On May 16, 2022, the Massachusetts Supreme Judicial Court held that the state did not have statutory authority to tax an out-of-state S corporation on the capital gain it received from selling its 50% membership interest in an in-state limited liability company (LLC).1 The court determined that taxation of the gain was permissible under the Commerce and Due Process Clauses of the U.S. Constitution because the S corporation received financial benefits from the LLC whose growth was tied to the protections, opportunities and benefits provided by Massachusetts. The parties agreed there was no unitary relationship between the entities, but the court decided to consider whether the state had statutory authority to impose tax on the gain. The court concluded that the state only provides statutory authority to tax the gain if there is a unitary relationship between the entities. Because the entities were not unitary, there was no statutory authority to tax the gain.
VAS Holdings & Investments LLC (VAS), an S corporation based in Florida, owned a 50% membership interest in Cloud5, a Massachusetts LLC operating a business with activities primarily concentrated in Massachusetts. VAS historically had operated a Canadian call center business through a series of subsidiaries, but in 2011 became a passive owner in the Cloud5 enterprise in which such operations were eventually integrated into the Cloud5 business. During the two years in which VAS owned this interest, Cloud5’s value greatly increased due to business activities occurring primarily in Massachusetts.
In October 2013, VAS sold its 50% interest in Cloud5 to an unrelated third party, realizing a capital gain of over $37 million. Because VAS was treated as a pass-through entity for federal income tax reporting purposes, it reported but did not pay federal income tax on the Cloud5 gain. The shareholders paid federal income tax on the gain and state income tax to their state of residence. None of the VAS shareholders was a Massachusetts resident.
For the 2013 tax year, based on an initial perception by VAS that the Cloud5 gain was subject to Massachusetts tax, VAS made estimated payments of Massachusetts corporate excise tax and nonresident composite taxes. After VAS later reported that no tax was due on the Cloud5 gain, the Massachusetts Revenue Commissioner issued refunds. The Commissioner subsequently determined during an audit that VAS in fact was subject to corporate excise tax on the Cloud5 gain,2 and withholding for the nonresident composite tax on the gain. VAS appealed the assessment to the Massachusetts Appellate Tax Board (ATB). Following a hearing, the ATB rejected VAS’s argument that the only methodology allowing the state to tax the gain was the “unitary business principle.” The ATB held that the Due Process and Commerce Clauses of the U.S. Constitution allowed the state to tax the Cloud5 gain. According to the ATB, the gain was taxable because Cloud5 had grown in value due to its business activities in Massachusetts, despite the fact that VAS had no other Massachusetts presence. The Massachusetts Supreme Judicial Court granted VAS’s application for direct appellate review.
Taxation of capital gain allowed by Constitution
At the outset, the Massachusetts Supreme Judicial Court outlined the constitutional limitations on state taxing authority as stated by the U.S. Supreme Court, based on the “fundamental requirement of both the Due Process and Commerce Clauses that there be ‘some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’”3 As explained by the Court, “the ‘broad inquiry’ subsumed in both constitutional requirements is ‘whether the taxing power exerted by the state bears fiscal relation to the protection, opportunities and benefits given by the state.’”4 The Commissioner successfully argued that the protections, opportunities and benefits that Massachusetts provided to Cloud5, VAS’s investee, satisfied the requirement of nexus between Massachusetts and VAS. Because the tax that Massachusetts sought to impose on the gain reflected Cloud5’s apportionment formula, the tax would capture the protections and benefits received. Under constitutional standards, Massachusetts could extend its taxing authority to the gain generated by Cloud5’s growth in the state.
