It’s been about 20 years since the founder of Tax Analysts, Thomas F. Field, retired. The occasion gives me pause to think about our conversations regarding the finer points of international tax policy and one recurring theme that was never far from Tom’s mind.
While meeting with members of our international editorial staff, Tom would routinely comment that “a lot of these cross-border issues are basically the same thing you see in the state practice area.” I’m paraphrasing, but you get the gist. I later learned that Tom would regularly meet with members of our state and local editorial staff and offer them the same observation, swapping out references to foreign borders with references to state borders.
Every jurisdiction wants to export its local tax burden to nonresidents, to the extent such an elusive feat is possible. These instincts are universal. They apply as much to the dynamic between Kansas and Missouri as they do to France and Germany.
That said, there are limits on extraterritorial taxation in the domestic context that don’t exist in the international sphere. There’s no equivalent to the U.S. Constitution’s commerce clause or the Internet Tax Freedom Act that tempers the fiscal ambitions of nation states. Apart from bilateral accords (tax treaties) and multilateral pacts (the European Union),1 there are few external constraints on sovereign taxing powers. “All is fair in love, war, and exporting your tax burden.”2 That was classic Tom Field.
These discussions took place well before the onset of digital services taxes, though Tom would not be surprised that so many foreign governments have turned to DSTs, ostensibly to backstop their corporate income tax regimes. He understood that gross receipts are a poor proxy for net income, but he also knew that such critiques are unlikely to dissuade lawmakers. He would be fascinated by what’s been going on in the state of Maryland and its attempt to tax out-of-state firms through a digital advertising services tax.3 Will Maryland’s DST survive the constitutional challenges based on the commerce clause or the ITFA? These battles are playing out in courts, and the most recent development came in July, as discussed below.
If Maryland’s DST overcomes these obstacles, other states will surely mimic the approach. The result could be a network of state-level DSTs stretching from coast to coast. The groundwork is already there, which demonstrates how badly states desire the new revenue source. Beyond Maryland, DSTs have been debated in the legislatures of Arkansas, Connecticut, Indiana, Louisiana, Massachusetts, Montana, New York, Nebraska, Oregon, South Dakota, Texas, Washington, and West Virginia. More recently, California is eyeing a DST of its own.
All of that’s happening despite the clear trend of state-level corporate income tax regimes moving away from physical nexus requirements in favor of the economic nexus concept. Critics can charge that state-level DSTs are superfluous, but the states aren’t listening.
There would be international consequences if U.S. states get away with homegrown versions of DSTs. Their existence detracts from the federal government’s ability to effectively argue against the spread of DSTs worldwide.4 How can the Treasury Department preach against a revenue tool that state governments intend to normalize?
I commented on Maryland’s DST in these pages last year.5 This week’s column addresses a related issue that I didn’t cover: Maryland’s attempt to block companies from directly passing the DST burden on to third parties. The resolution of Maryland’s passthrough prohibition is proving to be a big deal.6
Before we get into the weeds of the provision, let’s ponder what the General Assembly in Annapolis was hoping to achieve. Enacting the DST was one thing. The measure’s companion statute prevents affected taxpayers from forwarding the tax cost on to their customers (digital advertisers) through direct pricing add-ons. In the absence of such a measure, we’d expected taxpayers to pass the DST charge on to advertisers, who would then seek ways to pass the incremental cost on to their customers, and so forth until the economic burden rests with the end user. That’s the same scenario we expect under an excise tax, VAT, or any other consumption tax.
It’s the latter bit of the supply chain (the anticipated ripple effects on local consumers) that Maryland lawmakers were concerned about regarding their DST. The proposed solution was to force each business subject to Maryland’s DST to absorb the tax cost itself. That’s an audacious thing to attempt. If your brain functions anything like mine — a frightening proposition, I know — it will occur to you that Maryland’s passthrough prohibition goes against the natural order of things.
States impose tax all the time, but it’s not their prerogative to dictate where the resulting economic burden rests. This delves into market forces that are beyond their control. At first glance, the passthrough prohibition resembles a backhanded attempt at price controls, which are distasteful for a variety of reasons. On closer inspection, the provision is less about dictating prices and more about how resulting price adjustments are presented. Maryland doesn’t want it spelled out that future price increases are attributable to the DST.
