There are those who might disagree, but I don’t see anything inherently wrong with the concept of states imposing sales or gross receipts taxes on digital advertising, especially if they already tax a wide range of services. Yet that doesn’t mean there isn’t a problem. Though the concept may be sound, the key question is whether it’s workable. A proposed tax on digital advertising services requires legislatures to examine and resolve several issues that will surely derail such efforts.
Three states — Maryland, Nebraska, and New York — introduced legislation in January to tax digital advertising services. Maryland’s bill, S.B. 2, stems from an op-ed piece by Nobel Prize-winning economist Paul Romer. He said business models of online digital platform companies, especially the giants like Facebook and Google
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Maryland’s S.B. 2 imposes a new gross receipts tax on digital advertising within the state, including banner and search engine ads, website or application ads, and ads within a piece of software. The tax is determined by an apportionment formula. Nebraska’s bill, L.B. 989, extends its sales tax to digital advertising. New York’s bill, A09112, imposes a new 5 percent gross receipts tax on the gross income of companies harvesting user data that is shared with other companies. All these bills have several things in common: They violate the Permanent Internet Tax Freedom Act (PITFA), as well as several constitutional provisions.
Permanent Internet Tax Freedom Act
When the Internet Tax Freedom Act was signed into law in 1998, it clearly prohibited states and local jurisdictions from imposing multiple or discriminatory taxes on electronic commerce. Originally a moratorium of an enumerated duration, the moratorium was extended several times until 2016, when the law became permanent and was renamed PITFA. The Maryland, Nebraska, and New York bills unequivocally violate PITFA in that the taxes imposed are directed only at digital advertising. It might be argued that the Nebraska bill is simply an extension of its sales tax, but the problem is that non-electronic forms of advertising are not subject to the sales tax. As written, the New York bill’s broad sweep could conceivably cover every electronic and non-electronic business that collects customer data, from the big tech companies to the local grocer who collects customer information for loyalty cards. That could be an issue for some companies, especially the smaller ones. For them, having to pay the gross receipts tax on top of the income tax might very well wipe out any profit they may have made, effectively putting them out of business. In that instance, it could be argued that the proposed legislation is a breach of due process. Moreover, the proposal doesn’t define several core terms such as “data,” which might lead a court to void the legislation because of its vagueness.
Constitutional Considerations
There are several constitutional issues that could derail the states’ legislative proposals. The First Amendment is one of them, which forbids states to enact any law that infringes on the right of free speech. The U.S. Supreme Court has twice ruled that industry-specific taxes on the media violate the amendment’s protection. There is no question that these proposals are meant to target digital advertising platforms, and if these proposed legislative actions pass into law, they will undoubtedly be struck on First Amendment grounds. There is a foreign commerce clause issue, too. The United States has vigorously opposed taxes on digital advertising under consideration by countries in the EU and other countries contemplating digital advertising taxes, such as Canada. Indeed, France suspended its digital services tax, which would have fallen mostly on American companies, at least to the end of this year, after the current U.S. administration threatened to retaliate by imposing tariffs on French goods. For the states to enact such taxes would clearly undermine federal foreign policy, preventing the federal government from “speaking with one voice” in international affairs.
Practical Considerations for Maryland’s S.B. 2
As originally introduced, Maryland’s S.B. 2 sourced revenue to the state by the user’s IP address. However, what if a resident uses a virtual private network to access the internet? Some VPN providers use servers that are located not just nationally, but all over the world. At any given time, users might be connected to a domestic server that is not located in the state where they reside, or to a server located in a foreign country. The bill’s sourcing provision was later amended to factor apportionment. Specifically, the numerator of the apportionment factor is the gross revenue earned in the state, and the denominator is the gross revenue earned in the United States. The main flaw in this sourcing solution, said Ulrik Boesen, a senior policy analyst with the Tax Foundation, is that it does nothing to guide affected companies or the state in figuring out “how gross revenue will be will actually be determined by the companies or the state.” He went on to say that to borrow the apportionment formula for corporate income “makes exceedingly little sense here.” For determining corporate income, the factors — whether they be property, payroll, and sales; a combination of two factors; or even just the sales factor — serve as proxies to figure out what amount of a company’s income will be apportioned to a state and taxed accordingly. Boesen pointed out that if “the tax base is gross revenue from advertising in the state of Maryland, which is then ‘apportioned’ by dividing Maryland gross advertising revenue (x) by national gross advertising revenue (y), then multiplying that fraction by national advertising revenue (y), [t]his is, literally, (x/y) * y, which is to say: x. Apportionment does nothing here.”7 He then said resolving the apportionment issue in the legislation — that is, determining the tax base — is punted to the comptroller to figure out the tax base by regulation. Leaving the issue for resolution to the executive branch, Boesen said, “is not transparent tax policy.” Asked if there was any way S.B. 2 could be saved, such as by expanding its coverage to digital and non-digital services alike, Boesen said doing so “would solve the PITFA problem, but it has other problems,” such as running afoul of the First Amendment.
Conclusion
Taxing digital advertising services is controversial, both in the national and international arenas. In January, three states — Maryland, Nebraska, and New York — introduced legislation to tax these services, either through a gross receipts tax or a sales tax. All of these efforts engender serious issues. First, they directly contravene PITFA because they target digital advertising but not non-digital advertising, although New York’s proposed legislation is broad enough to cover both. Second, there are at least two constitutional issues that make the proposals subject to challenge. They are industry-specific to the media, which the Court has ruled unconstitutional under the First Amendment. The proposals also contravene the foreign commerce clause, in that they directly undermine U.S. policy, which opposes such taxes on an international scale. If states wish to tax digital advertising services — which they have every right to do — they need to find a better way to do it.