On May 16, 2022, the Massachusetts Supreme Judicial Court issued its decision in the VAS Holdings & Investments LLC v. Commissioner of Revenue case, which has been closely watched by the state and local tax community over the past year. The case addresses the proper application of the unitary business principle and Massachusetts’ ability to tax an out of state investor on its capital gains from the sale of non-unitary partnership interest. The Court ultimately ruled in favor of the taxpayer, finding no statutory basis for the imposition of Massachusetts tax on the gain. The Court rejected however the taxpayer’s argument that the commonwealth’s attempt to tax a non-resident investor violated the federal Due Process and Commerce Clauses of the U.S. Constitution.
VAS Holdings & Investments LLC (VASHI) was originally formed in 1999 under the laws of Illinois. The company was a holding company whose underlying subsidiary operated a call center in Canada, focused on supporting clients in the hospitality industry. In 2011, VASHI merged its Canada and U.S. operations with a Massachusetts-based limited liability company (LLC) also operating within its industry. After the 2011 transaction, VASHI held a 50% interest in a partnership, Cloud5, LLC (Cloud5), which was the sole owner of the underlying operating companies. VASHI also changed its legal domicile to the state of Florida and closed its offices in Illinois shortly after the transaction. For tax purposes, VASHI was taxed as an S corporation, and none of its shareholders were residents of Massachusetts.
After the 2011 merger, all of the operations of Cloud5 were managed by the legacy owner of the acquired Massachusetts LLC; VASHI had no employees or property in Massachusetts. VASHI did not participate in the operations of Cloud5 or have any operations of its own in Massachusetts. In 2013, VASHI sold its 50% interest in Cloud5, generating a $37M capital gain. This gain was reported by the shareholders of VASHI as subject to tax in their states of residency; none of the gain was reported as taxable in Massachusetts.
Between 2011 and 2013, the value of the business grew significantly, largely related to the growth in the legacy Massachusetts LLC’s business and the in-state management of Cloud5. The Massachusetts Department of Revenue asserted that the capital gain recognized by VASHI should be subject to tax within the state since the increase in value was related to business operations carried on, at least in part, within the state’s borders. The department assessed both corporate excise and composite taxes on the capital gain based on Cloud5’s reported in-state apportionment factors. VASHI appealed arguing that it did not have a unitary relationship with Cloud5 and that the assessment violated the Due Process Clause. The Massachusetts Appellate Tax Board ruled for the department and VASHI appealed to the Supreme Judicial Court.
The court’s analysis and conclusion
In holding for VASHI, the Massachusetts high court acknowledged that there was no unitary relationship between VASHI and Cloud5. The court held however that the lack of a unitary relationship did not alone render the tax unconstitutional under either the Due Process or Commerce clauses. The court emphasized that there was nothing in the U.S. Supreme Court’s jurisprudence that would prevent Massachusetts from taxing VASHI based on its “nexus to Cloud5 and to determine the tax using Cloud5’s apportionment percentage.” In so holding, the court rejected the taxpayer’s argument that the constitution required a unitary relationship before income can be apportioned. The court stated that that U.S Supreme Court “has acknowledged that the existence of a unitary relationship between the taxpayer and investee ‘is one justification for apportionment, but not the only one.’”
While rejecting the constitutional challenges, the high court nonetheless ruled in favor of VASHI. The court found that the Massachusetts revenue laws and regulations clearly incorporate the unitary business principle as a requirement for the imposition of tax. Because there was no unitary relationship, the court concluded that the tax was improperly assessed and the Appellate Tax Board decision was overturned.
The VAS Holdings case has been closely watched by the state and local tax community because an increasing number of states are taking an investee apportionment approach. While a taxpayer win in this case may appear to be a victory for the unitary business principle, the decision is much more nuanced. With the investee apportionment approach upheld in a recent New York City case and finding apparent constitutional support in Massachusetts’s analysis in VAS Holdings, taxpayers are left with the concerning proposition that many other states will follow suit and pursue similar approaches. The proper sourcing and taxation of capital gains for out of state investors has long been an especially complex area of tax—one that may continue to grow in complexity as states form interpretations that seemingly depart from what have been the long-standing guiding principles of fair and constitutionally valid state taxation.
Finally, some non-resident corporate partners may have paid tax on the disposition of a partnership interest in Massachusetts. If the relationship between the nonresident partner and the partnership was non-unitary, VAS Holdings may provide an opportunity to file refund claims. Taxpayers with questions about the investee apportionment approach or the VAS Holdings decision should contact their state and local tax adviser.