What was at stake
At issue in a recent, significant tax decision of the Supreme Judicial Court (SJC) was whether the Massachusetts commissioner of revenue could tax an out-of-state shareholder on the gains it derived from the sale of a Massachusetts business. The out-of-state entity, VAS Holdings & Investments, LLC (“VAS Holdings”), had no business activity in Massachusetts other than its investment in Cloud5 LLC (“Cloud5”). Rather, VAS Holdings was structured as a tax pass-through, the main business of which was investment.
The Appellate Tax Board (ATB) sought to impose a Massachusetts capital gains tax on VAS Holdings based on a theory of “investee apportionment,” which establishes a tax nexus to the commonwealth by the investment of an out-of-state shareholder in a Massachusetts business. The SJC rejected that theory and held that although “investee apportionment” is constitutional, the ATB had no statutory basis for asserting it to tax the capital gains of VAS Holdings.
Differing tax theories
The ATB acknowledged that VAS Holdings had no integrated business with Cloud5 and asserted an alternate theory for finding tax nexus. Instead, the ATB found nexus for taxation based on the out-of-state shareholder’s realization of the economic benefits and protections derived from Massachusetts when it sold its share in the Massachusetts business.
VAS Holdings countered that the only principle Massachusetts could use to tax it was the “unitary business principle.” Under that principle, an out-of-state entity may be taxed by Massachusetts if it is functionally integrated with a Massachusetts entity, sharing central management and economies of scale with it. Absent a “unitary business” with a Massachusetts entity, an out-of-state entity cannot be taxed because no state statute supports the apportionment of Massachusetts tax to an out-of-state entity based only on its in-state connections.
The SJC decision
The SJC noted that “investee apportionment” passes muster under the due process and commerce clauses of the U.S. Constitution because it establishes an appropriate nexus between an out-of-state investor and a sale of a business within the state. However, the SJC rejected the ATB assertion that it had the power to tax VAS Holdings under “investee apportionment” in the absence of any Massachusetts statute supporting it. Rather, the SJC took the position that the ATB had overstepped its authority by asserting a theory that the Legislature had never adopted. Massachusetts, under M.G.L c. 62 s. 32B, taxes out-of-state businesses only on a unitary business principle.
Citing Massachusetts case law in support, the SJC stated that no method of determining tax liability is valid unless authorized by statute and executed in accordance with its terms. The Legislature, and not the taxing authorities of Massachusetts, establishes tax policy and the mechanics of taxation.
Tax policy and the Legislature
The Massachusetts Legislature has made the policy decision that unless an out-of-state business is so tied to an in-state business as to establish a unitary function, management, and economies of scale, capital gains from the sale of the in-state business cannot be taxed by Massachusetts to the out-of-state business. Such a policy can favor Massachusetts start-ups and other businesses by allowing them to attract out-of-state business investors that are free of Massachusetts capital gains taxes once the Massachusetts business is sold. Massachusetts, in turn, reaps the economic benefits of such enriched, in-state businesses without necessarily eroding its tax base, as profitable, ongoing businesses and higher employment rates contribute to income tax collections within the commonwealth.
Evelyn A. Haralampu is a tax partner of Burns & Levinson LLP. She has authored a number of articles, including a chapter on the Employee Retirement Income Security Act of 1974 in the Massachusetts Continuing Legal Education treatise, Massachusetts Employment Law.