity virtually ground to a halt. Despite the lack of actual transactions, various industry sources estimated that aircraft values dropped30% or more depending on fleet type. The comparison of pre-9/11 and post-9/11prices published in the guides therefore provided useful information as to the relative decline in aircraft values. While the absolute prices themselves may not be accurate, the relative change in value can be a meaningful indicator of obsolescence, especially when a variety of sources are coming to similar conclusions regarding the extent of value declines.
One issue that may affect the degree to which assessment officials recognize obsolescence claims for the current and upcoming tax years is the extent to which the impact of 9/11 is considered to be lasting. The widespread opinion appears to be that the adverse impact on airline asset and business values is not temporary. Avitas, a consulting firm specializing in the aviation industry, publishes a guide, which contains both current market values and "base values" (which are defined as the long-term stabilized trend value not affected by market conditions). Avitas estimates that market values will remain well below long-term trend values for the next five years, predicting that current market values and base values will not return to a state of equilibrium until the 2005-06 timeframe.
Other Proposals for Quantifying Obsolescence
Immediately following 9/11, major airlines announced cutbacks in schedules and layoffs of employees in the range of 20%. Stock prices fell 40%-60%for most airlines. Although airlines are now flying at higher load factors than in the weeks following 9/11, it must be kept in mind that there are fewer flights and the fares being offered are extremely low. An article in the November 2001 issue of Air Transport World noted that at the fares being offered even before 9/11, airlines could not break even assuming the planes were 92-93% full. Many sources have pointed out that traffic for full fare business travelers is off significantly and is not predicted to rebound anytime soon. In fact, there is speculation that full fare business travelers may never be willing to pay the type of fares that were once the mainstay of airline revenue.
With the cutbacks in service precipitated by 9/11, new measures of obsolescence were proposed. Some practitioners suggested that obsolescence should be measured by the decline in business factors, which could either be viewed system-wide or based upon the decline in specific jurisdictions. Examples of measures that were proposed are:
- Decrease in landed weight
- Reduction in number of employees
- Percent that schedules were cut
- Decline in Available Seat Miles
- Percent drop in stock price
- Decline in passenger mile yields (which is the amount of passenger revenue earned per revenue passenger mile during a reporting period)
Another indication that aircraft values declined as the result of 9/11 was the escalation in the number of aircraft taken out of service and stored in the desert, awaiting future disposition. Estimates were that the number of parked aircraft increased from a little over 1,000 to 2,400 aircraft after 9/11. Speculation is that many of these aircraft, most of which are older models, will never return to revenue service. While the increase in surplus aircraft does not itself provide a measurement of obsolescence, this information substantiates that there is far more supply than there is demand, which supports the contention that aircraft values have significantly declined.
Public Policy Issues
One of the topics that the speakers for this session were asked to address was the public policy implications of pursuing significant assessment reductions, given the revenue shortfalls being experienced by most jurisdictions. Fortunately for the airline industry, there are relatively few jurisdictions where airlines represent such a significant portion of the tax base that assessment reductions would jeopardize government or school operations. In cases where specific carriers are a highly visible presence in a local community, the decision to pursue various tax strategies is generally influenced by upper management outside of the tax department, such as community affairs, public relations, government affairs and legal departments.
There is much evidence to support airline claims that in the aftermath of9/11, aircraft asset values as well as airline business values have declined markedly.
Although most industries will hopefully never have to experience a tragedy such as 9/11, there are nevertheless other external events that adversely impact property values in a variety of industries. The following are strategies that may be helpful in preparing claims for external obsolescence adjustments.
- Be prepared- know your industry and be willing to spend the time to educate assessment officials on the circumstances that caused the claimed loss in value. It should not take a major catastrophe such as the one faced by the airline industry to convince assessors that there is a legitimate valuation issue that must be addressed.
- Gather external documentation supporting your claim. Public recognition of the problems impacting your industry may offer independent support for a value reduction.
- Demonstrate technical expertise. Taxpayers who can present technical appraisal concepts to support their position and those who know and understand the tax environment (statutes, regulations, case law and the political climate) will likely be more successful.
- Utilize industry trade groups, tax associations or informal coalitions to gain consensus as to how the valuation problem should be addressed. Assessors will have a more difficult time denying relief if industry representatives are asking for consistent treatment and are presenting a unified position.
- Develop alternatives for measuring obsolescence. A particular method to measure obsolescence might not fit all jurisdictions equally well. If assessors are presented with choices as to how to reflect obsolescence, they may be more willing to accommodate a taxpayer's claim.
- Be persistent. Many taxpayers do not get the relief they seek because they give up too easily.
- Understand the assessment official's position. If there is initial resistance to an obsolescence claim, help the assessing official find answers to his or her concerns. Working cooperatively with an assessor to overcome these concerns can build trust, rapport and credibility.
Although these strategies may seem self-evident, it is surprising how many taxpayers do not have the time and/or resources to put together a persuasive case for obsolescence. It is not unusual for troubled industries to be paying far more in property taxes than they should because their companies will not allocate the resources necessary to successfully seek valuation reductions. The challenge for corporate tax representatives in today's economic environment is to convey to their management that the potential benefits of a legitimate and well-founded obsolescence claim is well worth the expenditure of resources.