Thinking more broadly, there’s a slippery slope to consider. If it turns out that state governments are capable of regulating where their DST burden rests, why stop there? Would they not attempt the same pricing manipulations for other state-level taxes? What’s to prevent them from blocking corporations from trying to pass their income tax burden onto customers (via higher prices) or employees (via reduced wages)? The more I think about it, the less I want state revenue officials telling private firms what prices they may charge their customers, or how they’re to explain their next price increase. And I say that as someone who generally supports a robust corporate income tax.
When state-level taxes become unsavory, a lot of firms will threaten to flee for friendlier turf. That’s not a problem here because Maryland’s DST is squarely aimed at out-of-state businesses.
Apropos of our founder’s observation some 20 years ago, these state and local taxation developments match things that occur at the international level. Maryland desires all the benefits of an exciting new revenue source, but it doesn’t want local consumers to feel the associated pain. That reminds me of the French tax official who once boasted that not a single person living in France would pay that country’s DST. The French official was wishing away the passthrough effect; Maryland lawmakers have blocked it legislatively.
Well done, Tom Field. Once again, you’ve hit the nail on the head.
Courts Weigh In
Maryland’s DST was enacted in 2021 without the support of then-Gov. Larry Hogan, who is currently running for a seat in the U.S. Senate. Proponents tied the DST to the state’s educational budget, promising to provide Maryland school children with world-class education opportunities.
There are, of course, other ways to fund public schools. The old-fashioned property tax comes to mind, but it’s generally unpopular with voters. The only reason you’re reading about Maryland’s DST in Tax Notes International is that it polls better than other available revenue sources. In that sense, DSTs are much like excise taxes on alcohol, tobacco, and (increasingly) cannabis. Hogan vetoed the DST legislation, only to have both chambers of the legislature override his veto by the required supermajority. The DST became effective for tax years beginning after December 31, 2021.
The scope of the DST is purposefully narrow. It reaches digital advertising services aimed at Maryland residents based on data obtained from their online activity. In-scope taxpayers are defined by dual revenue thresholds: $100 million of global annual gross revenue and $1 million of local annual gross revenue. The rate of tax can range between 2.5 and 10 percent, applied to a tax base that looks to worldwide revenue from digital advertising services. Note that the advertising revenue can accrue anywhere in the world, including outside Maryland and outside the United States. The law exempts broadcast and news media.
For our purposes, the key feature is the passthrough prohibition. It blocks companies from “directly” forwarding the tax cost to a customer through a separate fee, surcharge, or line item. The relevant statutory language reads as follows:
A person who derives gross revenues from digital advertising services in the State may not directly pass on the cost of the tax imposed under this section to a customer who purchases the digital advertising services by means of a separate fee, surcharge, or line-item.7
That leaves open the possibility of passing on the tax costs through indirect means, but that contingency was never going to assuage the big digital content providers at whom the bill was aimed. Comcast filed suit in September 2021, months before the law took effect. Its amended complaint alleged that Maryland’s DST violates the ITFA, the federal commerce clause, and federal and state due process requirements.
Comcast scored an initial victory in October 2022 in Anne Arundel County Circuit Court. Judge Alison Asti issued her decision from the bench after a hearing on the plaintiff’s motion for summary judgment and state’s motion to strike.8 She determined that the DST violated the ITFA and the commerce clause. She had previously rejected the state’s motion to dismiss, which argued that the plaintiff’s claim was premature because they hadn’t first exhausted their administrative remedies. The state would later appeal that aspect of the case.
Asti disagreed with the plaintiff’s allegation that the DST improperly delegated authority to the state’s comptroller regarding the calculation of the appropriate DST rate. The remainder of the counts went forward, resulting in the bench decision on Comcast’s motion for summary judgment.9
A point of contention was that Asti took judicial notice of the interchangeability of digital and conventional advertisements.10 That assumed away the state’s primary defense. Normally, the consideration of one party’s motion for summary judgment requires that contested facts be interpreted in a manner most favorable to the opposing party. That doesn’t seem to have happened here.
For there to be a violation of the ITFA, there must be a showing of discrimination between two things that are fundamentally equivalent; for example that the digital version is being taxed more harshly than its analog counterpart. According to the state, there should have been a trial on the matter of equivalence complete with the taking of evidence and expert testimony. If the trier of fact were to conclude that digital advertising and print advertising were fundamentally different creatures, there would be no disparate treatment and hence no ITFA violation.
