Tram Le and Judy Vorndran look at states following Maryland’s lead on digital services and how they have proposed versions of a new tax on digital advertising or data. How would those taxes work? What new taxes are already law, and which may eventually be enacted? And how can taxpayers protect themselves now?
By Tram Le and Judy Vorndran, Spreading SALTovation for Tax Notes State (December 6, 2021, p1031)
The impetus behind a digital tax of this type stemmed from a New York Times op-ed by Nobel Prize-winning economist Paul Romer.1 He asserted that giants like Facebook and Google have undermined the public’s trust in democratic institutions by allowing their platforms to become “havens for dangerous misinformation and hate speech,” thereby eroding “the commons of shared values and norms on which democracy depends.” To encourage these companies to shift to a “healthier, more traditional model,” Romer suggested that instead of using regulations or the antitrust law to ban the current model, which harvests user information to enable targeted advertisements, the federal and state governments should tax the revenue generated from these targeted advertisements. At the state level, Romer suggested that it could be done via a gross revenues tax — “a type of sales tax on the revenue a company collects for displaying ads to residents of the state.”
While gross receipts taxes have gone in and out of favor over the years, gross revenues taxes are new. As more states wade into gross revenue taxes, there is uncertainty regarding how these taxes are defined and enforced. One thing, however, is clear: The onus is on everyone — businesses and consumers — to pay gross revenues taxes on digital ad revenue streams.
In Maryland, the vetoed bill was silent on whether sellers of digital advertising services would be able to pass the tax through to taxpayers like a sales tax. The bill that took its place, however, said sellers could not pass the tax on to end users, making it a tax on the issuing entity and directly increasing business costs of providing advertising services.
Maryland lawmakers pushed the onus of application — creating forms, writing regulations, and defining sourcing — onto the comptroller’s office, all of which takes time to work through. Proposed gross revenue tax regulations have been issued,2 but the effective date was pushed back from January 1, 2021, to January 1, 2022.3
These starts and stops may have created further confusion. For example, how is a digital advertising tax going to be sourced in Maryland on California buyers for advertisements purchased for nationwide viewing? What about advertisers that get paid a percentage of transactions that consummate in a sale based on a revenue share agreement or commission? Or is the advertising a sale for resale that looks like a commission, but is not? How do value-added resellers fit into the taxing equation? Invoices, contracts, and agreements should be reviewed to even begin to understand what might constitute digital advertising.
What Are Digital Advertising Services?
Maryland 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.” This scope includes “any type of software website or application that a user can access.”
Digital advertisement services in the form of a banner or search engine are included in Maryland’s definition; however, properly characterizing other types of digital advertising as “other comparable advertising services” in the digital space would be nearly impossible, and imposing tax on some types of digital advertising services is arguably discriminatory. Print ads in newspapers and other outlets are not charged a tax, so why the interest in taxing digital advertisements?
The answer is that that is where potentially large revenue streams are hiding. Applications like Facebook and search engines like Google are free to end users because advertising foots the bill. From any search engine, search results often start with paid advertising before listing organic search items. The search engine makes money when a user clicks on the sponsored ad.
Technology companies capitalize on algorithms that identify and select products or services that might appeal to a user because of their searches. How this is different from mailing a catalog to a recipient who might be interested in buying an artificial Christmas tree because they live in Florida, where there are no native pine trees, is unclear. With print, catalog production might be subject to sales or use taxes, but the revenue from distributing those catalogs is only subject to ordinary income taxes, not a special advertising tax.
Although counter to historical treatment, digital ad revenue taxes are seen as a different animal. If tax authorities can figure out how to tax search engine optimization, information sharing, and metadata-gathering organizations, then we can expect tax policies the country over to begin doing so, regardless of how they treat print advertising taxes.
Figuring Out Sourcing and Apportionment Rules
A challenging issue that states face is deciding how these companies are supposed to know what part of their revenue is earned in what state. While the proposed Maryland regulations attempt to clarify sourcing rules, they do not adequately resolve the potential issues of double taxation when other states may impose a similar tax and risk taxing out-of-state revenue for digital advertising services, which cross state and international borders.
