As the Maryland Tax Court considers whether the state’s digital advertising tax should be struck down, litigation has popped up in multiple jurisdictions like weeds in a summer garden.
While some observers and industry groups take this as a sign that states should be wary of enacting legislation fraught with controversy, supporters maintain that it’s a fair price to pay for ambitious efforts to pursue taxation of new industries with novel business models.
DeAndré Morrow of Greenberg Traurig LLP told Tax Notes that the tax violates the federal due process and commerce clauses, noting that the tax rates are based on global gross income that isn't related to taxpayers’ Maryland revenue.
Chris Marchese, director of NetChoice's Litigation Center, said these constitutional problems were raised when the tax was first proposed. NetChoice and two other trade associations have challenged in federal court both the tax itself and the tax’s passthrough provision, which bars the digital ad tax from being directly passed on to customers through separate fees, surcharges, or line items. Many other challenges are being made at the tax appeal level.
However, the tax's supporters argue that it is a reasonable and constitutional way of addressing digital transactions that are not taxed the same as nondigital transactions and making the tax system fairer.
At the federal level, the U.S. District Court for the District of Maryland concluded that the associations’ challenge to the tax was barred by the Tax Injunction Act. It dismissed as moot the associations’ challenge to the passthrough provision after the Anne Arundel County Circuit Court ruled in Comcast v. Comptroller that the tax was unconstitutional.
Subsequently, the Fourth Circuit agreed that the TIA barred the challenge to the tax itself, but it disagreed with the district court’s decision that the challenge to the passthrough provision was moot, remanding the case to the district court to decide whether the passthrough provision was constitutional.
The district court concluded on July 3 that the associations had not established that the passthrough provision was facially unconstitutional.
The Maryland Supreme Court reversed the Anne Arundel County Circuit Court, finding that the plaintiffs were required to exhaust their administrative remedies before filing suit in circuit court. Roughly 20 taxpayers have now filed suit in the Maryland Tax Court seeking refunds for the tax.
Maryland’s Gamble
The Maryland legislature in 2021 enacted the tax on annual gross revenues derived from digital advertising services in the state over the then-governor’s veto. The tax applies to companies with global annual gross revenues of at least $100 million, and the rate ranges from 2.5 percent to 10 percent, depending on the company’s global annual gross revenues.
Subsequent legislation delayed the effective date of the tax to the 2022 tax year, exempted broadcast and news media entities from the tax, and adopted the passthrough provision.
Taxpayers challenging the tax argue that its structure — with the graduated rate schedule and threshold based on global revenues — violates the U.S. Constitution, particularly the commerce clause. They also contend that imposing a tax on digital advertising services that is not also imposed on traditional advertising services violates the Internet Tax Freedom Act. They further argue that the legislature intentionally targeted large, out-of-state tech companies and improperly left it to the comptroller to determine the tax base and how to source the sales.
Morrow said he believes the tax is clearly unconstitutional, adding that it is unfortunate that it was tied to education funding, suggesting that legislators may have tied the funding that way in hopes that it would carry weight with the courts.
“But the law is the law,” Morrow said.
Critics have said lawmakers had reason to know the tax was vulnerable to legal challenge. Sen. Alonzo T. Washington (D) had inquired into the constitutionality of a similar digital advertising tax bill in 2020, and an assistant attorney general responded in a February 2020 letter that there was some risk that a court could invalidate the tax on constitutional grounds.
The tax's challengers, like Google LLC, have also argued that testimony by Senate President Bill Ferguson (D) that the tax would not affect Marylanders’ day-to-day lives and that it was geared toward large multinational corporations, along with similar statements from other legislators during debate on the tax — such as from Sen. James Rosapepe (D), who said it would be a handful of Big Tech companies paying the tax — show that the legislature intended to punish large, out-of-state tech companies.
But Rosapepe told Tax Notes that the tax’s focus on Big Tech, far from being a defect, is a way for the state to make sure that mammoth out-of-state companies are also paying Maryland taxes, not just in-state companies. Rosapepe is vice chair of the Senate Budget and Taxation Committee and was a floor manager for the digital ad tax bill.