Comcast’s victory was short-lived. The state appealed the decision to the Maryland Supreme Court, which surprised many observers in May 2023 by holding that the circuit court lacked subject matter jurisdiction over the plaintiff’s claims. That was on account of Comcast not extinguishing its administrative remedies before proceeding to court. Maryland law permits limited exceptions to the exclusivity of administrative remedies, but the state supreme court ruled they were not applicable.11
The per curiam order remanded Comcast’s complaint to the circuit court with instructions to dismiss the claims without prejudice. It was not a decision on the merits. Comcast would need to jump through various administrative hoops before reviving its claim. In the alternative, it could pay the annual DST bill, once assessed, then seek a refund in the conventional manner before the Maryland Tax Court.
Other companies affected by Maryland’s DST are already doing that. The litigants include Apple, Google, Meta Platforms Inc., and Peacock TV LLC. Their cases are proceeding while others have been stayed. The four refund suits have been assigned to the same judge, Chief Judge Anthony Wisniewski. He expects to issue written opinions by the end of 2024. Given the high stakes, the losing side will probably appeal. Because the ITFA is a federal law, it’s likely these challenges will eventually be resolved by federal courts.
Meanwhile, a coalition of trade associations launched a separate complaint before the U.S. District Court for the District of Maryland. The plaintiffs were the Chamber of Commerce of the United States, NetChoice, and the Computer and Communications Industry Association. Like Comcast, the parallel federal case sought to block enforcement of Maryland’s DST, claiming an ITFA violation, a commerce clause violation, and a federal due process violation.12 The trade associations added a First Amendment count, alleging that the passthrough prohibition unfairly limited their member companies’ ability to speak with third parties.
The parties entered a stipulation regarding the ability of digital content providers to pass on the tax cost indirectly:
Tax-General section 7.5-102(c) does not prohibit a person who derives gross revenues from digital advertising services in the State from indirectly passing on the cost of the tax imposed . . . by factoring such cost into its customer pricing.13 [Emphasis added.]
As such, the First Amendment count isn’t about money or pricing. It’s about how prices are detailed on invoices.
The federal case did not produce the results that trade associations were hoping for, at least not yet. Judge Lydia Kay Griggsby initially determined the case was moot, citing the decision by the Anne Arundel County Circuit Court granting summary judgment in favor of Comcast. That changed when the Maryland Supreme Court reversed the circuit court, having found that Comcast failed to exhaust its administrative remedies. With the matter back in play, Griggsby found that the Tax Injunction Act blocked the pre-enforcement challenges, allowing Maryland’s DST to remain in place. Her December 2, 2022, ruling was appealed with mixed results. In its January 10 opinion,14 the U.S. Court of Appeals for the Fourth Circuit agreed that the TIA prevented the trade associations’ pre-enforcement claims relating to the ITFA, the commerce clause, and due process. Those counts were dismissed without prejudice. However, it concluded that the TIA did not bar consideration of the trade association’s First Amendment claim. That count was remanded to the district court to determine whether Maryland’s passthrough prohibition was constitutional.
Why the split decision? Strictly speaking, the passthrough prohibition was never a revenue provision. It regulates the details of pricing and fee structures, but it does not impose a distinct tax. The TIA has nothing to say about how private companies price their services or what supplemental fees one business charges another.
How does the Maryland law raise a First Amendment issue? As the trade associations describe it, the passthrough provision infringes on the rights of businesses to communicate with their customers as to how imposition of the DST affects the pricing of their services. Arguably that’s core political speech that merits the highest degree of constitutional protection. Alternatively, it’s commercial speech that also merits constitutional protection. In theory, it requires some kind of compelling state interest to justify a statutory limitation on protected speech. What compelling state interest justifies the restriction on protected speech? Answer: The state of Maryland doesn’t want people to connect the dots and realize that a price increase for digital advertising is attributable to the DST. Not so compelling if we’re honest about it. The Fourth Circuit also found that dispositions thus far of the Comcast litigation in state court did not moot a federal court’s evaluation of the passthrough provision.15
I think the Fourth Circuit got that correct. It sets up the possibility that Maryland’s DST could overcome its constitutional challenges (in state court) even if the passthrough prohibition is struck down (in federal court). The fate of the latter need not influence that of the former.
That would be fine with me, but recent developments aren’t trending in that direction. On July 3 the district court granted the state’s motion to dismiss the last remaining count of the trade associations’ complaint. It ruled that the plaintiffs failed to establish that the passthrough prohibition was facially unconstitutional. It conceded that the statute attempts to regulate commercial conduct and protected speech but found such actions to be justified by the law’s “plainly legitimate sweep.”16
I wasn’t expecting that. And I’m a little surprised that a state law preventing businesses from communicating with their customers merits such high esteem. It seems flimsy that Maryland’s desire to avoid embarrassment (people correctly attributing a price increase to the DST) is a compelling state interest. Hello, slippery slope.