Under the proposed regulations, revenues from digital advertising services are sourced to Maryland when any portion of the advertisements are viewed through a device in the state. To determine a device’s location, the rules suggest that taxpayers look to the IP address, geolocation data, device registration, cookies, or any other comparable information. However, a device’s location may be difficult to determine if taxpayers do not have reliable or accurate information, especially when advertisements are viewed with devices via virtual private network and the location is shielded.
As for the apportionment formula, the numerator would include the number of devices that have accessed the digital advertising services from a location in the state, and the denominator would be the number of devices that have accessed the digital advertising services from any location. The factor would then be applied to the taxpayer’s digital advertising gross revenue to compute the digital advertising gross revenue attributable to Maryland.
This calculation is complicated and requires taxpayers to distinguish the reach of their digital advertising revenue versus other related and unrelated business revenue. Devices with an indeterminate location are excluded from the apportionment factor. When taxpayers are unable to make such determinations, the exclusions likely distort the apportionment factor out of proportion with actual activity.
Other Issues and Concerns to Address
The intent here appears to be to expand the tax base to include Google, Facebook, and other large online platforms as the tax affects only taxpayers that have global revenues above $100 million. Taxpayers at the $100 million level of global revenue would be right at the 2.5 percent starting rate, which is phased up to 10 percent depending on the taxpayer’s annual global revenue. So, the more digital advertising, the higher the tax rate.
It is unclear which taxpayers other than the advertising tax umbrella, but we are unsure why that couldn’t include traditional print media, which is transitioning to a hybrid of print and online.
Another major concern with digital advertising tax is the concept of tax pyramiding. It is unclear at what stage of the transaction this tax applies or if it could apply at multiple stages of a digital advertising transaction, creating a tax-on-tax situation. The proposed Maryland regulations have exclusions for some broadcasters and news outlets but could still capture many other companies and taxpayers not initially intended to be taxed.
Years ago Maryland similarly enacted a tax on computer services that was repealed before it was effective, so there is precedent for the state moving forward with tax policy before it is ready to enforce it. Michigan did something similar and repealed its tax within days of passing. Neither of these attempts to expand the tax base had constitutional challenges — rather, both alienated businesses and undermined competition. With its digital advertising tax, Maryland may see that enacting an unconstitutional tax is not good for anyone.
The digital advertising tax is controversial and under challenge in court at the state and federal level. There are questions that must be answered about whether it violates the Internet Tax Freedom Act, a federal law that prohibits discriminatory taxes and runs afoul of the interstate commerce clause. States interested in enacting a similar tax will be watching as the Maryland litigation unfolds.
Other State Initiatives to Tax Digital Services And Data
Several other states have considered imposing a tax on digital advertising services with similar provisions to Maryland’s digital advertising services tax. For example, Connecticut proposed H.B. 6187, which would impose a 10 percent tax on annual gross revenues from digital advertising for businesses with annual worldwide gross revenue of at least $10 billion. H.B. 363 in Montana would impose a 10 percent tax on gross revenue from digital advertising in the state for sellers with worldwide revenue of $25 million or more. Similarly, New York introduced bills imposing a gross receipts tax under S. 1124 and a sales tax under S. 302 on digital advertising in the state.
Texas also has H.B. 4467, which would impose a tax on global gross revenue, which is computed before any expenses or taxes according to generally accepted accounting principles of at least $100 million on taxpayers with an assessable tax base (annual gross revenue) of at least $1 million from digital advertising services in the state. The tax rates would depend on the taxpayer’s annual global gross revenues. The rate would be 2.5 percent of a taxpayer’s assessable base if gross revenue is between $100 million and $1 billion, up to 10 percent of a taxpayer’s assessable base if gross revenue is over $15 billion.
Then there are states looking to tax income derived from the sale of user data. Most recently, New York proposed, in S. 1124, a 5 percent tax on the gross income of taxpayers that derive income from user data shared by individuals in the state. Oregon H.B. 2932 would impose a 5 percent gross receipts tax on the privilege of doing business in the form of selling taxable personal information obtained from individuals using an Oregon IP address. In Washington, H.B. 1303 would impose a 1.8 percent business and occupation tax on those engaging in the business of selling or exchanging personal and consumer data in the state for consideration.