“This is not a short-term issue to try to close a budget gap,” Rosapepe asserted. “This is a serious reform of our tax system.” He argued that lawmakers are trying to make sure Big Tech pays its fair share over the long run.
“We're not talking about Silicon Valley start-ups,” Rosapepe said. “Thresholds in the legislation make very clear we're talking about a handful of huge, worldwide companies.”
Rosapepe said lawmakers understood that there would be litigation over the tax from well-funded companies and were not assuming that they would collect the revenue immediately. “We knew there would be fights,” he said, adding that they are ready for it.
Rosapepe said it was predictable that affected companies would use every argument they could come up with to undermine the tax, noting that the companies spoke up when the tax was proposed and said they believed it was unconstitutional and in violation of the ITFA.
Litigation plaintiffs have asserted that the digital advertising tax was based on a template provided in a 2019 New York Times op-ed by Nobel Prize laureate Paul Romer entitled “A Tax That Could Fix Big Tech.” The associations contended that the op-ed painted large social media platforms as havens for misinformation and hate speech and argued that a surcharge on the business models of digital advertising companies was necessary to fund remediation efforts, through education, to combat the negative externalities.
Morrow asserted that the tax was initially presented to the legislature as a way to reform Big Tech, but that when the actual tax was rolled out, it was purely for revenue generation.
Morrow said an irony is that the sourcing regime that the comptroller’s office came up with technically requires a company to mine more user data — a frequent criticism of Big Tech — to make sure they are not being overtaxed.
Morrow said the digital ad tax is an example of legislation that is both tied to very important initiatives and enacted by legislators who expect it to be litigated and don’t care. “They’re doing this knowing that it’s going to be challenged,” he said.
University of Connecticut law professor Richard Pomp told Tax Notes that he believes legislators fumbled when drafting the law, adding that the tax didn’t have to be as starkly unconstitutional as it turned out to be.
“Someone didn't understand how the pieces fit together,” Pomp said.
But Rosapepe said the state attorney general had advised them that the tax would be constitutional. He added that common sense also suggests that the tax is constitutional, as only in-state revenues are actually taxed.
Rosapepe argued that the digital advertising tax is not that different from the evolution of tax policy in the past. “In the 19th century, the railroads weren't being taxed fairly, so the states had to fix how they taxed railroads,” he asserted, adding that the same happened with oil companies.
“It's not that unusual, as industries develop, that the tax system has to catch up with the economy,” Rosapepe said. “And that's really what this bill was about: catching up with the real economy.”
The Legal Fight
Whether or not the tax is as legally deficient as critics claim, it was — predictably and instantly — a magnet for litigation upon enactment.
With the Maryland Supreme Court concluding in Comcast that taxpayers challenging the tax were required to exhaust their administrative remedies, four cases have proceeded to motions hearings before the Maryland Tax Court — Peacock TV LLC, Apple Inc., Google, and Meta Platforms Inc. — since May. Arguments before the tax court have mainly focused on the commerce clause and the ITFA.
Maryland Tax Court Chief Judge Anthony Wisniewski has ordered post-hearing briefings in those cases and has indicated that he anticipates releasing written orders before the end of the calendar year. Almost all the remaining cases have been stayed pending those four decisions.
Approving of the tax court’s seeming decision to consider each taxpayer’s challenge independently, Pomp said that even if the issues are similar, the arguments will be framed differently, and different arguments will be emphasized in each case. He added that it would be a shame if a particularly nuanced argument or someone’s unique insights were not given adequate attention.
Regarding the constitutional implications, Pomp argued that the tax’s varying rates based on digital advertisers’ global gross revenues are “blatantly unconstitutional under the commerce clause,” asserting that Maryland can’t increase its tax's rate based on out-of-state activities that are unrelated to the tax.
Pomp added that the law’s passthrough prohibition on separately itemizing the tax seems wrong as a matter of policy and could also present First Amendment concerns, though he said the commerce clause violation is the biggest and most obvious constitutional defect.
