BOSTON (SHNS) – The Supreme Judicial Court ruled Monday that the Baker administration erred when it taxed the gain that an out-of-state company realized when it sold its interest in a Massachusetts-based company, ruling in a closely-watched case that could have drastically changed how capital gains taxes are applied.

As commissioner of the Department of Revenue in 2016, current Baker administration budget chief Michael Heffernan determined that 100 percent of the $37 million capital gain earned when VAS Holdings & Investments (VASHI) LLC, an Illinois- then Florida-based S corporation, sold its interest in Massachusetts-based Cloud5 LLC was taxable by Massachusetts. The company said Heffernan in 2017 rejected its appeals for an abatement. In 2019, the Appellate Tax Board upheld the assessment on VASHI, which led the company to take the case to the SJC.

Ruling Monday in VAS Holdings & Investments (VASHI) LLC v. Commissioner of Revenue, the SJC determined that the tax that Massachusetts imposed was within the constitutional limitations on the state’s authority to tax a nondomiciliary corporation but also established that the Legislature “has chosen to adhere to the unitary business principle in formulating its taxing policy.”

Under the unitary business principle, Massachusetts can only tax the capital gain if there is “functional integration, centralization of management, and economies of scale between the out-of-State corporation and the in-State entity,” or if the investment in the in-state entity “serves an operational function of the out-of-State corporation,” the court said.

“Thus, although the Constitution does not prevent the taxes asserted by the commissioner … the taxes — a corporate excise tax in the amount of $914,489, and a nonresident composite tax in the amount of $1,717,406 — are invalid because there is no statutory authority for the taxes so asserted,” Justice Dalila Argaez Wendlandt wrote in the high court’s decision.

An operator of Canadian call centers for the hospitality industry, VASHI merged in 2011 with Massachusetts-based Thing5 into a combined company called Cloud5 valued at roughly $35 million. VASHI “had no involvement whatsoever in the business operations of Cloud5 after the merger,” an attorney wrote in a court filing, and Thing5 employees in Massachusetts took over the functions of VASHI’s Illinois offices, which closed.

Cloud5 was sold to an independent third party for $85 million in 2013 and VASHI realized a capital gain of $37.28 million on the sale of its 50 percent stake. The state’s argument, as articulated by the Appellate Tax Board, was that the increase in Cloud5’s value and the gain realized from its sale “were inextricably connected to and in large measure derived from property and business activities in Massachusetts” and therefore are subject to the state’s capital gains tax.

Michael Bowen, an attorney representing VASHI, told the SJC during oral arguments in January that a ruling upholding the state’s argument could lead to chaos, even for small individual investors, in a hypothetical situation that Justice Scott Kafker said was “frightening.”

“Under the commissioner’s theory of taxation in this case, you as a Massachusetts resident, on the sale of your stock in Ford Motor Company, theoretically would owe tax in every jurisdiction in which Ford Motor Company does business because every jurisdiction in which Ford Motor Company does business would argue that they’ve somehow contributed to the appreciation of the stock that you just sold,” Bowen said.