Episode 33: Exploring Digital Advertising Taxes
Welcome back to “Tackling Tax,” where we’ll bring you the latest on tax policy and strategies—in an easy-to-understand format. Whether you’re looking to learn more about tax bills, global tax implications, or planning insights for your business, you’re in the right place.
Listen every other week for more from our guests, which include everyone from university scholars to industry professionals to the firm’s experienced leaders.
In this episode, we’ll look at digital advertising taxes, a topic that is becoming increasingly controversial as the Maryland Tax Court recently struck down the tax. We welcome Nicole Johnson, a state and local tax attorney with Blank Rome in New York, to share her insights.
If you have any questions or need any assistance, please reach out to a professional at Forvis Mazars.
Transcript
IRIS LAWS
On this episode, we're focusing on a topic becoming increasingly controversial: digital advertising taxes. For our conversation today, we welcome Nicole Johnson, an attorney and partner with Blank Rome in New York. From your one stop for tax updates and analysis, I'm Iris.
LANCE JACOBS
And I'm Lance.
IRIS LAWS
It's Tuesday, August 25th and this is “Tackling Tax.”
LANCE JACOBS
It's my pleasure to introduce Nicole Johnson, who's a state and local tax partner at Blank Rome out of their New York office. Nicole has vast experience in state and local tax, including income and franchise tax, sales and use taxes, gaming taxes, among other taxes. In addition to handling litigation matters extensively, she also serves as a consultant and an advisor to clients on transactional and operational matters as well.
I'd also be remiss if I didn't note that her firm bio states that she's a licensed bartender, so I may have to ask her some advice on my personal quest on how to make the perfect martini. Iris, you won't be surprised that I have thoughts.
IRIS LAWS
Not at all.
LANCE JACOBS
Nicole, welcome.
NICOLE JOHNSON
Well, thank you, Lance and Iris for having me today. And I think, as we should at the end of this, everyone should celebrate with the perfect martini.
LANCE JACOBS
Absolutely. So, it was kind of a big week last week in in state and local tax—I guess every week is a big week in state and local tax—with the issuance of the opinions out of the Maryland Tax Court on the digital advertising taxes, which is going to be the focus of our discussion today. So, Maryland was the first in the country to impose a digital advertising tax.
I think it goes back to 2021 or 2022. Just to kind of level set for our audience, can you give us a basic overview of what the digital advertising tax is and how it works, at least according to Maryland?
NICOLE JOHNSON
Of course. And that's always how you have to start, right? This is how it works, according to the comptroller. Not maybe according to those who actually have to implement the tax. So, if we look at the digital ad tax, you're looking at three kind of components of it. The first is for a company to be subject to the tax, they have to have global gross revenues over $100 million.
And I think that that piece is key. So, you need global gross revenues. You also need $1 million in annual gross revenues from digital advertising services in Maryland. And that's determined by an apportionment formula. And you look at where those ads essentially were viewed on devices. So, if you have a thousand devices that are viewing this ad and 400 are in Maryland, and the rest, the other 600 are across the country, that means that’s your percentage assigned to Maryland and you need to have over a million in gross revenue from that digital ad services assigned to Maryland.
The third component is you need to be not exempt from the tax. So, when they were enacting the tax, they did a few carveouts specifically for broadcasters and news media entities. So, if you're one of those entities, you're not subject to the tax. But essentially what you're looking at is your global revenues. And then that tiny amount that could be taxable in Maryland, right?
So, those are the basics; are you subject to the tax, do you have digital advertising services which is a bit broader of a question. But if you get into the actual application of the tax, you start looking at the varying rates. And those rates vary from 2.5%, up to 10%, and it's based on your amount of global revenue.
And that'll be a key point of the decisions that we talk about is that if your global revenues are only $100 million, your tax rate is 2.5%. If your global revenues are $15 billion, that means that your tax rate is 10%, not having anything to do with what you do in Maryland. So, it's not your apportioned amount that you're determining that tax rate on.
