At a Glance…

Following the vote by the Maryland Senate to override a gubernatorial veto on Friday, February 12, 2021, Maryland became the first state to enact a tax on digital advertising services.  Amendments to the new law are now being considered by both chambers of Maryland’s General Assembly.  Below, we take an in-depth look at Maryland’s newest tax, highlight the immediate and potential residual effects of Maryland General Assembly’s veto override and the potential changes, and provide a forecast on whether the tax will survive the expected judicial challenges.

Review of Maryland’s Digital Advertising Gross Revenues Tax

Digital Advertising Services

Until two days before the early end of the 2020 legislative session, House Bill 732 (“HB 732”) focused on the taxation of cigarettes, electronic smoking devices, and other tobacco products. However, after the smoke cleared, the General Assembly rolled in a new tax – the Digital Advertising Gross Revenues Tax (“Digital Ad Tax”). The Governor vetoed HB 732 on May 8, 2020. However, on February 11, 2021, the General Assembly voted to override the Governor’s veto.

The Digital Ad Tax imposes a new tax on the annual gross revenues businesses derive from providing “digital advertising services” in Maryland.1 The legislation (currently) defines “digital advertising services” to include “advertisement services on a digital interface, including advertisements in the form of banner advertising, search engine advertising, interstitial advertising and other comparable advertising services.”2

Calculating the Digital Ad Tax

The Digital Ad Tax is imposed on a business’s “annual gross revenues,” defined as “income or revenue from all sources, before any expenses or taxes, computed according to generally accepted accounting principles,” derived from digital advertising services in Maryland.3

An apportionment fraction is to be used to determine the annual gross revenues derived from digital advertising services in Maryland.4 The numerator would be the gross revenue of a company that comes from digital advertising in Maryland and the denominator would be the gross revenue of a company that comes from digital advertising across the U.S.5 How companies should determine the state from which revenues are derived is an open question. The law requires the Comptroller to adopt regulations to resolve this question.

Who is Subject to the Digital Advertising Gross Revenues Tax?

As currently enacted, the Digital Ad Tax potentially applies to numerous businesses, including many located outside Maryland. While the minimum assessable tax base is global annual gross revenues of at least $100 million,6 the threshold for being required to file an annual return with the Comptroller is just $1 million in annual gross revenues from digital advertising in Maryland.7 Additionally, persons who expect their annual gross revenues derived from digital advertising services in Maryland to exceed $1 million are required to file a declaration of estimated tax and pay 25% of the estimated tax on or before April 15, 2021.8 Further, declarations of estimated tax, estimated tax returns, and payments of 25% of the estimated tax will be due on or before June 15, 2021, September 15, 2021, and December 15, 2021.9

Regardless of whether the Digital Ad Tax is ultimately due, the law requires businesses that provide digital advertising services to determine whether they derive revenues from digital advertising services from within Maryland. If a business projects that its receipts derived from digital advertising services in Maryland will exceed the $1 million annual threshold, it will have a filing obligation that is quickly approaching. Based on a plain reading of the statute, a filing requirement exists even for taxpayers that do not meet the minimum assessable tax base threshold. Presumably, businesses with global gross revenues of less than $100 million will be required to file declarations stating that they do not owe tax.

Notable Administrative Issues

April 15, 2021 Filing Deadline

Since last year, various tax practitioners have questioned how digital advertising revenue would be sourced for purposes of determining the amount of receipts derived from digital advertising services in Maryland for purposes of the Digital Ad Tax. The legislative solution was to pass the buck. The law requires the Comptroller to draft regulations to determine the state from which revenues from digital advertising services are derived.10 While this conundrum was ancillary to the many legal issues that plague the law, it now likely tops the list of concerns for affected taxpayers. Because the law was enacted by way of an override of a gubernatorial veto, it takes effect 30 days after override.11 This means that the April 15, 2021 deadline for the filing of a declaration of estimated tax and paying at least 25% of the “reasonably estimated” Digital Ad Tax is intact. It is unclear if the Comptroller’s Office will be able to draft regulations in time for the initial filing deadline. Affected taxpayers should contact their tax advisers immediately to determine how best to address these issues.

Internet Tax Freedom Act

It would be an understatement to say that Maryland’s Digital Ad Tax raises a number of legal issues. The most prominent issue is that the Digital Ad Tax likely violates the Internet Tax Freedom Act (the “ITFA”).12 In 1998, Congress enacted the ITFA to prohibit state and local governments from imposing “multiple or discriminatory taxes on electronic commerce.”13 The ITFA specifically defines what constitutes a “discriminatory tax.” If a transaction is generally not taxed when it is conducted through traditional commerce, then the ITFA bars a state from taxing a similar transaction when conducted through e-commerce.14

The Digital Ad Tax seeks to impose a discriminatory tax of precisely the kind that the plain language of the ITFA prohibits. This is because the law imposes a tax on digital advertising services, while not imposing the tax on similar non-digital advertising services. For example, the Digital Ad Tax could be imposed on the annual gross revenues derived from the advertising of an item on a website, but tax would not be imposed on annual gross revenues derived from the advertising of that same item in magazines or on billboards. The industry carve outs contained in SB 787 would only further highlight the unlawfulness of the tax. Specifically, the explicit exemptions for certain broadcast and media companies included in Senate Bill 787 (described below) would only serve to illustrate the discriminatory nature of the tax.

