Like a new motorcycle with an oil leak, the recent Harley-Davidson decision has a certain aesthetic appeal, but it gets messy when you examine it closely. On May 28, 2015, the California Court of Appeal found that a lower court erred by dismissing Harley-Davidson, Inc.’s Commerce Clause challenge to California’s requirement that interstate unitary businesses compute their tax using the combined reporting method. Harley-Davidson, Inc. v. Franchise Tax Bd., No. D064241 (Cal. App. Fourth Dist. May 28, 2015). But, the Court also found that certain Harley-Davidson special purpose entities (“SPEs”) had nexus with California for Due Process and Commerce Clause purposes, even though they had no physical presence in the state.

Calculating State Income for Unitary Businesses

As readers may know, a unitary business is comprised of a number of commonly owned and controlled businesses, wherein each is dependent on or contributes to the operation of the entire business enterprise. Under California’s statutory scheme, unitary businesses doing business only in California are allowed to compute their tax using either the separate accounting method (which treats each corporate entity discretely for purposes of determining their tax liability) or the combined reporting method (which aggregates the entire amount of business income of all the corporations in the unitary group). On the other hand, unitary businesses doing business both within and without California are required to use only the combined reporting method.

Harley-Davidson has two business lines – a motorcycle business and a financial services business – but reported income only on the motorcycle business because it felt the financial services business was not unitary with the motorcycle business. Upon audit, however, the Franchise Tax Board (“FTB”) determined that the two were indeed unitary, and issued an assessment for additional taxes.

After unsuccessfully protesting the FTB’s determination, Harley-Davidson sued for a tax refund, asserting that the differential treatment afforded to intrastate and interstate unitary taxpayers violates the Commerce Clause. Although the trial court sustained the FTB’s demurrer, the Court of Appeal held that California’s statutory scheme is facially discriminatory.

In analyzing the applicable law, the Court found that it must apply the three-prong test ofOregon Waste Sys., Inc. v. Dep’t of Envtl. Quality of State of Ore., 511 U.S. 93 (1994) to determine: (1) whether the relevant aspect of the subject tax scheme treats intrastate and interstate unitary businesses differently; (2) whether any differential treatment discriminates against interstate commerce either by benefiting intrastate businesses or burdening interstate businesses; and (3) whether any discriminatory differential treatment withstands strict scrutiny.

The FTB essentially conceded that the first prong was satisfied, but disputed the second and third prongs. With regard to the second prong concerning discrimination, the Court cited numerous precedents supporting its conclusion that California’s scheme for determining how unitary businesses compute their California income tax liability “discriminates on its face on the basis of an interstate element in violation of the Commerce Clause,” and found the FTB’s arguments to the contrary unavailing.

Nevertheless, the Court ultimately remanded the matter to the lower court to determine whether California’s tax scheme withstands strict scrutiny. Although the parties briefed this issue to the Court, because this issue was raised for the first time on appeal, the Court found that the record below was undeveloped with respect to the third prong ofOregon Waste.


Notwithstanding the apparent taxpayer victory regarding the calculation of California income tax liabilities for interstate unitary businesses, the Court also held that two of Harley-Davidson’s SPEs in its financial services business, which were created to hold financial assets for purposes of securitization, had substantial nexus with California even though the entities had no physical presence in California.

The financial services business consisted of Harley-Davidson Financial Services, Inc. (“HDFS”) and its subsidiaries, including Harley-Davidson Credit Corporation (“HDCC”), which was used to service loans made to Harley-Davidson dealers and customers. To generate liquidity in a manner that would shield investors from bankruptcy risk associated with Harley-Davidson’s business, HDCC used two of its wholly-owned SPEs to securitize the loans. Although HDCC had nexus with California, the SPCs had no offices, employees, or property in the state. In fact, the SPCs had no employees, and nearly all their functions were completed by other entities in Illinois and Nevada.

Notwithstanding the fact that the SPEs were separate legal entities with no direct presence or business in California, the trial court found the SPEs were taxable in California because HDCC and its parent, HDFS, had nexus with the state and acted as agents for the SPEs.

On review, the Court of Appeal determined that there was substantial evidence to support the trial court’s decision. Specifically, the court found that an agency relationship had been established between the SPEs and HDCC because: (1) the SPEs were only formed so that HDCC could obtain more favorable pricing from securitization investors than HDCC could obtain by directly securitizing the loans itself; (2) the SPEs were governed by directors and officers who also were directors and officers of HDCC; (3) the SPEs had no employees of their own but, rather, acted entirely through HDCC employees; (4) the SPEs were only permitted to securitize HDCC loans; (5) HDCC selected the pools of loans to securitize, administered the sale of the SPEs’ securities to underwriters, and indemnified the underwriters; and (6) HDCC undertook collection activities on the SPEs’ loans, including visits to an auction house in California on 17 days to assist in the auction process—a process the Court found was designed to ensure the value of the collateral securing the loans held by the SPEs.

Having found that HDCC acted as an agent for the SPEs, the Court easily found that they had nexus with California under both the Due Process and Commerce Clauses.


Although the Court found the tax scheme facially discriminatory, the FTB still has a chance to breathe life into the existing reporting requirements if it can show that the differential treatment passes strict scrutiny. On appeal, the FTB argued that even if the state’s differential treatment discriminates against interstate commerce, it nonetheless passes strict scrutiny because California has a legitimate reason to impose the discriminatory tax—i.e., to collect more tax revenue because the FTB believes allowing multistate unitary businesses to file on a separate return basis will lead to manipulation by taxpayers. The Court certainly could have addressed this issue on appeal, but instead kicked the can down the road by remanding it to the trial court for an initial determination. We would not be surprised to see this issue back before the Court of Appeal, given its significance.

Perhaps more troubling, however, is the Court’s decision on the nexus of Harley-Davidson’s SPEs, because it is not uncommon for multistate corporations to use special purpose entities to bundle loan pools for the purpose of securitization. Although the Court’s decision in this regard adds to the growing number of decisions attributing nexus to out-of-state entities based on the in-state activities of third parties, taxpayers with similar structures may want to confer with a tax professional to ensure their positions are defensible.