Morrow said he believes one of the reasons why Comcast and Verizon challenged the tax starting at the circuit court level is because the merits of the constitutional claims are so strong. He contended that basing the rates of the tax on global gross income results in multistate providers paying more tax than in-state providers and conflicts with the comptroller’s argument that the tax is a lawful exercise of the state legislature’s authority to tax economic activity within the state.
However, “I think that there's nothing inconsistent with having a sales tax with progressive breaks, or having a backup sales tax with progressive rates,” Darien Shanske, a professor at the University of California, Davis, School of Law (King Hall), countered, adding that this is essentially how the digital advertising tax functions.
Shanske, along with Young Ran (Christine) Kim of Yeshiva University's Benjamin N. Cardozo School of Law and other tax law professors, filed an amici brief with the Maryland Supreme Court in Comcast arguing that the tax does not violate the ITFA and that the use of global revenues to determine a taxpayer’s rate is reasonable and constitutional.
But Shanske added that while he believes the extraterritorial argument against using worldwide receipts and a threshold is trivial, using the size of in-state sales is also a reasonable proxy, and using a flat rate may also make a state’s case before a judge easier.
Kim argued that the tax does not impose an undue burden on interstate commerce and that there is a connection between the size of a platform and the untaxed consumption of its services within Maryland, adding that “even if the Maryland tax revenue might be small, the business model that enables the profits in Maryland can be related to the data collected from worldwide.”
Kim added that the goal of digital services taxes is to tax consumption in the digital economy that is otherwise not taxed, with digital advertising revenue used as a proxy for that untaxed consumption.
But Morrow said the commerce clause argument is probably the strongest of the constitutional arguments against the tax, agreeing with Pomp. He also said the ITFA argument would prove to be a winner for the taxpayers.
Importantly, one of the comptroller’s main counters to taxpayers’ ITFA claims is that the ITFA is itself illegitimate because it violates the anti-commandeering doctrine within the federal supremacy clause. Morrow said that’s the first time he’s seen that argument made in a case.
Maryland has specifically argued that the U.S. Supreme Court’s 2018 decision in Murphy v. National Collegiate Athletic Association changed the landscape for the anti-commandeering doctrine. The state acknowledged that Congress may preempt state laws when a federal law confers rights or regulates private actors, but it asserts that the ITFA imposes restrictions only on states and impinges on the states’ sovereign power to tax.
But Morrow said relying on such a novel argument when one is in the position of defending a first-in-the-nation tax speaks to the lack of strength of the state’s arguments, adding that the state is “grasping at straws.”
While the digital ad tax challenge seems to be the first time that the anti-commandeering issue has been raised in litigation, there has been speculation since Murphy was decided that states would eventually use the doctrine to take aim at the ITFA.
Morrow said the doctrine applies in instances in which the federal government compels a state to take an action or enforce federal standards, but he distinguished the ITFA because it “aims to protect the free flow of commerce over the internet” by “placing a restriction on the type of taxes a state can impose on digital commerce.”
Morrow added that the ITFA is akin to setting a national policy on internet taxation and fits within the concept of federal preemption.
Shanske argued that there has not been much litigation concerning the ITFA and that states like Maryland have a straightforward winning case, even without the presumption against broad preemption, if discrimination for purposes of the ITFA is interpreted as it is for the dormant commerce clause and the Railroad Revitalization and Regulatory Reform Act of 1976.
“With the presumption, the states have an excellent chance of eventually winning before appellate courts,” Shanske added.
Kim argued that digital advertising is not similar to print or traditional advertising. Rather, she said, digital advertising is essentially related to the platform’s business model, unlike traditional advertising, and the targeted advertising techniques are also different.
Kim argued that if there is a consumption tax gap, then there is no discrimination as to the electronic commerce transactions and the tax is easy to justify as valid under the ITFA.
Shanske gave the example of Google Maps, explaining that a customer purchasing a book of maps would be subject to sales tax on the price of the book but may or may not be subject to sales tax on downloads of those same maps.
If a person uses Google Maps instead, Shanske continued, that is a consumption good that should also be subject to sales tax, but there is no charge for using the service. He added that while the basis is unknown, the revenue from the ads that Google is selling “must at least roughly approximate the value of the free services that it is providing, or it wouldn't be able to provide those services.”
