The decision by a Maryland circuit court striking down the state's digital advertising tax, while a major victory for big tech, could have implications that spread beyond the state.
The decision will slow down other states in their march toward taxing digital advertising, and has implications for the Biden administration's decision to comply with the OECD's efforts to usher in a global minimum tax.
"It's completely proper to tax digital goods and services. There's no difference between purchasing software on a CD and using it off the internet," observed Mike Bernard, chief tax officer at Vertex. "This is well-established, and most jurisdictions are moving toward that."
'Digital exhaust' is a second level of information that is being purchased off the internet, according to Bernard: "These are ancillary things that are created when people use the internet, such as intelligence reports. For example, if you buy a Buffalo Bills football jersey, someone is tracking you. The next time you're on a sports website, you may get an offer to buy a football signed by Josh Allen. That's from 'digital exhaust.' The information is gathered from whatever websites you visit and is sold as part of a report, which may, as in this case, be bought by someone who sells memorabilia. They will buy the reports and tailor emails to potential customers. Digital exhaust is also taxable."
The third level, digital advertising, has not been so certain. "There was a hint that digital advertising tax would be discussed in a number of state legislatures in 2023," said Bernard. "But the judge's ruling [striking down the Maryland digital advertising tax] was very sound. For the other side, it's not like losing by a field goal, but by three touchdowns."
The decision in the Anne Arundel County Circuit Court granted summary judgment against the Maryland comptroller. Judge Alison Asti stated in her order that:
- The Maryland Digital Advertising Gross Receipts Tax violates the Supremacy Clause of the U.S. Constitution and the Internet Tax Freedom Act because the tax constitutes a discriminatory tax;
- The tax violates the Commerce Clause of the Constitution because the tax discriminates against interstate commerce; and,
- The tax violates the First and Fourth Amendments to the Constitution because it singles out the plaintiffs [Comcast of California/Maryland/Pennsylvania/Virginia/West Virginia LLC] because it singles out the plaintiffs for selective taxation and is not content-neutral.
Other states have been considering similar legislation to the Maryland tax, noted Michael Jacobs, a partner at Reed Smith. "They have not enacted their legislation because of the Maryland law. One of the arguments against enactment was the potential constitutional issues. They made the decision to stay away from enacting such a tax until these issues are cleared up. The Maryland decision will make it less likely that other states will jump on the bandwagon."
The Internet Tax Freedom Act of 1998 is the biggest problem for other states, he indicated: "They could probably structure a tax to get around the First Amendment and the Commerce Clause issues, but the logic of this decision makes it almost impossible for other states to single out digital advertising under the IFTA."
The Maryland provision taxes gross revenue, Jacobs noted. "You don't even have to be profitable. Taxpayers that have been making estimated payments of the Maryland Digital Advertising Tax should be thinking about filing refund claims," he suggested.
The ITFA prohibits states from taxing e-commerce differently from non-ecommerce. "The first argument opponents make is, 'Show us in your law where you would tax a non-electronic version of the same thing,'" said Scott Peterson, vice president of U.S. tax policy and and government relations at Avalara and the first executive director of the Streamlined Sales Tax Commission Governing Board.
The law was enacted by the Democratic-controlled Maryland General Assembly, over the veto of Republican Governor Larry Hogan. While digital advertising has been characterized as a tax on big U.S. tech companies, Republicans in the legislature celebrated the ruling as a boon to small businesses that depend on affordable advertising to market their services.
"Maryland has an existing income tax," observed Peterson. "There's no reason why the state's current income tax wouldn't have already picked up income from those companies. They might have been concerned that some companies don't have enough physical presence in Maryland to tax their income — sometimes sales tax nexus and income tax nexus are different in the same state, while sometimes they're the same. For instance, in Tennessee there still has to be physical presence in the state for an entity to be subject to income taxation."
Advertising is speech, and governments can't regulate speech, Peterson noted: "In Maryland's case, the law doesn't apply to the non-digital equivalent. Once a government starts to slice and dice advertising, and treat some speech differently from other speech, that's when they get into trouble."
Most of the arguments from digital advertising tax supporters are about how the tax can survive under the IFTA, according to Joyce Beebe, a fellow in public finance at Rice University's Baker Institute for Public Policy. "They say traditional advertising and digital advertising are completely different. I haven't seen strong arguments from DAT supporters defending the law on constitutional grounds."
"Also, although the argument is not about 'economics' anymore, gross receipts tax — that taxes revenues opposed to a profit-based tax that allows deduction of costs — is generally considered a bad idea due to tax pyramiding," she added. "If you don't allow deduction of intermediate inputs used for generating the final revenue, these elements will be taxed several times during the production process. Some of the legislators were also concerned that Maryland taxpayers would end up paying higher costs for services."
International ramifications
Beebe noted that the original intent of OECD's efforts is not revenue collection. "The OECD's BEPS [base erosion and profit shifting] project wants to align taxation with value creation — the market jurisdictions or users contribute to the contents, create value for the big tech platforms, and need to benefit accordingly. Recall that an important goal of Pillar One is to avoid unilateral digital services taxes, which are revenue-based taxes like DAT. The most recent Pillar One announcement — the 2023 Multilateral Convention – requires countries to withdraw their existing [digital services tax].
Beebe foresees the two movements converging because of the need for revenue. "The U.S.'s major argument against the OECD initiatives is that the U.S. will lose tax revenue to foreign countries. Although Treasury has previously said it will be revenue-neutral, some lawmakers are doubtful. Overall, both DAT and Pillar One face an uphill battle."
Vertex's Bernard sees a number of factors in play. "Countries are increasingly interested in making sure their own house is in order before agreeing to global agreements," he said. "It's a form of economic nationalism."
"They will look at the Maryland decision and it won't slow them down," he continued. "In the post-pandemic world, they need the money and they can't take on more debt. They have cut services as much as they can, so they will move forward with what's best for them, and they believe these companies can afford it. They don't have to be concerned about the Commerce Clause or the ITFA."
The global minimum tax was supposed to be a solution for all countries where it was perceived that companies benefitting from a market would pay some income tax to pay their "fair share."
"The digital tax attaches to that issue," he said. "Had Maryland won, it would have given a boost to the idea that signing onto the global minimum tax was good."
"But in the U.S., it will have to be done by treaty," he said. "Given the current lack of support for it in the Senate, it is unlikely it will have enough support. And that support is fading elsewhere in the world due to economic nationalism — nations have made the decision to take care of themselves first."