It is your global revenues that you're determining that amount on. The other interesting aspect of it is let's say you have $99 million worth of digital ad revenue worldwide. Your tax rate is zero. But as soon as you hit that $100 million, you are subject to tax, and the smallest bracket would be 2.5%. And so, it's really looking that $1 tips you over to suddenly having all of that income be taxable as opposed to really a graduated step up.
IRIS LAWS
All right. Well that definitely helps with some background for someone who's not a state and local tax person. Makes a lot more sense. You know, talking with Lance a little bit before this, he mentioned maybe a long and tortured litigation history when it comes to this. Could you shed a little more light on that or maybe highlight/lowlight, if it was based on a situation?
LANCE JACOBS
Sure, and I would like to call back, Nicole did leave you a couple little breadcrumbs in her answer that are going to come when we start talking about the decision that the tax court laid out. You're going to want to recall those breadcrumbs. I'm not necessarily saying you rewind and listen to it again. But she did point out some breadcrumbs that are going to be significant when we discuss those three decisions, as it were.
So, right after the tax got enacted, taxpayers litigated. And in state and local taxation, taxpayers generally don't want to litigate state tax matters in state court. I, when I talk to my clients about it, the parallel I use to litigating something in state court is to sports and it's like you're always playing a road game.
So, the first move is that taxpayers like to sue in federal court on state tax matters if they can. The key word there is if they can, because there's a federal law called the Tax Injunction Act that really is a bar to litigating, is a bar to litigating state tax matters in federal court. So, there was a case filed in federal court that largely got kicked out of federal court, but one piece got held back.
So, most of it got kicked out of federal court but the piece that got held back was a First Amendment issue. And the First Amendment issue, I think, boiled down to this: the statute expressly barred the digital advertising companies from expressly passing through the tax to their customers, and that case was retained in federal court and ultimately produced a taxpayer win that was upheld at, I believe, at the Fourth Circuit Court of Appeals, which was the bar on passing through the tax was lifted and taken out of the tax.
The next stage was those pieces that were sent back to the state for hearing. They actually in, I think it was in Anne Arundel County circuit court, taxpayers won a victory there, finding that the tax was unconstitutional. That case wound its way up to what was historically called the Maryland Court of Appeals, but they renamed it because it was the most confusing state court naming convention in the nation outside of New York.
But what is now the Maryland Supreme Court overturned that decision based upon, again, a technicality based upon the idea that taxpayers, when they litigate things, have to exhaust their administrative appeals. So, there's a line that you have to follow, a series of steps, if you will. And according to the Maryland Supreme Court, these taxpayers jumped the line. So, they had to go back to square one and have it work all its way through in the proper order.
Which brings us, I think, and Nicole, if I missed any cases, I think those are the big ones. If I missed any cases, feel free to add in here. But that's where we're at. That's how we ended up with these particular cases before the Maryland Tax Court.
NICOLE JOHNSON
I think you've covered it. I mean, those are really what mattered to get us where we are today for Apple, Peacock, and Google.
IRIS LAWS
So, then let's talk about maybe last week, then Nicole. From there, can you break down the opinion that we just recently had?
NICOLE JOHNSON
Sure. I mean, it was a resounding win for the taxpayer. So, there were three separate decisions. And if you are dorky enough, you can go ahead and read all three. They are strikingly similar. So, I would say maybe save your time, but if you're interested enough, go ahead. So, for Apple, Peacock, and Google essentially what the tax court said is it ruled for them on all issues.
It ruled for them under the Internet Tax Freedom Act, the ITFA, as well as their constitutional arguments, really looking at the four-prong test of “Complete Auto,” and then also due process and saying that across the board this tax fails and the comptroller can't support it, right? So, if we look at the ITFA, essentially it means you can't have a discriminatory tax against electronic commerce.
