Fees masquerading as taxes have become increasingly common. And, as illustrated by the Iowa Supreme Court’s recent decision in Kragnes v. City of Des Moines, Docket No. 09-1473 (Mar. 2, 2012), in some cases all or part of a fee may constitute an illegal exaction to the extent it is deemed to be a tax. In Kragnes, the Iowa Supreme Court affirmed the district court’s holding that municipal franchise fees imposed on gas and electric services for almost 10 years exceeded the city’s reasonable costs of regulating the gas and electric franchises and, thus, the difference between the tax collected by the city and the city’s reasonable costs constituted an illegal tax.

Prior to mid-2009, Iowa cities were authorized to impose franchise fees based on gross receipts from the sale of utility services to the public, but the fees had to be “reasonably related to the reasonable costs of inspecting, licensing, supervising, or otherwise regulating the activity that is being franchised.” Kragnes v. City of Des Moines, 714 N.W.2d 632, 642-43 (Iowa 2006). In 2004, Kragnes filed a class action claiming that at least part of the fees on gas and electric services was, in fact, an illegal tax because the amount of the fees far exceeded what the city was entitled to recover through cost-based franchise fees.

The Iowa Supreme Court reviewed the individual components of the franchise fees in an effort to determine the reasonable costs of regulating each utility. The court found that the costs that the city would incur to maintain rights-of-way even if utilities were not located there could not be included in the franchise fees. The court also held that unexpected, acute costs arising from unforeseen environmental events like ice and snow storms could not be included in the franchise fees. To the extent these costs were included in the franchise fees, the Iowa Supreme Court held that the franchise fees on gas and electric services constituted an illegal tax.

Kragnes is unusual because courts traditionally have analyzed whether a fee is an illegal tax by reviewing the entire fee, not its components. To the extent that other courts are willing to entertain the notion that a part of a fee could be an illegal tax, we anticipate that a number of fees across the country may be subject to challenge.