The targeting of the Digital Ad Tax is similar to that of an Illinois sales tax nexus provision that applied to remote sellers that advertised via website but not remote sellers that advertised through traditional commerce (e.g., mail order catalogs, telephone sales, etc.). The Illinois provision was challenged in Performance Marketing Association v. Hamer.15 In Performance Marketing, the taxpayer argued that if it used any advertising method other than the Internet, it would not have an obligation to collect and remit tax on its sales.16 But for the taxpayer’s use of the Internet, there was no collection obligation on its sales. The Illinois Supreme Court found that this law violated the ITFA because a tax collection obligation existed only on the party engaged in electronic commerce.17 The remedy in Performance Marketing was to declare the nexus provision “void and unenforceable.”18

Commerce Clause Issues

The Digital Ad Tax may also violate the Commerce Clause of the U.S. Constitution. The use of global gross revenues, instead of Maryland revenues, for purposes of determining the tax rate raises issues under the Commerce Clause because it could result in a multistate provider of advertising service being taxed at a higher rate than a purely intrastate provider – even if both providers had the same annual gross revenue from digital advertising services attributable to Maryland. Applying a higher effective tax rate to a multistate or global advertising business discriminates against interstate and foreign commerce. Additionally, the Digital Ad Tax’s sourcing provisions may violate the Dormant Commerce Clause, which limits a state’s ability to impose a tax burden on an out-of-state company that unduly burdens interstate commerce.

What is New?

Proposed Amendments to the Digital Ad Tax

After catching wind of the potential of a veto override, various taxpayers and advertising associations engaged in campaigns to raise awareness of the potential business and legal consequences of enacting the Digital Ad Tax. A chief concern is that providers of digital advertising services will pass the cost of the tax on to purchasers of such services. In reaction, identical bills were cross-filed in both chambers (Senate Bill 787, introduced on February 5, 2021 and House Bill 1200, introduced on February 8, 2021).

As introduced, the bills seek to exempt certain advertising service providers by modifying the definition of “digital advertising services” to exclude advertisement services on digital interfaces that are owned or operated by or operated on behalf of entities that primarily engage in either “the business operating of a broadcast television or radio station” or “the business of newsgathering, reporting, or publishing articles or commentary about news, current events, culture, or other materials of public interest.”19 Additionally, the bills seek to prohibit digital advertisement service providers from “directly” passing on the Digital Ad Tax to their customers “by means of a separate fee, surcharge, or line-item.”20 The current language in each bill note that the amendments would take effect July 1, 2021 and apply to all taxable years beginning after December 31, 2020.

The Senate Budget and Taxation Committee held a hearing on Senate Bill 787 on February 17, 2021 and the House Ways and Means Committee held a hearing on House Bill 1200 on February 26, 2021. As a next step, each Committee will vote (e.g., favorable, unfavorable, favorable with amendment, or no recommendation) on the bills and report to their respective floors. If either bill makes it though its second and third readings, it will be sent to the opposing chamber for consideration. If passed, the bill will be sent to the Governor’s desk.

Notable Administrative Issues

Neither of the bills, as introduced, would take effect immediately upon the Governor’s approval.21 The July 1, 2021 effective date raises questions regarding the statutory filing obligations for providers of advertising services that meet the definition of digital advertising services prior to the passage of amendments. The current law mandates companies that expect to meet the revenue threshold to file declarations of estimated tax, file a quarterly estimated tax return, and pay 25% of the estimated tax on or before April 15, 2021 and June 15, 2021.22 Additionally, the law provides that the willful failure of any person who is required to file a return is guilty of a misdemeanor and is potentially subject to monetary penalties.23

During both hearings, the sponsors of Senate Bill 787 and House Bill 1200 acknowledged that the Digital Ad Tax and proposed amendments would be challenged in court.24 One lawsuit, seeking a declaration and injunction against enforcement of HB 732, has already been filed in the United States District Court for the District of Maryland.25 While the complaint briefly mentions the proposed amendments, it does not address the additional legal issues presented by the amendments. If the amendments were to be enacted, the classifications of advertising service providers created by the exemptions would arguably violate the Equal Protection Clause of the U.S. Constitution due to a lack of a rational basis for discriminating against advertising services provided on a digital interface. A litigant might also argue that the proposed amendments that prohibit service providers from separately stating the Digital Ad Tax on the bill to their customers violate the free speech protections set forth in the First and Fourteenth Amendments.

With the enactment of the Digital Ad Tax, Maryland becomes the first state to impose a tax specifically on digital advertising revenue, but it may not be the last. Similar legislation is under consideration in several other states, including Connecticut,26 Massachusetts,27 Montana,28 and New York.29 To the extent that any of these states decide to use Maryland’s law as a blueprint, those taxes will likely raise the same legal issues Maryland’s Digital Ad Tax.