On February 12, 2021, Maryland enacted the nation’s first digital advertising tax with a controversial vote by the Maryland Legislature to override the governor’s veto. The new tax is the first of its kind and is imposed at rates of up to 10% on a company’s gross receipts derived from digital advertising in Maryland. The law is effective March 14, 2021 and retroactively applicable to all taxable years beginning after December 31, 2020. Digital advertisers in Maryland should prepare for how to address reporting and remittance obligations due as soon as April 15, 2021.
The Maryland digital advertising tax is ripe for challenge on various bases, including as unconstitutional under the Due Process and Commerce Clause and as violative of the Permanent Internet Tax Freedom Act. Unsurprisingly, less than a week after its enactment, four major technology trade organizations filed a complaint in federal court in Maryland to challenge the new tax. The complaint, filed on February 18, 2021, alleges that the tax was enacted with the intent to discriminate against out-of-state digital advertising companies engaged in global business activities.
Various Aspects of the Tax Lack Clear Guidance
Applicable to all taxable years beginning after December 31, 2020, Maryland’s novel digital advertising tax is assessed on a company’s gross receipts derived from the provision of digital advertising services into Maryland. Digital advertising services broadly 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.” No further guidance has yet been released as to the scope of digital advertising services subject to tax.
Tax rates on revenue from digital advertising services range between 2.5% at the lowest bracket (for companies with $1 billion or less in global annual gross revenue) to up to 10% at the highest bracket (for companies with more than $15 billion in global annual gross revenue). The applicable tax rate depends on the company’s gross receipts from all global sources, rather than the company’s digital advertising revenue. Companies earning less than $1 million in gross revenue from digital advertising services in Maryland are not subject to the tax.
In addition, for apportionment purposes, the tax is computed based on worldwide gross receipts, but is apportioned based on Maryland gross receipts divided by total U.S. gross receipts. Accordingly, the tax fails to provide factor representation for foreign gross receipts that are included in the tax base and which would otherwise dilute the apportionment percentage. The determination of Maryland source digital advertising receipts is also unclear, and the Act merely provides that the Maryland Comptroller “shall adopt regulations that determine the state from which revenues from digital advertising services are derived.” However, the Maryland Office of the Comptroller has not yet released regulations or guidance. Prior legislation proposing a tax on digital advertising services suggests that sourcing may be determined based on the IP address of a user’s device or on whether the device had been used in the state. In practice, these standards would be very difficult to administer in a manner that results in a fairly apportioned tax. For example, IP locations may be imprecise and taxpayers may have difficulty determining the sourcing of receipts based on other data. Moreover, the Maryland corporate tax apportionment regulations do not specifically address digital advertising revenue to offer comparative guidance and consistent treatment.
Despite the lack of guidance, taxpayers are required to estimate and report Maryland digital advertising tax liabilities on or before April 15, 2021. The initial report requires prepayment of at least 25% of the estimated annual tax for all digital advertising services in the state for the current year. If a taxpayer underestimates the amount of gross revenue for the year, a penalty of up to 25% may apply to the extent the amount was underestimated. Additionally, willful failure to file a return may be subject to misdemeanor criminal penalties involving a fine of up to $5,000 and/or imprisonment for up to 5 years.
Legislative history suggests that lawmakers drafted the bill to specifically target certain large digital advertising companies and that lawmakers believed the tax charges could not be passed through from the taxpayers to consumers. As enacted, the digital advertising tax may potentially be interpreted as allowing the charge to be passed on to customers. Pending legislation in the Maryland General Assembly, however, would affirmatively block targets of the tax from passing the charge on to advertisers as a separately-stated line item, but would not prohibit indirectly passing on of the cost of the tax such as by raising prices. Further amendments to the law are also under consideration, including possible tax exemption for news media entities. Notably, Maryland legislators did not amend the state income tax in their enactment of the digital advertising tax, meaning that taxpayers with digital advertising activities in the state are potentially subject to multiple taxation on the same income, while other taxpayers are not.
Significant Legal Challenges
Maryland’s new digital advertising tax raises significant constitutional concerns, including under the Due Process Clause and Commerce Clause. These limitations under the U.S. Constitution generally provide that a state may not impose taxes which discriminate against out-of-state or foreign taxpayers in favor of in-state taxpayers. Maryland’s tax is assessed based on a company’s global revenues, meaning the tax could produce an unconstitutional result: a higher tax burden on multinational businesses compared to Maryland-only digital advertisers. As such, the tax may unfairly apportion income attributable to Maryland because the apportionment formula fails to provide factor representation of taxpayers’ foreign gross receipts. Other potential constitutional challenges arise under Foreign Commerce Clause principles, stemming from the law’s potential to subject taxpayers to enhanced risk of multiple taxation or to impair federal uniformity due to the discrimination against multinational and foreign taxpayers. Moreover, the tax may also be challenged as violating the First Amendment because the it discriminates based on the type of speech since only digital advertising, but not other forms of advertising media, are subject to the new tax.
Further, a gross receipts tax on digital advertising potentially violates the federal Permanent Internet Tax Freedom Act (ITFA) which prohibits a discriminatory tax on electronic commerce. In the new lawsuit challenging Maryland’s digital tax, petitioners point to express statements by lawmakers singling out specific digital companies with the bill. Also, because Maryland taxes digital advertising but does not similarly impose tax obligations on non-digital advertising revenues, such as via newspaper or radio, the tax is potentially discriminatory in violation of the ITFA.
Other States Considering Digital Advertising Tax
Unless Maryland’s tax on digital advertising receipts is successfully overturned, more states are expected to pursue taxes on digital advertising services, fueled in part by sizeable state budget deficits in the wake of COVID-19. As opposed to gross receipts tax like the one in Maryland, other states have considered legislation to include digital advertising in its sales tax base, raising separate concerns from the Maryland tax. Other states considering gross receipts or sales tax on digital advertising include Connecticut, the District of Columbia, Indiana, Massachusetts, Montana, Nebraska, New York, Oregon, South Dakota, Washington, and West Virginia.
Next Steps for Digital Advertisers
Maryland’s new digital advertising tax raises significant legal issues. Companies with receipts from digital advertising should carefully consider their filing position in Maryland. Specifically, taxpayers should consider possible opportunities to challenge the law and should take care to preserve their right to claim refunds on tax paid in the event that the tax is successfully overturned. Companies providing digital advertising services are encouraged to contact the authors to understand the new Maryland tax filing obligations, potential challenges to applicability of the tax to their business, potential sourcing methodologies, the ability to pass through the tax to customers, and for guidance to preserve opportunities for refunds on any taxes paid under the new law.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of approximately 725 lawyers practicing throughout a network of 13 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy and technology sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.