California Appellate Court Rules on Nexus of Special-Purpose Entities, Tells Lower Court to Rule on Constitutionality of Filing Election

By Mark Cook, MBA, CPA, CGMA, Irvine, Calif., and Peter Seidel, J.D., LL.M., Los Angeles

Editor: Mark G. Cook, CPA, MBA, CGMA

On May 28, 2015, the Court of Appeal for California's Fourth District issued a two-part ruling in the case of Harley-Davidson, Inc. v. Franchise Tax Board, 237 Cal. App. 4th 193, 187 Cal. Rptr. 3d 672 (Cal. Ct. App. 2015), determining that (1) two special-purpose entities (SPEs) related to Harley-Davidson Inc. (HD), with no physical presence in California, nevertheless established nexus under both the Due Process and Commerce Clauses of the U.S. Constitution under an agency theory, through related companies doing business in California; and (2) the California superior court erred in sustaining the Tax Board's demurrer of HD's challenge to the constitutional legitimacy of California Revenue and Taxation Code Section 25101.15 under the Commerce Clause. That section allows purely California (i.e., intrastate) combined filing groups to make an annual election to file either on a combined basis or on a separate-entity basis. Combined filing groups located within and without California (i.e., interstate) do not have the option to file on a separate-entity basis.

Special-Purpose Entity Nexus

From 2000 to 2002, a subsidiary of HD, HD Financial Services (HDFS), created two SPEs to secure loans created by HDFS. Both the appellate court and superior court determined that HDFS established nexus via its relationship with third-party HD dealerships in the state: HDFS and the dealerships were seen as interdependent because HDFS provided training and consulting services to the dealerships. A separate HD subsidiary, HD Credit Corp. (HDCC), was the entity responsible for accepting loans.

In a standard HD financing transaction, HDFS first approved the retail loans, and HDCC then obtained the loans for submission to the SPEs. After the SPEs purchased the loans from HDCC, they transferred the loans into SPE trusts for securitization. The SPE trusts sold securities to provide additional liquidity to HDCC, allowing HDCC to expand its loan business. Relying primarily on the California appellate court decisions in Borders Online v. State Bd. of Equalization, 29 Cal. Rptr. 176 (Cal. Ct. App. 2005), and Scholastic Book Clubs, Inc. v. State Bd. of Equalization, 255 Cal. Rptr. 77 (Cal. Ct. App. 1989), the Harley-Davidson court determined that the interaction between the SPEs and HDCC created an agency relationship.

Rejecting HD's claim that agency requires satisfaction of what the court referred to as a "rigid, three-factor test" for determining whether there was an agency relationship (see Harley-Davidson, fn. 14, citing Alvarez v. Felker Mfg. Co., 41 Cal. Rptr. 514 (Cal. Ct. App. 1964)), the court focused on the following facts to make its determination:

  • The SPEs were created for the purpose of establishing more favorable pricing for HDCC, and they were only permitted to securitize HDCC loans;
  • The SPEs had no employees of their own but acted entirely through HDCC employees;
  • The directors and officers of the SPEs were the same as the directors and officers of HDCC; and
  • HDCC exercised significant control over the SPEs: HDCC selected the pools of loans to securitize, undertook collection activities on the SPE loans, and provided the employee who visited California over a total of 17 days to work on the auctions involving HD motorcycles.

Based on this relationship, the court determined that the SPEs established the requisite nexus in California under both the Due Process and Commerce Clauses.

Due Process Clause

Relying on the Supreme Court holding in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the court found that the SPEs had purposefully availed themselves of California's market via HDCC and HDFC by establishing the requisite "minimum contacts" with the state, and the imposition of tax on the SPEs did not offend "traditional notions of fair play and substantial justice" (Harley-Davidson, 237 Cal. App. 4th at 216). The court determined this because the real purpose of the SPEs was to generate liquidity for HDCC; the SPE loan pools contained more loans from California than any other state; and when California customers defaulted on their loans, it was HDCC that oversaw the collection activities, including the repossession and sale of the motorcycles at California auctions.

