California Appellate Court rules on nexus of special-purpose entities, tells lower court to rule on constitutionality of filing election.

• Author: Cook, Mark

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...