In reaching its conclusion on the constitutional issue, the court relied on the U.S. Supreme Court’s decisions in International Harvester Co. v. Wisconsin Department of Revenue5 and Wisconsin v. J.C. Penney Co.6 The U.S. Supreme Court upheld a Wisconsin privilege tax that required out-of-state corporations conducting business in Wisconsin to deduct a tax from the dividends they paid to investors, regardless of whether the investors were Wisconsin residents. In these cases, the nonresident shareholders received the privileges, protections and benefits of conducting business in Wisconsin because they invested in a corporation that was doing business in the state. Based on these decisions, the Massachusetts Supreme Judicial Court determined that the tax that Massachusetts sought to impose on VAS satisfied constitutional standards. The profit that VAS realized in Massachusetts by selling its 50% interest in Cloud5 reflected the benefits, opportunities and protections received by Cloud5 and VAS. The court explained that the fact that this case concerns profits in the form of capital gains rather than dividends “is of no constitutional significance.”7
The court rejected VAS’s argument that the U.S. Supreme Court repudiated International Harvester and J.C. Penney in more recent decisions8 and the unitary business principle is the only constitutionally permissible methodology allowing a state to tax an out-of-state corporation’s income from capital gains. In rejecting this argument, the court explained that “the Supreme Court has not held that the unitary business principle is the exclusive methodology permissible under the Constitution to determine the limits of a [s]tate’s taxing power.” As interpreted by the court, the U.S. Supreme Court has determined that a unitary relationship between the taxpayer and its investee “is one justification for apportionment, but not the only one.”9
In support of its decision, the court explained that the U.S. Supreme Court decisions applying the unitary business principle to dividends and capital gains to an out-of-state corporation differed from the tax to be imposed on VAS in two major respects. First, in such decisions, the states relied on the unitary business principle to reach out-of-state income because the state had no connection to the entity that was the source of the dividend or capital gain.10 Second, in cases where the taxing state had the requisite connection, the state did not rely on that nexus but instead relied on the unitary business principle to use the apportionment percentage applicable to the out-of-state corporation that received the income rather than the entity that was the source of the income.11 The Commissioner did not rely on the unitary business principle to assess tax on the gain. Rather, the Commissioner relied on the connection between Massachusetts and Cloud5, ultimately basing the tax on Cloud5’s apportionment percentage reflecting the significant Massachusetts activity that drove the increase in Cloud5’s value, rather than VAS’s percentage. The use of Cloud5’s apportionment percentage satisfied the constitutional requirement of a rational relationship between the tax and the relevant activities.
No statutory authority to tax capital gain
While the Commissioner succeeded in its constitutional argument, the court explained that statutory authority must exist in order for a state to impose a tax.12 Neither the Commissioner nor VAS had previously raised the issue of whether the Commissioner was authorized by statute to impose tax on the gain.13 After the case was argued, the court asked the parties to submit briefs on the statutory authority issue. Massachusetts statutes and regulations follow the unitary business principle for imposing tax.14 The court held that although the Constitution does not prevent the taxes asserted by the Commissioner, the corporate excise tax and nonresident composite tax were invalid because there is no statutory authority for imposing these taxes on the gain in this case. In a footnote, the court acknowledged that jurisdictions that have authorized the approach advanced by the Commissioner, such as New York City, New York, and Ohio, have enacted legislation expressly authorizing this approach.15
After reviewing the relevant corporate excise tax provisions, the court concluded that Massachusetts apportionable income and allocable income are defined by reference to the unitary business principle. The court determined that the asserted corporate excise tax and nonresident composite tax was not authorized by statute either as apportionable or allocable income because there was no unitary business between VAS and Cloud5,16 VAS’s commercial domicile was Florida, and the Commissioner’s regulations clearly use the unitary business principle to determine the income subject to tax.17 Because the Commissioner did not have statutory authority to tax VAS’s capital gain based on Cloud5’s connection to Massachusetts, the court reversed the ATB’s decision.
This decision thoroughly evaluated the U.S. Supreme Court’s Due Process and Commerce Clause decisions concerning a state’s authority to impose income tax on gain received by out-of-state entities whose sole connection with the state is a non-unitary ownership interest in a business with presence in the state. Taken by itself, the court’s constitutional analysis favored the state by determining that imposition of Massachusetts corporate excise tax on the gain received by VAS passed constitutional muster because the capital gain was tied to the protections, opportunities, and benefits provided by Massachusetts. Under constitutional standards, the court determined a unitary business relationship is not required in order to impose tax on the out-of-state entity. Thus, the state was successful on the constitutional issue.