The court rejected HD's arguments that (1) a finding of nexus based on agency requires the out-of-state entity to exercise "pervasive and continuous operational control" over the in-state entity (i.e., the agent); and (2) the U.S. Supreme Court's holding in J. McIntyre Machinery, Ltd. v. Nicastro, 131 S. Ct. 2780 (2011), bars nexus under the Due Process Clause unless the SPEs specifically availed themselves of California's market. The court's primary objection to the J. McIntyre argument was that, unlike the facts in J. McIntyre, the SPEs' contact with California was not established through independent distributors but through the SPEs' corporate parent. Also, the SPEs arguably did target the California market because HDCC attended 17 motorcycle auctions in California.

Commerce Clause

Having established an agency relationship between the SPEs and HDCC, the court in its Commerce Clause analysis relied primarily on the U.S. Supreme Court cases of Tyler Pipe Industries v. Department of Revenue, 483 U.S. 232 (1987), and Scripto v. Carson, 362 U.S. 207 (1960). Those cases established the prevailing rule that an agent's presence in a state can satisfy an out-of-state company's physical-presence requirement under the Commerce Clause. With that in mind, the court addressed three of HD's Commerce Clause objections to nexus for the SPEs:

1.The SPEs lacked physical presence in California: With the agency relationship established between the SPEs and HDCC, the physical location of the SPEs was immaterial.

2.Third parties only establish nexus for an out-of-state company where their activities are "significantly associated with the [out-of-state entity's] ability to establish and maintain a market" in the state: The court responded that nexus-creating activities need not be limited to sales activity. More important to the court was that the activities of HDCC were "integral and crucial" to the SPE's securitization business.

3.The activities of HDCC within California were de minimis and could not give rise to substantial nexus: Relying on the California appellate decision in Borders Online, the court noted that similar cases have established substantial nexus with merely one or two physical visits in a state by an employee or independent contractor. Thus, the court reasoned that the 17 visits into California by an entity established as the SPEs' agent was more than de minimis and sufficient to establish substantial nexus for the SPEs under the Commerce Clause.

Commerce Clause Challenge to Section 25101.15

The second part of HD's challenge to its California tax liability addressed the constitutional legitimacy of Cal. Rev. and Tax. Code Section 25101.15. Under that section:

If the income of two or more taxpayers is derived solely from sources within this state and their business activities are such that if conducted within and without this state a combined report would be required to determine their business income derived from sources within this state, then such taxpayers shall be allowed to determine their business income in accordance with [Cal. Rev. and Tax. Code] Section 25101.

In short, a purely California (i.e., intrastate) combined filing group has an annual option to choose whether to file its California corporate franchise tax return on a combined or separate-entity basis. At the superior court level, the California Franchise Tax Board (FTB) moved for demurrer on the issue, and the motion was granted (Harley-Davidson, Inc. v. California Franchise Tax Board, No. 37-2011-00100846-CU-MC-CTL (Cal. Super. Ct. 5/1/13)). In its appeal, HD emphasized the facial inconsistency between California-only (i.e., intrastate) and interstate combined filing groups under the statute. Because the claim addressed the constitutional legitimacy of the California corporate statute, the appellate court, under the guidance of Cutler v. Franchise Tax Board,146 Cal. Rptr. 244 (Cal. Ct. App. 2012), determined the central question to be one of law, and so reviewed the demurrer de novo to determine whether HD had alleged facts sufficient to state a cause of action under a legal theory.

Based primarily on the U.S. Supreme Court's Commerce Clause analysis in Oregon Waste Systems, Inc. v. Department of Environmental Quality of State of Ore., 511 U.S. 93, 100-101 (1994), the appellate court stated that to conclude the matter, it had to determine three things:

  • Whether the relevant aspect of California's tax scheme treats intrastate and interstate unitary business differently;
  • Whether any differential treatment discriminates against interstate commerce either by benefiting intrastate businesses or burdening interstate businesses; and
  • Whether any discriminatory differential treatment withstands the strict-scrutiny standard of Commerce Clause analysis.