Yet other states such as Arkansas, Connecticut, and Indiana are targeting social media providers. Arkansas S.B. 558 would impose a 7 percent sales tax plus $1 for the average number of Arkansas account holders on advertising revenue from social media platforms that have annual gross revenue of at least $500,000 from social media advertising services in the state. The definition of social media advertising services resembles Maryland’s definition of digital interface and includes “advertising services that are placed or provided on a social-media platform, including without limitation banner advertising, promoted content, interstitial advertising, and other comparable services.” “Social-media provider” includes companies that maintain or operate a public social medial platform, and that have at least 500,000 Arkansas account holders. Connecticut — under H.B. 5645 — would impose an annual gross revenue tax on income derived from social media advertising services in the state.
Indiana is considering a “social media provider surcharge tax” and “annual registration fee” on social media providers based on the number of active users in the state. H.B. 1312 would impose a 7 percent surcharge tax on “annual gross revenue derived from social media companies that maintain a public social media platform and have more than 1 million active users, have annual gross revenue of at least $1 million from social media advertising services, and derive economic benefit from data individuals shared with the company in the state.”
Also, Indiana’s H.B. 1572 would impose an annual fee of $5 per active account holder on taxpayers with more than 1 million active users in the state. There is no revenue threshold requirement for the annual fee.
Digitized Format Taxes
Most products and services now being considered for digital taxes once had a tangible equivalent and were part of the tax base. What we’ve seen over the years is that that tax base eroded as new technologies delivering goods and services (that were historically taxed) morphed into digital format and went online. State taxes that avoid expanding the tax base and instead focus on purely tangible equivalents like downloaded e-books, movies, and music have been the easiest to implement.
Those taxes without a tangible equivalent — created in the digital space for the digital space — are trickier to implement, such as streaming and web-based cloud storage such as Amazon Web Services Inc. Washington was the first state to step up in 2009 to pass sweeping legislation that gave us a peek at where states would be headed with digital taxation.4 Sponsored by Rep. Ross Hunter, who had worked at Microsoft, the law recognized that technology that is taxed today might be obsolete tomorrow.
Washington created a digital automated service tax5 meant to capture anything technology related and was created in conjunction with taxes on digital products and remotely accessed software. Then, the state created carveouts and exceptions that have become obsolete or subject to interpretation.
There are carveouts for services that involve principally human effort, such as those considered a professional service. For example, a financial analysis report created at the customer’s request that reflects the financial expert’s professional analysis, calculations, and judgment, which is sent to the customer electronically, is considered evidence of a professional service and not a digital good.
In setting the law, Washington recognized that these products could be concurrently used in multiple jurisdictions. The law gives purchasers the ability to issue an exemption certificate, which protects sellers. Today, several states have followed Washington’s lead and provide for multiple points of use exemptions.
Evolving Nature of Digital Taxes
In this evolving area of tax law, taxpayers must choose an enterprise-wide path, be able to explain why they are doing what they are doing, and make sure they can justify a consistent practice regarding tax imposed on their digital services.
As additional states adopt taxes they see working elsewhere, taxpayers might need remediation strategies to catch up. In one state the taxpayer could be overtaxed, but then in another they may not report any customers and be undertaxed.
With all the uncertainties in how digital services are characterized and sourced, it will be difficult to determine who pays the tax on this new and emerging industry. One thing is for sure: Taxpayers and consumers will be the ultimate payers as businesses pass along a share of their digital advertising costs in their pricing.
Upfront work on determining what tax implications might exist will help: Keep employee records, contract addresses, and use tax review support. Ask questions and know who the users are. Examine marketing materials, ancillary documents, contracts, and invoicing practices with the new tax in mind. If dealing with a refund claim on a retroactive basis, this consistency and contemporaneous records will help bolster a taxpayer’s claim.
1 Paul Romer, “A Tax That Could Fix Big Tech,” The New York Times, May 6, 2019
2 Maryland Register, Proposed Action on Regulations (Aug. 30, 2021).
3 Comptroller of Maryland, Digital Advertising Gross Revenues Tax Bulletin 21-2, “Applicability Date of Digital Advertising Gross Revenues Tax Delayed” (undated).
4 Wash. H.B. 2075
5 Wash. Rev. Code section 82.04.192.
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