Conclusion
We expect that the corporate income tax burden is predominantly borne by the owners of capital. That suits us because the levy is justified as a tax on capital income. The tax succeeds to the degree it falls on shareholders. By implication, it functions less well when the burden is born by others.
Separate and apart from the legality of Maryland’s DST, we must wonder what themes the state is projecting with its passthrough prohibition. In terms of public messaging, the state is trying to convince constituents that the DST is something other than a consumption tax — as demonstrated by the inability of digital content providers to outwardly forward the tax costs on to third parties. This is a feckless chore in several respects. Isn’t this a bit like the Wizard of Oz demanding that Dorothy not look behind the curtain?
How are citizens to judge the efficacy of a state-level DST? If we adhere to the implied messaging, Maryland’s DST would succeed to the extent it is felt by nonresident businesses and fail to the extent it hurts resident consumers. In short, the tax is working when Marylanders are led to believe they aren’t paying it — even if the reality is that they are.
I’m not opposed to DSTs generally. In fact, I regard their advent as an inevitable consequence of transformational changes in commerce, technology, and society. I’ve previously argued that countries without a DST on the books are committing fiscal malpractice. But I also believe tax administration demands a high degree of transparency. That leaves no room for states to mask a consumption tax to resemble something that it’s not, or to create inaccurate depictions of who ultimately pays a tax. I would tell other states to go ahead with their DST plans but kindly refrain from telling private businesses how they must price their services and what they can’t tell their customers. The burden of any tax should be expressed as transparently as possible.
FOOTNOTES
1 Even within the EU framework, direct taxation is regarded as a national competence.
2 Paraphrasing him, again.
3 Various media outlets and court pleadings have referred to the statute in question (H.B. 732) as Maryland’s digital advertising tax, in part to distinguish it from a separate tax measure (H.B. 932) that applies to digital downloads and streaming services. For these purposes, I refer to H.B. 732 as Maryland’s DST.
4 For related analysis, see Karl A. Frieden and Barbara M. Angus, “Convergence and Divergence of Global and U.S. Tax Policy,” Tax Notes Int’l, Aug. 30, 2021, p. 1163.
5 Robert Goulder, “Let’s Get Salty: The World Is Watching Maryland v. Comcast,” Tax Notes Int’l, May 22, 2023, p. 1129.
6 As used here, the reference to Maryland’s passthrough provision has nothing to do with partnerships, S corporations, or limited liability companies.
7 Md. Code, Tax-Gen., section 7.5-102(c).
8 Andrea Muse, “Judge Strikes Down Maryland Digital Ad Tax,” Tax Notes State, Oct. 24, 2022, p. 311.
9 Along the way, the court had to deal with the state’s motion for recusal, seeking to have Asti removed from the case because of her previously stated position that there were no factual matters before the court that merited a trial.
10 Order, Comcast v. Comptroller of Maryland, Case No. C-02-cv-21-000509 (Anne Arundel County Cir. Ct. Oct. 20, 2022).
11 Muse, “Maryland High Court Explains Why It Dismissed Digital Ad Tax Suit,” Tax Notes State, July 17, 2023, p. 228.
12 Chamber of Commerce of the United States v. Lierman, Civil Action No. 1:21-cv-00410-LKG. The current defendant, Brooke Lierman, is Maryland’s comptroller; she succeeded Peter Franchot.
13 Joint Status Report, Chamber of Commerce of the United States v. Franchot, Civil Action No. 1:21-cv-00410-LKG, ECF No. 68, at 1 (D. Md. Apr. 4, 2022).
14 Chamber of Commerce of the United States v. Lierman, No. 22-2275 (4th Cir. Jan. 10, 2024).
15 Muse, “Fourth Circuit Revives First Amendment Challenge to Maryland Digital Ad Tax,” Tax Notes State, Jan. 15, 2024, p. 243.
16 Chamber of Commerce of the United States v. Lierman, Civil Action No. 1:21-cv-00410-LKG (D. Md. July 3, 2024). See also Muse, “Federal Court Dismisses Challenge to Digital Ad Tax,” Tax Notes State, July 15, 2024, p. 179.
END FOOTNOTES