Essentially what they were trying to say is that if you don't tax something in physical form, that you shouldn't be able to tax it in electronic form, something that's done over the internet. So, I think the easiest example of that is think of a book, right. If you don't tax that book in physical form, but you want to tax the book that you have on your e-reader, well, that would be a violation of the ITFA.
And I think to me that is one of the most clear violations, right? They are very similar products. One is being taxed, one isn't. And so, therefore you can't do that under the ITFA. So, here the question was is digital advertising that is subject to tax in Maryland similar to other types of advertising. You know, if you're looking at print advertising, things like that, if you're picking up a magazine or a newspaper, other types of advertising that you would see, is it similar to that?
And I believe the court noted that they had days of trial over what is similar, what does similar mean? And I have to say, well, I am a tax nerd. That would be rough to sit through days of it.
IRIS LAWS
The barnburner that one, yeah.
NICOLE JOHNSON
I mean, I assume the audience was busting out the doors with excitement over those days, as important of an aspect as it is. But it really was looking at what is similar in terms of digital ad taxes and the department, or the comptroller had witnesses, as did the companies. And ultimately the tax court said very cleanly that digital advertising is similar to—it's even more than similar.
It is essentially the same as other types of advertising. And therefore, when you're taxing that and not the physical or other forms of it, the non-digital means of it, you're violating ITFA, and therefore the law can't stand as it is.
IRIS LAWS
It makes logical sense to me. I mean, Lance, your thoughts?
LANCE JACOBS
So, I, actually, I am going to kick this back to Nicole because reading the judge's opinion, initially he was very complimentary of all four witnesses that were called during the, what Iris referred to as the barnburner session.
But reading between the lines, what seemed to me to be the—again, and not that this was the most exciting trial to witness— whether you want to call it the Perry Mason moment or the “you can't handle the truth” moment if you want to bring it up a little bit further, was the expert for the state who, and I may be muddling this a little bit, that he wasn't comfortable opining on what similar meant because it was a legal concept, but he was comfortable opining on what it was to be comparable and what I assume one of the taxpayers lawyers said, hey, when you go to Webster's and you look at it, the second definition for comparable is similar.
So, that was kind of like if you read between the lines, I thought that that particular piece of evidence carried weight for the taxpayer significantly. It sounded like, you know, even though that judge was very complimentary of all four witnesses, it sounded like that was kind of some weak sauce from that government's witness.
NICOLE JOHNSON
I agree with you that the judge was very complimentary of the witnesses, and I think that that's the right thing to do. It's not that, you know, you had somebody that was going at they're lying through their teeth that you really wouldn't believe. It was just more so of, okay, his opinions. And it is very clear like experts are limited as to what they can testify about.
They cannot testify about an interpretation of the law. That's not their job, that's the judge's job, right? That's the court's job. And so, I think that that was the fine line that the witness was trying to walk. And unfortunately, he just ended up on the wrong side of it because he didn't understand kind of where it was going.
I think he also gave an example of something he wasn't comfortable saying that traveling by horse is not, you know, similar to you traveling by an Uber. And again, there are differences there. But what the court got down to is really what is the purpose of it? And if the purpose of traveling by horse or Uber is to get from point A to point B, then they're similar.
And that's what the court said here. If the point of digital advertising is to put this in front of consumers, this product, this item, this service, whatever it may be, whether you're doing it non-digital or digital means it's similar too and so you really need to look at the purpose of it.
LANCE JACOBS
Yeah. So, to me, I hear what you're saying and you're constrained to, you know, expert testimony in the field in which you have expertise. I guess to me, you know, he approached the word similar as if it was a term of art. And I really think it was just a plain English word. Comparable, if you will, to comparable.
NICOLE JOHNSON
But I think that was a hard they were trying to walk that line and just did not do it. And I don't know that it could be done.
