The recent Harley-Davidson opinion from the Superior Court of California, County of San Diego is an alarming example of why it is important to apply the appropriate constitutional standard in state tax cases.  In a Commerce Clause challenge, where the taxpayer argued a California statute discriminated against interstate commerce, both the California Appellate Court and the trial court applied Equal Protection standards in their Commerce Clause analyses.  In doing so, the courts upheld an otherwise discriminatory tax scheme on the grounds that it furthered the state’s legitimate interests in generating revenue and ensuring income is fairly apportioned among the several states.  Such a holding effectively guts the protections offered under the dormant Commerce Clause and highlights the analytical differences between discrimination under the Commerce Clause and discrimination under the Equal Protection Clause. 

In California, intrastate unitary groups may file income tax returns on either a combined or separate basis. In contrast, interstate unitary groups must file on a combined basis.  Harley-Davidson, Inc. and certain of its subsidiaries (“Harley-Davidson”) challenged this differential treatment on constitutional grounds, arguing mandatory combined reporting discriminates against interstate commerce and thus violates the Commerce Clause of the U.S. Constitution.

The Franchise Tax Board (the “FTB”) initially argued Harley-Davidson’s discrimination challenge did not state a valid claim and the trial court agreed. Harley-Davidson, Inc. & Subs v. California Franchise Tax Board, 37-2011-00100846-CU0MC0CTL (Cal. Super. Ct. 2012) (“Harley I”).  On appeal, the California Appellate Court reversed, finding Harley-Davidson’s discrimination claims sufficiently pled. Harley-Davidson, Inc. v. Franchise Tax Board, 237 Cal. App. 4th 193 (2015) (“Harley II”).  The appellate court also noted, in response to arguments first raised by the FTB on appeal, that a discriminatory tax may still be constitutional if the state “can ‘show that it advanced a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.’” Harley-Davidson, Inc. v. Franchise Tax Board, 237 Cal. App. 4th 193, 202 (2015) quoting Oregon Waste Systems, Inc. v. Department of Environmental Quality of Oregon, 511 U.S. 93, 100-101 (1994).  The appellate court referred to this test as “strict scrutiny” and because the trial court record had not been developed to allow a strict scrutiny analysis, the case was remanded to the trial court to determine “whether the [FTB] has identified a legitimate reason for differentiating between and discriminating against interstate and intrastate unitary businesses and, if so, whether that legitimate reason can be adequately served by reasonable nondiscriminatory alternatives.” Id. at 208 (internal quotations omitted).

As a result of the appellate court’s reversal, Harley-Davidson’s motion for summary judgment on the discrimination issue was revived, but short lived. On October 31, 2016, the trial court denied Harley-Davidson’s motion for summary judgment. Harley-Davidson, Inc. & Subsidiaries vs. Cal. Franchise Tax Board, Case No. 37-2011-00100846-CU-MC-CTL (Cal. Super. Ct. 2016) (“Harley III”).  The trial court, relying on written testimony of an expert witness, determined that there likely was a triable issue of discrimination, noting, for example, open issues as to whether the combined reporting mandate results in greater compliance burdens for out-of-state taxpayers.  However, the trial court held further that even if the California statutory scheme is discriminatory, it survives a strict scrutiny analysis.

According to the trial court, to survive a strict scrutiny challenge, the state need only prove the statute furthers a legitimate rather than a compelling interest. Harley III citing C&A Carbone, Inc. v. Town of Clarkstown, 511 U.S. 383, 392-94 (1994).  The court held that the state appeared to have a legitimate state interest in ensuring that “all business income from interstate business is accurately accounted for” and “fairly apportioned.” Harley III citing Allied-Signal, Inc. v. Dir., Div. of Taxation, 504 U.S. 768, 784 (1992); Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 164-65 (1983).  Mandatory combined reporting, according to the court, furthers this legitimate interest.  The court also noted California has a legitimate interest in “preventing the manipulation and hiding of taxable income.”  Upon finding legitimate state interests for mandatory combined reporting, the court remarked there did not appear to be any nondiscriminatory alternatives that would serve the state’s legitimate interests.

The Harley III decision continues the disturbing trend of the erosion of the protections afforded by the dormant Commerce Clause.  The results of Harley III are concerning, primarily because if Harley III’s strict scrutiny analysis is extended to its logical conclusion, a state could enact virtually any taxing scheme in furtherance of its legitimate interest to generate tax revenue without regard to the restrictions of the dormant Commerce Clause.

The Commerce Clause jurisprudence allows for sustaining facial discrimination in one circumstance: upon a showing that the interstate discrimination compensates for a burden already born by intrastate commerce (called the “compensatory tax defense.”) Fulton Corp. v. Faulkner, 516 U.S. 325 (1996).  The trial court did not evaluate, nor did the FTB raise, the compensatory tax defense.

We note that a motion for summary judgment was before the trial court in Harley III, and the court’s finding that there are facts in dispute is sufficient to deny such a motion.  That said, the discrimination issue should now be tried.  However, the trial court’s “strict scrutiny” holding negates the necessity for a trial, finding resolution of the discrimination issue moot in light of the state’s legitimate interests in ensuring all revenue is accounted for and fairly apportioned.  We anticipate Harley-Davidson will appeal the Harley III decision on these, and possibly other, grounds.