Shanske said a similar example would be if streaming services were to switch from a subscription model to a free-with-ads service. He argued that while it would look like the consumption tax base had disappeared, in actuality the value of the streaming service would be the advertising revenue.
What It Could Mean
Morrow said he doesn't believe there will be any immediate legislative reaction to the pending litigation, noting that a decision from the Maryland Tax Court in the cases isn’t expected until the fall or winter.
But Morrow added that the litigation will likely continue beyond the tax court level, suggesting that no matter how the court rules, it will be appealed. Noting that the taxes are tied to the Blueprint for Maryland’s Future and that the state’s education system needs funding, Morrow said he doesn't think Maryland will give up with so much at stake. He added that the state will also have to contend with the economic impact from the Francis Scott Key Bridge's collapse.
According to Robyne McCullough, spokesperson for the state comptroller, Maryland collected around $82.49 million from the digital advertising gross revenue tax during calendar year 2023.
Morrow argued that while legislative reforms could be enacted to make the tax more constitutional going forward, those adjustments would not change the fact that the tax was illegal before the amendments or that, if the courts agree, the state will likely have to refund the revenue collected with interest. He added that there could be action taken to limit the interest, like what the legislature did in response to Comptroller v. Wynne of Maryland, saying he believes the legislature would have to eventually react to a loss because of the revenue involved.
Several other states have also considered digital advertising tax proposals, and while none of them have enacted one yet, that may change if the Maryland tax is upheld.
California legislators proposed digital advertising taxes this year despite the pending Maryland litigation. A.B. 2829 proposed a 5 percent tax on annual gross revenues from digital advertising services to fund youth mental health services.
Like Maryland’s tax, the proposed California tax would have applied to businesses with at least $100 million in annual global revenues and would not have been allowed to be directly passed on to a customer through a line item or surcharge.
California's S.B. 1327 would impose a 7.25 percent levy on gross receipts derived from “data extraction transactions” by companies engaging in the sale to advertisers of user information or access to users, but it would exempt receipts below $2.5 billion annually. News media organizations would also be exempt, and the tax would be apportioned to the state if the user is in the state.
A.B. 2829 failed to advance in April, and although S.B. 1327 passed the Senate on June 27, a deal between California and Google appears to have ended the bill's prospects. But the deal has been extensively criticized, suggesting at least the possibility that a future proposal could gain traction. Both bills have been the subject of criticism, with the Council On State Taxation arguing that the levies could run afoul of the U.S. Constitution and the ITFA.
COST has also warned Nebraska that a proposed 7.5 percent advertising services tax on businesses with gross advertising revenue exceeding $1 billion (under L.B. 388) would “likely face protracted litigation similar to Maryland’s digital advertising tax,” arguing that the tax is controversial and untested and would violate key tax policy principles.
Kim argued that the outcome of the Maryland litigation may also influence the future of DSTs at the international level.
Kim added that if pillar 1 of the OECD's two-pillar global corporate tax reform plan — which requires the repeal of DSTs — fails, many European countries may have more momentum to resume their DSTs if Maryland’s tax is upheld.
“If pillar 1 fails in the near future, then a digital tax is actually the strongest alternative to deal with the outdated international tech storm or digital economy,” Kim said, arguing that this is potentially a huge implication of the state tax case.
While the ultimate outcome of the fight is anticipated with intense interest by observers, Marchese said the process for challenging the digital ad tax and vindicating taxpayers’ constitutional rights has been convoluted and a waste of judicial resources, pointing to a case’s rejection from federal court because of the TIA.
Marchese said the TIA was passed in 1937 during the Great Depression, when state tax revenues were declining, as a way for Congress to help states worried that businesses would challenge increased taxes as unconstitutional. The act, Marchese said, allowed states to get the money first and deal with any legal issues later.
But Marchese argued that because of the TIA, federal courts have not really grappled with whether a state law has violated the ITFA — also a federal law. Taxpayers instead have to exhaust their administrative remedies, which could take between five and 10 years in Maryland, he said, adding that the process is "very expensive and very inefficient" and is a “denial of due process.”
