Maryland’s digital ad tax may be a constitutional overreach
Shining a light on potential problems for Maryland's digital advertising tax grab
The tax came into law last month after the Maryland General Assembly voted to override Governor Larry Hogan’s veto. The law imposes a tax on gross revenues earned from digital-advertising services within Maryland.
The tax, as against digital-advertising revenue earned within Maryland, breaks down as follows:
- No tax for entities with global annual gross revenues under $100 million;
- 2.5% for entities with global annual gross revenues from $100 million to $1 billion;
- 5.0% for entitites with global annual gross revenues higher than $1 billion, up to $5 billion;
- 7.5% for entities with global annual gross revenues higher than $5 billion, up to $15 billion;
- 10.0% for entities with global annual gross revenues higher than $15 billion.
Tech industry groups promptly filed a lawsuit in a bid to strike down the tax. They list several reasons for why Maryland’s digital advertising tax scheme is unlawful, but most of their arguments largely rest on a common premise: that the tax impermissibly interferes with interstate commerce.
Multiple legal bases are at issue here; for simplicity, we’ll focus on the grandest one of all — that of the dormant Commerce Clause.
What’s in a state?
Under the doctrine of the dormant Commerce Clause (inferred by the Courts from Article 1, Section 8 of the US Constitution), states may not enact taxes that discriminate against interstate commerce. Some federal statutes, too, prohibit this kind of taxation. For example, while a state may place an income tax on income made within said state, it may not impose what amounts to an excise tax on the act of doing business interstate.
Yet interstate discrimination is precisely how the plaintiffs characterize Maryland’s digital-advertising tax; they focus on the fact that the tax rates are based on gross revenues earned globally, despite the assessable base being Maryland-only revenues.
State taxes based on gross revenues instead of net profits are not automatically invalid under the Constitution (although at least two current members of the Supreme Court would seem to think otherwise). Still, plenty of such taxes fail to survive Supreme Court scrutiny. After all, mathematically speaking, it can be difficult for such taxes to avoid multiple taxation — often considered a cardinal sin under the dormant Commerce Clause.
A crash course in consistency
To identify the kind of double taxation that violates the dormant Commerce Clause, US courts apply both an “internal consistency test” and an “external consistency test”.
Under the internal consistency test, a court considers what would happen if every other state had a tax exactly like the one in question. If the same monies would potentially be subject to more than one of these taxes, then the tax is probably unconstitutional.
The hypothetical nature of this test is typically irrelevant; even in the absence of other states imposing a similar tax, the mere risk of double taxation is a constitutional red flag.
The external consistency test is broader and less hypothetical. Here, a court simply weighs the proportionality of the tax. It’s not particularly scientific, but if a taxpayer can meet their burden of proof that the taxable income is “out of all appropriate proportions to the business transacted in the State,” then the tax is probably unconstitutional.
In the instant case in Maryland, the risk of judicial elimination of the tax is heightened because of the “global annual gross revenues” tax-rate scheme. It appears theoretically possible for a company to owe to the state of Maryland more than 100% of its digital-ad profits actually derived from Maryland — even though the tax is supposed to be against Maryland-only revenues.
Grossing out big tech
In their complaint, the plaintiffs give an example of a hypothetical company making just over $15 billion in global annual gross revenues (triggering the maximum digital-advertising tax rate of 10%)—with $1 billion of that amount in profits, and 2% of all revenues and profits apportioned to Maryland. Therefore, the company has earned $20 million from Maryland in profits—but has an assessable base under Maryland’s digital-advertising tax law of $300 million.
The plaintiffs explain:
“If all of the revenues of the company … were derived from digital advertising, the company would be liable for … $30 million under the Act—10% of 2% of $15 billion. That is nearly 20 times the rate of the corporate income tax. And it would more than wipe out the $20 million in profits attributable to the company’s economic activity in Maryland.”
Plaintiffs note that this would be in addition to $1.65 million the company would owe to Maryland under the state’s 8.25% corporate income tax.
(Technically, there is a typo or miscalculation in the plaintiffs’ brief here. The plaintiffs cite the figure in their example as $15 billion exactly. The maximum digital-advertising tax rate of 10% does not apply until global annual gross revenues exceed $15 billion. For simplicity, we assume the negligible extra dollar in the figure that plaintiffs surely meant to include. Otherwise, the digital-advertising tax rate would be 7.5%. Even with this lower rate, however, the multiple-taxation point stands; in an “exactly $15 billion” example taxed at 7.5%, the digital-advertising tax bill would come to $22.5 million — still exceeding the $20 million in Maryland-apportioned profits.)
Because this would threaten to “more than wipe out” a company’s entire Maryland-earned profits, it could create an unconstitutional risk of multiple taxation as among the states.
Moreover, it is not immediately clear to what extent the lawyers advising the Maryland General Assembly considered these issues. In multiple memoranda concerning this legislation sent from the Maryland Attorney General’s Office, the dormant Commerce Clause issues were analyzed only from a transactional IP-tracking perspective—and not from an overall dollars-and-cents perspective.
In fairness, plaintiffs’ example assumes proportionally distributed capex and opex; debates on how to apportion income for the purposes of weighing the constitutionality of state taxes can get murky — and the plaintiffs bear the burden of proof. Time will tell if the plaintiffs prevail.
As of this writing, the defendant (the Maryland state treasury’s comptroller) has until April 16 to file a response to the lawsuit.
Disclaimer: This article is provided for informational, educational and/or entertainment purposes only. Neither this nor other articles here constitute legal advice or the creation, implication or confirmation of an attorney-client relationship. For actual legal advice, personally consult with an attorney authorized to practice in your jurisdiction.
This article first appeared on MarTech Today