For years, affiliate marketers, social media companies, online marketplace platforms, and search engines alike have enjoyed the seemingly ubiquitous tax-free landscape from their digital activities afforded to them by the United States’ Internet Tax Freedom Act of 1998. However, that could all be changing soon.
On the horizon, taxpayers should prepare themselves for the next evolution in state taxation: digital advertising taxes. As policymakers and tax practitioners eagerly look to Maryland spearheading the first-in-the-nation digital advertising tax (DAT), legal concerns have been raised about the validity of Maryland’s recently enacted tax.
Poised as a gross receipts tax on in-state digital advertising revenues, Maryland’s DAT takes aim at large technology companies that have benefited from years of digital advertising as the catalyst for generating insuperable amounts of wealth.
Maryland’s digital ad tax applies a graduated rate that escalates based on the taxpayer’s global annual revenues. The tax brackets are as follows:
- 2.5 percent of the assessable base for persons with global annual gross revenues of US$100 million through $1 billion
- 5 percent of the assessable base for persons with global annual gross revenues of more than $1 billion through $5 billion
- 7.5 percent of the assessable base for persons with global annual gross revenues of more than $5 billion through $15 billion
- 10 percent of the assessable base for persons with global annual gross revenues exceeding $15 billion
Currently, Maryland’s DAT applies to taxpayers with at least $1 million of annual gross revenues derived from digital advertising services within Maryland and taxpayers with global annual gross revenues of $100 million or more.
Taxpayers subject to the tax are expected to file an annual declaration of estimated tax and make quarterly estimated tax payments. Maryland’s first declaration of estimated tax is due April 15, 2022. In addition, taxpayers must maintain books and records of their digital advertising services provided in Maryland to validate the basis for their apportionment and, ultimately, the taxpayer’s calculated digital ad tax.
The Maryland Comptroller has issued proposed regulations to provide clarity on the calculation. The Comptroller proposes to calculate the numerator of the apportionment factor by determining whether the device showing the advertising is in Maryland. The denominator is the number of devices that have accessed the digital advertising services from any location. This fixes one of the issues with the statute in which the denominator was only devices in the U.S., but the revenues were worldwide revenues.
Expanding on the legality of Maryland’s digital ad tax, the law presents unique constitutional challenges at the federal level that will undoubtedly be an uphill legal battle for the state. Maryland’s DAT law creates a legal inequity, in that, the law unfairly targets online advertisers, while not applying the same rules to other forms of advertising in the state, such as, radio, television, and print.
The Internet Tax Freedom Act was created over twenty years ago to prevent this type of digital discrimination. However, similar to the surprising outcome for many tax practitioners in the Wayfair case, it’s entirely possible the federal law will evolve to service the ever-changing e-commerce landscape.
The legal battles include the complaint filed in federal district court by the U.S. Chamber of Commerce and various trade groups. Their complaint states that the new law violates the dormant Commerce Clause, the Fourteenth Amendment Due Process Clause, and the Internet Tax Freedom Act. They argue that the tax is discriminatory in that it favors in-state companies, and it punishes out-of-state activities as the tax base specifically includes gross receipts from outside the state of Maryland.
In addition, Comcast and Verizon have filed a separate complaint in state court. Their complaint challenges the tax on grounds similar to the federal district court case and on additional grounds that it violates the Supremacy Clause and the Declaration of Rights in the Maryland Constitution.
New York, Connecticut, Indiana, Montana, Nebraska, Oregon and Washington, have all drafted or proposed similar legislation for gross receipts consumption-based taxes on digital advertising services. In 2021 alone, twelve DATs or similar tax-type data bills were introduced in various states.
However, many of these bills have not been enacted because state legislators are waiting on how Maryland’s digital advertising tax will be implemented amidst the administrative, economic, and legal challenges.
Is California Next?
Maryland’s new law has put many California tech companies on notice. Moreover, the question is: “Will California enact its own DAT?” Admittedly, it’s too early to make any reasonable predictions. While it’s possible California could enact a DAT, or something similar, it’s unlikely to happen anytime soon.
First, the Internet Tax Freedom Act would need to be challenged by state lawmakers, adjudicated by the Supreme Court, and changed. This is no easy feat. Next, California would need to pass its own law either through California legislative and executive branches, or potentially through a state proposition.
Given that California is already seen as an unfriendly business state compared to Texas, Tennessee, and Florida, a California DAT could create more incentives for companies to leave the state or cease to do business in California altogether.
Additionally, tech is a prominent and influential business sector in California. The industry contributes to the state’s corporate income tax revenue, and it creates jobs, leading to an echo revenue stream generated by individual California resident taxpayers.
From a state sourcing perspective, determining where to source digital ad revenues can be problematic, especially, when an ad’s reach, impression location, and impact are unknown to the advertiser.
By California regulations standards, Section 25136-2 provides cascading rules on how to source services and intangibles, including digital ad revenue. In situations where either the benefit of the service or intangible is indeterminable, California allows taxpayers to use a reasonable approximation approach, whereby, sales are bifurcated by jurisdiction based on a common variable, such as census data population, ad impressions, unique user IDs, customer quantity, sales metrics, etc.
Furthermore, California’s sourcing regulations are soon changing. Proposed amendments to the sourcing of sales other than tangible personal property go into effect starting 2023.
What does the future hold for online advertisers? At this point, it’s unclear. Many of the DAT and sales of personal data laws currently proposed are targeting Big Tech, but there will certainly be a ripple effect amongst small businesses who use their services. Online marketplaces will need to adapt, and more importantly, stay educated on this constantly evolving issue.