However, the court eventually found in favor of VAS by applying a statutory authority analysis that was not previously raised by VAS or the Commissioner. Massachusetts law does not currently provide authority for imposing tax on gain based on an “investee nexus” approach, but the Massachusetts legislature conceivably could enact a statute imposing “investee nexus” to tax gain in the future. As noted in the decision, a small number of jurisdictions permit the taxation of an out-of-state owner on gain received from the sale of its ownership interest in a pass-through entity operating in the jurisdiction even though there is no unitary relationship. Last year, the New York City Tax Appeals Tribunal allowed the imposition of city general corporation tax on an out-of-state entity that had an ownership interest in a pass-through entity based in the city.18 Likewise, other jurisdictions may attempt to impose tax on gain in “investee nexus” situations in which no unitary relationship exists between the entities. Given the constitutional issues in this decision, Massachusetts may appeal this case to the U.S. Supreme Court.
1 VAS Holdings & Investments LLC v. Commissioner of Revenue, Massachusetts Supreme Judicial Court, No. SJC-13139, May 16, 2022.
2 Unlike most states, Massachusetts imposes an entity-level corporate excise tax on S corporations that have a certain amount of total receipts. MASS GEN. LAWS ch. 63, § 32D(a)(ii); MASS. REGS. CODE tit. 830, §§ 62.17A.1(11); 62.17A.2(8)(b). Specifically, S corporations are subject to the net income measure of the tax if their total receipts for the tax year are at least $6 million.
3 Allied Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 777 (1992), quoting Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-345 (1954).
4 MeadWestvaco Corp. v. Illinois Department of Revenue, 553 U.S. 16, 24-25 (2008), quoting ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307, 315 (1982).
5 322 U.S. 435, 437 (1944).
6 311 U.S. 435, 444 (1940).
7 The U.S. Supreme Court has determined that “for constitutional purposes capital gains should be treated as no different from dividends.” Allied-Signal, 504 U.S. at 780.
8 VAS cited Allied-Signal and MeadWestvaco to support this argument.
9 Allied Signal, 504 U.S. at 787.
10 See F.W. Woolworth Co. v. Taxation & Revenue Department, 458 U.S. 354, 372 (1982).
11 See MeadWestvaco, 553 U.S. at 30; Allied-Signal, 504 U.S. at 776.
12 Gillette Co. v. Commissioner of Revenue, 683 N.E.2d 270, 274 (Mass. 1997).
13 The court determined that VAS did not waive this argument even though it failed to bring this issue before either the ATB or Massachusetts Supreme Judicial Court. The U.S. Supreme has recognized that “[t]here may always be exceptional cases or particular circumstances which will prompt a reviewing or appellate court, where injustice might otherwise result, to consider questions of law which were neither pressed nor passed upon by the court or administrative agency below.” Hormel v. Helvering, 312 U.S. 552, 557 (1941).
14 MASS GEN. LAWS ch. 63, §§ 32B; 32D; 38; MASS. REGS. CODE tit. 830, §§ 62.5A.1; 63.38.1.
15 N.Y. TAX LAW § 210.3, repealed by Ch. 59, part A, § 15, Laws 2014; OHIO REV. CODE ANN. § 5747.212; N.Y. CITY ADMIN. CODE § 11-604.3(a). It should be noted that OHIO REV. CODE ANN. § 5747.212, which relates to the determination of an equity investor's apportionment of a gain from the sale of a closely-held business, was found to be unconstitutional on an “as applied” basis in Corrigan v. Testa, 73 N.E.3d 381 (Ohio 2016). In that decision, the Ohio Supreme Court rejected the application of the use of any methodology other than the unitary business principle in interpreting the sourcing statute. In a footnote, the Massachusetts Supreme Judicial Court stated its disagreement with the Corrigan decision as it viewed such decision as a misreading of International Harvester.
16 The court noted that VAS and Cloud5 lacked the functional integration, centralization of management, and economies of scale that are the hallmarks of a unitary business relationship.
17 MASS. REGS. CODE tit. 830, §§ 62.5A.1(2), (6)(a), (d); 63.38.1(2), (3), (4)(a).
18 In the matter of Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp., New York City Tax Appeals Tribunal, No. TAT(E)16-9(GC), March 12, 2021 (released May 2021), aff’d, New York Supreme Court Appellate Division, First Department, No. 2021-2517, April 12, 2022.
Robert C. Michaelis
Rob has approximately twenty years of experience in the tax industry.
- State and local tax
Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
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