LANCE JACOBS
Yeah, I think like as I sit there and think about two approaches, the analogy I came up with in talking to one of our colleagues is, imagine, if you will, two different Monet paintings. Right? And the state is getting up super close and like, well, this one has purple dots and this one has yellow dots. And the taxpayers are like, step back. That's a painting of flowers. They're both flowers and they're similar. And I think the judge ultimately sided with the taxpayer's interpretation.
You know, you mentioned that it was a clean sweep by by the taxpayers. You know, I think it's important for our listeners to know they only really had a win on any one of these grounds. Right? They didn't have to sweep. They didn't have to sweep the series. They just had to win on one. But when you get to the rest of the opinions, and again, I think that there was a little bit of an element of, you know, and not faulting the state for this, right, because this is what you do in litigation is you throw anything at the wall to see what sticks.
So, one of the arguments that the state made is, you know, essentially, even if this violates the Internet Tax Freedom Act, there's no private cause of action under the Internet Tax Freedom Act. And that's not what the; I don't think they were arguing for redress under ITFA. They were just arguing that it violates ITFA and therefore it can't stand.
NICOLE JOHNSON
Right? I mean, the comptroller was trying to make an argument essentially, that the only one that can bring a claim under the ITFA is the federal government. And that would be ridiculous, right? Like, practically speaking, it would become nonfunctional, right? A taxpayer has to be able to say this violates federal law, and therefore you are preempted from making this argument and enforcing this tax.
And so, I appreciate, like you said, the comptroller was just trying to throw it all at the wall, see if anything will work. And that's what they need to do, right? That is their job. It just didn't work in their favor this time.
LANCE JACOBS
Yeah. So, going back to the breadcrumbs you laid, you made a point of—this is a little facetious because I know the answer, but I'm going to pose the question anyways—you made a point of pointing out that elements of the tax were based upon unapportioned revenues, and I was hoping you could explain to our taxpayers why that was significant to our taxpayers. Our listeners, excuse me, why that was important for the taxpayers in this case?
NICOLE JOHNSON
All right. So, when we talked about the decision, there's the ITFA aspect of it, but there's also when you're looking under the U.S. Constitution, does it violate the Constitution as a tax. And typically, where state tax cases go is they go “Complete Auto.” And there's the four prongs. And here focused on three of those four prongs. So, it focused on; was the tax fairly apportioned, did it discriminate, and then, was it fairly related to the services provided by the state?
And so, if you're looking at those prongs two, three, and four, essentially the court said that it violates all of them for those same reasons. And it has to do with how the tax is calculated, because that taxpayer, you may have two taxpayers that have, let's say, $2 million of Maryland digital advertising revenue because of how the apportionment formula worked, but one taxpayer’s global sales may be $100 million.
So, they get that 2.5% tax rate, and the other taxpayer may have $15 billion of global revenues, so they get a tax rate of 10%. When you're looking at those two different tax rates, there really is no difference in the services that are being provided to company A versus company B, or the services that the state's providing on their behalf.
There is no difference in what those companies are doing because they have the same amount of Maryland sales, right? So, the same amount of devices are accessing the same amount, that same percentage. So, they've got the same amount of Maryland sales related to this income, but their tax rates are vastly different based on all of the activity outside of the state.
And that could be across the country. So, why should company B have to pay a drastically higher tax based on their activity in Europe or Asia or Antarctica? Maybe there's a massive global revenue coming out of Antarctica for some of these companies? That has no relation. It means it's not fairly apportioned because you've got these vast differences there.
And that's really where the court kept coming back to is how the tax is calculated doesn't relate at all to the activities conducted by these entities in the state, and therefore it's discriminatory, it's not fairly apportioned, and it doesn't fairly relate to the services being provided.
LANCE JACOBS
That last prong, even for me, and I've been doing this state and local tax for 30 years. That element also involves the due process clause for lack of, you know, those analyses are very similar. So, not only—and the judge made very short shrift of that piece in his opinion, but he did note that it violated the Due Process clause as well.
