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California affirms use of combined reporting in Harley-Davidson case

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On Aug. 22, 2018, the California Court of Appeal, Fourth District, affirmed that the California Franchise Tax Board (FTB) can mandate the use of combined reporting by interstate unitary businesses, but permit intrastate unitary companies to choose either separate or combined reporting.1 After independent review, the Court found that there is a legitimate state interest to require combined reporting of taxable income of interstate unitary entities to accurately compute all income attributable to California, despite any potential discriminatory effect on interstate commerce.

Background The taxpayer, Harley-Davidson, sued the FTB for a tax refund following an FTB examination that resulted in a finding that two of Harley-Davidson’s business lines, consisting of a motorcycle business and a financial services business, comprised a unitary business and had to file its corporation income/franchise tax returns on a combined basis. Following an unsuccessful protest, Harley-Davidson paid the additional assessed taxes under protest and subsequently filed suit against the FTB to recover a refund of the assessed amounts.

Noting that intrastate unitary businesses are afforded the choice of computing their tax on either a separate or combined basis, unlike interstate unitary companies, Harley-Davidson alleged in its complaint that the difference in the treatment of interstate and intrastate unitary businesses violated the Commerce Clause of the U.S. Constitution.2 The FTB filed a demurrer to Harley-Davidson’s claims, which the trial court sustained, on the basis that Harley-Davidson’s allegations as to a Commerce Cause violation were not sufficiently pleaded.

The California Court of Appeal ruled in Harley-Davidson’s favor and reversed the trial court’s demurrer ruling, with instructions to conduct further proceedings. In doing so, the Court of Appeal stated that the appeal arose from an order sustaining a demurrer with an undeveloped record “with respect to whether the [FTB] has identified a legitimate reason for differentiating between and discriminating against intrastate and interstate unitary businesses and, if so, whether that legitimate reason can be ‘adequately served by reasonable nondiscriminatory alternatives.’”3

On remand from the California Court of Appeal, the San Diego trial court granted an FTB motion for summary judgment on the issue of whether a California statute discriminates against multistate taxpayers under the Commerce Clause by providing only intrastate unitary businesses with an election to compute their tax on a separate accounting method or combined reporting method.4 The trial court ruled that although the statute may be discriminatory, the law is permissible because the state has a legitimate interest in ensuring the accurate accounting of business income from interstate activities. Harley-Davidson appealed, resulting in this controversy.

Court of appeal decision The sole issue facing the Court was Harley-Davidson’s claim that the disparate treatment between interstate and intrastate companies harmed the flow of interstate commerce by providing a direct commercial advantage to intrastate unitary entities. While the Court agreed that there were triable issues of fact around the issue of discrimination, it ultimately found the need to accurately measure and tax all income attributable to California to be a legitimate state interest to require combined reporting of taxable income of interstate unitary businesses. Further, it ruled that this interest outweighs any possible discriminatory effect.

While Harley-Davidson appeared to agree with the FTB that there was a legitimate state interest to require combined reporting of unitary interstate businesses, it contended that there are reasonable, nondiscriminatory alternatives to the current reporting system. However, the Court disagreed and noted that Harley-Davidson was unable to point to facts in the record to support this position. Citing previous decisions, the Court noted that “separate accounting cannot be extended to interstate corporations because it ‘ignores or captures inadequately’ the transfers of value that take place among the many entities that can make up a unitary enterprise, and can lead to ‘the manipulation and hiding of taxable income.’”5 The Court rejected Harley-Davidson’s contention that the FTB has “‘tools at its disposal’ to seek out all the ‘subtle and largely unquantifiable transfers of value’ among the entities of a unitary business and to prevent manipulation.”6 Instead, the Court noted that the U.S. Supreme Court has repeatedly held that the formula apportionment of unitary business income is both constitutionally permissible and “often the only reasonable and practical manner in which a state may levy and collect taxes to which it is constitutionally entitled.”7

Further, the Court determined that Harley-Davidson was unable to show that prohibiting intrastate unitary companies from using either the combined or separate accounting methods would yield a more reasonable alternative. The Court stated that, because all of the income earned by an intrastate unitary business is taxed by California, intrastate unitary businesses have less opportunity to hide and/or manipulate taxable income among separate entities. Simply put, the Court provided that “intrastate entities are not similarly situated to interstate entities for purposes of filing taxes“ and that Harley-Davidson had provided no support for its claim that requiring intrastate unitary businesses to always file using the combined reporting method would be a reasonable, nondiscriminatory alternative.

Commentary The Commerce Clause issue addressed in this decision has garnered significant attention over the past several years as this case has progressed through the California court system, with a focus on the potential implications to California from a revenue perspective if a finding of discrimination were sustained. This most recent ruling is likely to result in an appeal by Harley-Davidson to the California Supreme Court.

As this case has developed, given the stakes involved, many taxpayers have filed protective refund claims for tax years that are now closed for assessment under the applicable statute of limitations. Such taxpayers should be aware that, based on this decision, they may not prevail in their efforts. However, the claims will remain open at least for the moment, as Harley-Davidson determines whether to file an appeal. In the event an appeal is granted, a possibility remains that California’s tax scheme would not withstand strict scrutiny. While the term “strict scrutiny” at first blush would make it seem like there is a high bar to strike a finding of discrimination, finding a legitimate state interest often lowers the bar substantially, and courts are often receptive to arguments revolving around state revenues. In this case, the ability of the FTB to argue that the need to accurately measure and tax all income attributable to California is a legitimate state interest was persuasive here. It would not be surprising for the FTB and other state tax authorities to continue to lean on these types of arguments in future challenges to tax regimes.

Taxpayers may also wish to consider the impact of filing on a separate accounting or combined reporting basis for open tax years or on a prospective basis. However, taxpayers wishing to make a separate accounting election on an originally filed return, even with disclosure, are cautioned that they may potentially be subject to penalties in the event the FTB ultimately prevails.



1 Harley-Davidson, Inc. v. California Franchise Tax Board, California Court of Appeal, Fourth District, No. D071669, Aug. 22, 2018.
2 The Commerce Clause of the U.S. Constitution grants Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” U.S. CONST. art. I, § 8, cl. 3. As explained by the Court of Appeal, “[t]hough phrased as a grant of regulatory power to Congress, the clause has long been understood to have a ‘negative’ aspect that denies the states the power unjustifiably to discriminate against or burden the interstate flow of articles of commerce.” Citing Oregon Waste Systems, Inc. v. Department of Environmental Quality, 511 U.S. 93, 98 (1994).
3 Harley-Davidson, Inc. v. Franchise Tax Board, 237 Cal.App.4th 193 (2015).
4 Harley-Davidson, Inc. v. California Franchise Tax Board, California Superior Court, San Diego County, No. 37-2011-00100846-CU-MC-CTL, Oct. 31, 2016 (minute order).
5 Citing Barclays Bank PLC v. Franchise Tax Bd., 512 U.S. 298, 303 (1994); Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 164 (1983).
6 Citing Container Corp. of America, 463 U.S. 159.
7 Citing Handlery v. Franchise Tax Board, 26 Cal. App. 3d 970 (1972).



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