Marchese added that “Congress should not be in the business of protecting states from facing their day in court over the unconstitutional laws that they pass,” noting that section 1983 under the Civil Rights Act allows plaintiffs to challenge some unconstitutional state laws through pre-enforcement challenges.
In recent years, there has been lobbying of Congress to amend the TIA to allow more state tax challenges in federal courts.
Controversial Legislation
Marchese said that in recent years states have seemed to be emboldened to dismiss constitutional concerns when mulling new laws, saying that Maryland’s digital ad tax is a high-profile example of a larger trend.
He said that during his time testifying, he's heard several lawmakers justify ignoring constitutional concerns by saying that maybe it’s time the U.S. Supreme Court changes its mind on key questions.
“You have states like Utah, which just tried to moot one of our lawsuits against its unconstitutional regulation of online speech by repealing the law and then repassing it, but making it private right of action only,” Marchese said, referring to the passage of S.B. 194, which requires social media companies to implement systems to determine whether an account holder is a minor and provide heightened privacy and supervision tools for those accounts.
NetChoice has filed suits over similar laws enacted in California, Arkansas, and Ohio that require social media companies to verify the age of account holders and provide heightened controls, contending that those laws violate the First Amendment.
NetChoice also challenged online speech laws enacted by Texas and Florida that bar social media platforms meeting revenue or user thresholds from censoring certain content, including Texas’s H.B. 20 and Florida’s S.B. 7072. The U.S. Supreme Court vacated the lower court opinions in the cases concerning the laws in Moody v. NetChoice LLC after concluding that they had not conducted the proper analysis.
“Ultimately what you get is this picture of lawmakers not liking the fact that the courts are striking down their laws as unconstitutional,” Marchese said, though he acknowledged that this has also been a complaint of lawmakers throughout the history of the United States.
Stating that America’s system of government is designed to operate with courts in this manner, Marchese said that “now you have lawmakers who are eagerly sort of doing these creative maneuvers to try to evade judicial review.”
But some controversial tax legislation has been upheld in recent years. In Washington, critics argued that a capital gains tax would violate the state constitution, with one group filing a lawsuit to overturn the bill before the governor had signed it into law.
The Washington Supreme Court, however, concluded that the capital gains tax is a lawful excise tax instead of an income tax subject to the state constitution’s uniformity requirement. The U.S. Supreme Court denied cert in the case in a January 16 order.
“I certainly don't think states should deliberately impose taxes that are controversial and/or subject to litigation,” Shanske said. But he noted that “every tax has its real and perceived issues, and so if government is to be funded, then the question is which imperfect tool to choose.”
“Taxes become less ideal through the political process, but I think messy compromise is a qualified good thing because it at least shows the system is working,” Shanske added.
However, Marchese said that “all businesses and all Americans should be very concerned that the level of dysfunction in our political processes has reached a point where a lot of lawmakers seem to think that the Constitution itself is an ambiguous document” to be ignored.
America’s judicial system has become so expensive that the average American is unlikely to have the resources to vindicate their constitutional rights, Marchese said, adding that the plaintiffs still have to devote their time and public image even if nonprofit groups and pro bono attorneys are willing to litigate the case.
“It comes down to really just hoping that some people in society have the resources to vindicate rights on behalf of everyone,” Marchese said.
Marchese noted that the previous Maryland comptroller, Peter Franchot, publicly said that he believes the circuit court’s decision should not be appealed and that lawmakers should instead go back to the drawing board and come up with a digital ad tax with fewer constitutional problems. However, Marchese said, the decision to defend the tax ultimately resides with the Maryland attorney general.
But Shanske argued that “if states allow themselves to be cowed by the promised litigation, they will be ceding more tax authority than they have to,” adding that “Congress preempting any of their tax authority is already a disfavored state of affairs.”
Shanske noted that if various antitax groups had sensible preferences that were not spectacularly regressive, then he would “have no problem steering states for the easy win in the first instance.”
Shanske said he hopes other states will consider pursuing this and similar taxes. “There needs to be a good policy argument and a good legal argument for [states] to proceed, but they certainly shouldn't let litigation keep them from doing the sensible thing.”