IRIS LAWS
Nicole, do you expect an appeal or what's next for this case?
NICOLE JOHNSON
So, the comptroller has 30 days to appeal and they appeal into the circuit court. And there's a variety of circumstances that you can go to different circuit courts, typically Anne Arundel for these types of tax issues. And so, they have 30 days to appeal to the circuit court, for the circuit court to issue a decision, kind of go through that process.
Then they can go up to either the appellate court or the Supreme Court. Now, as Lance has noted, they changed their name three or four years ago. Now, there is a process after the circuit court issues their decision that if the controller loses, they could appeal directly to the Supreme Court and ask for a writ of certiorari.
My guess is that the comptroller wouldn't do that. It is in the comptroller's favor to drag this out as long as possible, because the statute of limitations closes. So, they have three years really to file amended returns into audit. And so, those companies that haven't filed for amended return seeking a refund should absolutely do so immediately. But that's why it's in the comptroller's interest to let that statute run.
Because this tax was enacted back in, I think Lance had said, 2021. You're starting to see some of those statutes close. And I think I read the other day that Maryland has collected something like half a billion dollars of tax revenue from this tax. And so, it's in their interest to keep as much of that as they can. Now, is it possible that the circuit court could rule for the comptroller?
It's possible. I think that decision would be blatantly wrong, but it is possible. But so, I think that it is absolutely that the controller will appeal. I think it will be interesting to see what they do after the circuit court if they choose, if they lose again at the circuit court, whether or not they would choose to appeal to just continue to drag it out, which I think is likely, or if they would go back to the drawing board and see if they could craft a constitutional tax that would hit these.
LANCE JACOBS
Yeah. No, I agree, I think a couple of things. Yeah, you talked about, I believe, coming out of the circuit court and I agree with would probably be in Anne Arundel. And for those of you across the country who are unaware, I live in Maryland. Maryland's capital is in Annapolis, which is in Anne Arundel County. And that's why it's where you find most of these tax cases.
Although, you know, while I suspect that's where it's going to be, you know, when you read the jurisdictional statute, they do have some flexibility as to where they want to, where they can bring it next. I’d imagine, like you said, they're going to bring it into Anne Arundel as well. And then, they have an appeal as of right to the Maryland Court of Appeals, which is the intermediate appellate court. I still have to work through those names.
They have an appeal as of right to the Maryland Court of Appeals, and then it would be up to the discretion of the Supreme Court, the Maryland Supreme Court, much like in the U.S. Supreme Court, as to whether they want a grant a writ of certiorari to hear that court. And, you know, I think, Nicole, I agree with you that post-circuit court is going to be a critical inflection point.
I suspect they're going to drag it out. And I suspect, you know, if they get adverse opinions, I suspect whoever loses as it goes up, that there will be writs of certiorari if and when it goes to the Maryland Supreme Court up to the U.S. Supreme Court. You know, I don't think there's been a case interpreting ITFA, certainly not in this context.
So, I think that that's probably where it's heading. And it'll, you know, that will be a couple of years down the road and it will be interesting one if that occurs, and two, if the Supreme Court grants cert for that. And I do think the other thing that you kind of hinted at, you know, there is a roadmap here for a constitutional tax.
The judge is telling them what they can't do. But if you read between the lines and maybe not even read between the lines, maybe if you take five seconds to think about it, there is a constitutional tax to be had here, which is, you know, don't discriminate against digital services and make sure you're taxing everyone equally. Now, the question is going to be whether that's palatable politically in Maryland. And that I can't answer.
But, you know, and I think that these are questions that are going to be asked by state courts in other jurisdictions, like, you know, Washington state just sort of did something like this with digital advertising, with an advertising tax, excuse me, that is effectively only going to fall on the digital space. Utah has a law. I think Illinois also has a law. I think those are the ones that I look to see kind of the next steps and where the next battlegrounds are in litigation.
