On May 28 2015, The California Court of Appeals issued a decision in Harley-Davidson, Inc. v. Franchise Tax Board, 187 Cal.Rptr.3d 672; and it was ultimately about much more than the validity of an election within California’s combined-reporting regime. It also tackled issues and, perhaps most importantly, blurred lines surrounding the Commerce Clause’s substantial nexus requirement. In Harley-Davidson, the court concluded that two corporations with no California physical presence had substantial nexus with California due to non-sales-related activities conducted by an in-state agent. The court applied an “integral and crucial” standard for purposes of determining whether the activities conducted by an in-state agent satisfy Commerce Clause nexus requirements.
The corporations at issue were established as bankruptcy-remote special purpose entities (SPEs) and were engaged in securing loans for their parent and affiliated corporations that conducted business in California. As a preliminary matter, the court found that an entity with a California presence was an agent of the SPEs. The court then concluded that the activities conducted by the in-state agent created California nexus for the SPEs that satisfied both Due Process and Commerce Clause requirements.
The Due Process Clause requires some “minimum connection” between the state and the person it seeks to tax, and is concerned with the fairness of the governmental activity. Accordingly, a Due Process Clause analysis focuses on “notice” and “fair warning,” and the Due Process nexus requirement will be satisfied if an out-of-state company has purposefully directed its activities at the taxing state. In Harley-Davidson, the SPEs purpose was to generate liquidity for the in-state entity in a cost-effective manner so that it could make loans to Harley-Davidson dealers, including dealers in California. Additionally, the SPEs’ loan pools contained more loans from California than from any other state, and the in-state entity oversaw collection activities, including repossessions and sales of motorcycles, at California locations on behalf of the SPEs. As a result, the court concluded that “traditional notions of fair play and substantial justice” were satisfied.
The Commerce Clause requires a “substantial nexus” between the person being taxed and the state. The Supreme Court of the United States has addressed this substantial nexus requirement, holding that a seller must have a physical presence in the taxing state to satisfy the substantial nexus requirement for sales-and-use tax purposes. In Tyler Pipe Industries v. Washington State Department of Revenue, 483 U.S. 232 (1987), the Supreme Court stated that, “the crucial factor governing [Commerce Clause] nexus is whether the activities performed in this state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.” While Harley-Davidson argued that the activities of the in-state agent could not create nexus for the SPEs, as such activities were not sales-related activities, the California court rejected this argument stating that “this argument fails from the outset, however, because the third-party’s in state conduct need not be sales-related; it need only be an integral and crucial aspect of the businesses” (internal citations omitted). The court observed that participating in actions to repossess motorcycles “maintain[ed] the value of the security interests underlying the securitization pools” and was “integral and crucial” to the SPE’s securitization business, thus, creating nexus for the SPEs.
Since Tyler Pipe, no case has expanded the “purposeful availment” or “substantial nexus” standards to encompass attribution of activities not relating to an out-of-state company’s ability to establish and maintain an in-state market. Although, some have argued that Tyler Pipe has left this door open. In contrast, other activities that do not directly generate income—such as purchases from in-state suppliers—have been found to be non-nexus creating. The court’s decision in Harley-Davidson blurs the “market-enhancement” bright line by asserting that a broader range of activities conducted by in-state “agents” could satisfy Commerce Clause requirements if the activities are deemed “integral and crucial” to an out-of-state entity’s business. Interestingly, the court cites to a California Supreme Court decision, involving two foreign insurance companies and nexus under the Due Process Clause, to presumably support its Commerce Clause conclusion.
Since “integral and crucial” is a fairly amorphous standard, would an out-of-state business that retains a California law firm or a California management consulting firm to provide general advice (i.e., not specifically related to California) become subject to California taxation? After conversations with Franchise Tax Board (Board) employees, we understand the Board is encouraged that this decision reflects a broader view of the activities of an in-state person that can be attributed to an out-of-state business for nexus purposes. While this seems to be the superficial conclusion in Harley-Davidson, a closer review of the court’s rationale reveals that the court may have been confusing the “representative” and “alter ego” sub-categories of attributional nexus—or possibly, confusing unitary facts (which relate merely to apportionment concepts) with jurisdictional requirements. Perhaps the factors on which the court relied should have resulted in merely the conclusion that the two SPEs are properly includable in a combined California return, and not that such SPEs are taxpayers themselves.