United States

California: Mandating Combined Reporting for Interstate, but not Intrastate Taxpayers Violates Commerce Clause

Jun 01, 2015
From KPMG TaxWatch

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The California Court of Appeal, Fourth District recently ruled on two important corporate income/franchise issues affecting multistate taxpayers. The first issue was whether the trial court erred when it sustained the Board’s objection to a taxpayer’s claim that requiring interstate taxpayers to file a combined report, but allowing intrastate taxpayers to elect between combined reporting or separate accounting, violated the Commerce Clause. The second issue before the court was whether two special purpose entities (SPEs) formed by the taxpayer had California nexus for the tax years at issue.

Under California law, multistate taxpayers engaged in a unitary business are required to file a combined report. Unitary groups that are completely intrastate in nature can elect to file combined or use separate accounting. The taxpayer, a motorcycle company and its several subsidiaries, argued that the differential treatment afforded to intrastate and interstate unitary businesses violated the Commerce Clause because benefits were conferred on intrastate unitary taxpayers that were not “available to . . . interstate unitary taxpayers and that operated as burdens on . . . interstate unitary taxpayers.” In analyzing whether the law was discriminatory, the court looked to whether (1) the relevant aspect of California's tax scheme treated intrastate and interstate unitary businesses differently, (2) any differential treatment discriminated against interstate commerce either by benefiting intrastate businesses or burdening interstate businesses, and (3) any discriminatory differential treatment could withstand strict scrutiny.

After quickly concluding that the differential treatment prong was satisfied, the court reviewed a number of discrimination cases and determined that the taxpayers’ had sufficiently alleged—at least for purposes of surviving the Board’s demurrer—that the differential treatment of intrastate and interstate unitary groups was discriminatory under Commerce Clause precedent. The court next remanded the case to the trial court to address the Board’s contention that even if the differential treatment discriminated against interstate commerce, it nonetheless passed a strict scrutiny analysis because the state had a legitimate reason for the discriminatory treatment.

Having addressed the discrimination claim, the court next addressed whether the trial court erred when it held that the two SPEs created for the purpose of bundling and selling securitized loans had substantial nexus with California, despite their lack of physical presence in the state. The taxpayer, through its financing subsidiaries, originated loans to customers in all 50 states. After the financing subsidiaries originated loans with customers, certain loans were transferred to the SPEs to be bundled and sold. The financing subsidiaries, however, continued to earn fees from servicing the loans. The SPEs were created to function as “bankruptcy remote” entities for financial statement purposes- meaning that the assets and liabilities of the SPE’s were not consolidated on the taxpayer group’s financial statements.

Although the SPEs had no physical presence in California, the trial court held that they were doing business in California through their agents (the financing subsidiaries and motorcycle dealers). The appeals court agreed. After reviewing a number of “agency nexus” cases, the court concluded that substantial evidence supported a finding that the financing subsidiary was an agent of the SPEs. Notably, the court rejected the taxpayer’s argument that the in-state conduct performed on behalf of an out-of-state taxpayer had to be sales-related to create nexus. In the court’s view, it was sufficient if the in-state conduct was an “integral and crucial aspect of the business.” Having reached this conclusion, the court did not address whether the motorcycle dealers were also the SPEs’ agents. Finally, the SPEs’ contacts with California were sufficient to satisfy the Due Process Clause and the SPEs’ physical presence in California (through their agents) likewise met the physical presence Commerce Clause requirement. Please contact Doug Bramall at 480-459-3491 with questions on Harley Davidson, Inc. v. Franchise Tax Board (May 28, 2015).

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.