I did see that one of the lawyers for the taxpayers in the press basically said something like, bring it on. So, he's ready to go and he's ready to take it to the next level in those states as well. And he also fired a warning shot against states that are considering enacting taxes like this. So, it will be, you know, it will be a fascinating and, you know, it's been titillating all the way up. And it will continue to be so I think for the next couple of years.
NICOLE JOHNSON
I think that that is absolutely true. When you start looking at this, and like you noted, that the judge did put in a roadmap; there are even some footnotes that say that, you know, the Tax Court may have found differently if these facts were present and they're not. And so, it does give guidance to the comptroller and other states as to how they could do this in a constitutional manner or arguably constitutional manner.
I think the tricky part is it comes down to kind of legislative drive and that, right? You look at some of these companies, it was an easy sell legislatively to be like, there's all this money to be had that's not getting taxed. And then you start looking at, okay, well to make that constitutional, it means you'd have to tax all of these other companies as well and is that the right answer or not?
And so, I think that they, it's more on the legislatures to do the job to say, hey, we have to look at this overall, this is a problem. But I agree with you that there will be court decisions for a few years to come. It will be interesting. Do you think that, right, when you had Wayfair go through and obviously it was dealing with Nexus, so, a different position.
But you had South Dakota trying to start with their law and many states enacted a provision said that this is valid as soon as the Supreme Court rules. Will there be other states that if we get this case up to the level of a Supreme Court that may enact something similar that says, you know, if Maryland's digital ad tax is upheld, these provisions will fall into place.
LANCE JACOBS
I think it's there was probably much more uncertainty going back to Wayfair as to the outcome. I think this was such a resounding taxpayer win. And, you know, Wayfair was also correcting what was a very real economic problem, which was the loss of sales tax base, because when we were younger, we would go to the bookstores to buy books. And then the internet came and I was getting books shipped to me by Amazon, and those were largely escaping tax.
I'm not sure that the same, I think there are probably more non-tax policy reasons driving this than pure tax policy reasons driving the rush to tax digital advertising. But yes, like you said it's going to be interesting.
IRIS LAWS
So, I'm hearing a few things. If I think about our listeners and they're like okay, well, what do I actually do, right? I heard file an amended return, maybe? What else should they be thinking about at this point, Nicole?
NICOLE JOHNSON
I think filing, I mean, if you have paid this tax, regardless of what amount, you file an amended return seeking a refund for all open periods. You get those amended returns in ASAP, right? That's the first thing you want to do.
The second thing is start considering those, like Lance pointed out, those taxes across the country that are very similar in thinking about what your strategy is going to be. Is it going to be simply that, once that tax gets enacted you're going to file and then you're going to file an amended return to claim a refund, or are you going to file under protest? What strategy do you want to have going forward knowing that the Maryland tax has been struck down, for now, and that appeal will be going on for a few years? How do you want to handle this as other states potentially jump on that bandwagon?
LANCE JACOBS
Yeah, I think that's exactly right. I think this is not just a Maryland issue. This is broader than Maryland. And you don't want to be in a position where you're potentially leaving money on the table in some of those other states where, you know, the worst thing that can happen is your refunds get denied, right?
And at least you're still, you have administrative and other options. And I'm sure that these issues are being litigated. I know these issues are being litigated in those states. So, I think keeping optionality is probably the key. You want to make sure you have enough optionality so that you're not leaving money on the table on some of these things.
IRIS LAWS
Well, it's a fascinating case and some fascinating issues and topics that we talked about today. So, it'll definitely be interesting to see where we go from here and maybe what Maryland and other states across the country like we talked about, do in light of the decisions. So, Nicole and Lance, thanks for your time today, and thank you for joining us on the podcast.
NICOLE JOHNSON
Thank you for having me.
IRIS LAWS
And that's our show. Thanks for joining. Remember to subscribe and listen in for the next episode of the podcast. Until next time.
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