With regard to the differential treatment question, the appellate court acknowledged that the FTB had effectively conceded the issue in its briefing (citing the FTB's briefs, which stated that "section 25101.15 provide[s] wholly in-state businesses . . . an election to file their returns on either a unitary combined reporting basis, or a separate-entity basis [while] [m]ultistate unitary businesses have no corresponding election.") With regard to the discrimination question, the appellate court found within federal decisions such as Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), and South Central Bell Telephone Co. v. Alabama, 526 U.S. 160 (1999), as well as California authority established under Cutler v. Franchise Tax Board, 208 Cal.App.4th 1247 (Cal. Ct. App. 2012), Ceridian Corp. v. Franchise Tax Board, 102 Cal. Rptr. 611 (Cal. Ct. App. 2000), and Farmer Bros. Co. v. Franchise Tax Board, 134 Cal. Rptr. 390 (Cal. Ct. App. 2003), that the burden of showing discrimination had been met. The court did not find persuasive the FTB's arguments (1) that the court must look at the levelof tax imposition (i.e., the percentage) to determine whether constitutionally significant discrimination had occurred, or (2) that cases upholding California's ability to apportion income from interstate businesses should determine whether Cal. Rev. and Tax. Code Section 25101.15 is itself discriminatory.

With regard to the strict-scrutiny question, the Commerce Clause requires the defender of a discriminatory statutory scheme, in this case the FTB, to prove (1) that the taxing scheme has a legitimate local purpose and (2) that purpose cannot be "adequately served by reasonable nondiscriminatory alternatives" (citing Oregon Waste, at 100-101). Since the FTB had only raised this issue on appeal, it had not developed a record related to the claim that there was such a legitimate local interest that could not be served by adequate alternatives. To develop that record, the appellate court remanded HD's challenge to Cal. Rev. and Tax. Code Sec. 25101.15 to the superior court to "make these determinations in the first instance" (Harley-Davidson, 237 Cal. App. 4th at 208).


SPE nexus: Based on its agency analysis, the court did not have difficulty finding nexus for the SPEs under both the Due Process and Commerce Clauses. While the taxpayer was ultimately unsuccessful, it is noteworthy that yet another state court was asked to address the J. McIntyre holding in the context of state tax nexus. In J. McIntyre, theCourt ruled that where a company merely put its product into the stream of commerce and that product happened to end up in a state (New Jersey), the "stream of commerce" connection was not sufficient to establish that the taxpayer had availed itself of the state's market to create nexus under the Due Process Clause (J. McIntyre Machinery, Ltd., 131 S. Ct. 2780 (2011)).

HD argued that due process was not satisfied under J. McIntyre because the SPEs did not specifically target California. The Harley-Davidson court reasoned that in the case of the SPEs, J. McIntyre did not control because (1) the SPEs did not act through independent contractors but through their corporate parent; and (2) the SPEs did, in fact, target the California market because HDCCattended 17 auctions in the state to help maintain the value of motorcycles secured by SPE loans.The requirements of J. McIntyre were met through the agency relationship between the SPEs and HDCC. Since J. McIntyre was decided in 2011, taxpayers have prevailed on due-process grounds in states' highest courts in nexus cases such as Scioto Insurance Co. v. Oklahoma Tax Comm'n, 279 P.3d 782 (Okla. 2012), and, in West Virginia, Griffith v. ConAgra Brands, Inc., 728 S.E.2d 74 (W. Va. 2012).

While the Harley-Davidson court did not interpret J. McIntyre as barring due-process nexus for the SPEs, the relationship between the in-state and out-of-state entities in the case is arguably distinguishable from the Scioto and ConAgra cases: In those cases, in-state contact by the out-of-state entities was limited to the use of their intellectual property. Just how broadly future state courts will interpret the scope of the J. McIntyre holding in the context of state tax nexus under the Due Process Clause remains to be seen.

Subsequent to the appellate court's holding, Harley-Davidson petitioned the California Supreme Court to hear the nexus issue. On Sept. 16, 2015, that petition was denied (Harley-Davidson, Inc. v. Franchise Tax Board, No. S227652 (Cal. 9/16/15)).

The constitutionality of Cal. Rev. and Tax. Code Section 25101.15: The requirement for interstate corporate groups to file on a combined basis is one of the cornerstones of the California corporate franchise tax. Even if Cal. Rev. and Tax. Code Section 25101.15 is declared unconstitutional, it seems unlikely that an annual filing election for interstate filing groups will suddenly cease. After the Harley-Davidson case makes its way through the California courts, it seems more likely that a statutory change would omit the current annual election benefit given to intrastate filers, as opposed to striking the combined filing requirement for interstate filing groups. As of this writing, the case of Abercrombie & Fitch v. Franchise Tax Board, No. 12CECG03408 (Cal. Super. Ct. 10/22/12) (case filed), is awaiting a resolution of this issue in Harley-Davidson before further proceedings.


Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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