Maryland Digital Ad Tax Case Leaves States in Limbo, But Digital Taxes Aren’t Going Away

By Michael Bernard and George Salis.

The digital economy has caused an incredible shift in how jurisdictions create, administer, remit and audit indirect taxes. Over the last decade, businesses, governments, regulators and policy makers have all been trying to make sense of this new retail landscape. Properly structuring tax models and aligning regimes that are equitable for all stakeholders, while attempting to balance the economic interests of all participants has now become a vital societal priority.

This revolution has seen its share of controversy. As federal, state and local governments explore new avenues for revenue in the digital space, it’s only natural that they’ll bump up against, and sometimes move beyond, existing regulations. While much of this recent regulatory movement has mainly applied to digital and remote sales, ecommerce and marketplace facilitators the question of where, when and how sales and other digital taxes should be applied, indicates that state and local governments are also mining less visible, but foreseeable revenue alleys.

This has been playing out in Maryland over the last few years as the state has become a national litmus test for the legality of taxing companies based on their digital advertising revenue.

Controversial From the Start

In 2021, Maryland enacted the Digital Advertising Gross Revenues Tax (DAGRT). The tax levies a rate of 2.5% to 10% on businesses that gross more than $100 million in global revenues with at least $1 million of that being derived from digital advertising in Maryland.

The process to make the bill a law was fraught from the start. After the DAGRT was passed by the Maryland legislature, then Gov. Larry Hogan vetoed the bill—only to see his veto overridden by lawmakers. The state estimated that tax revenue could raise about $250 million a year to help pay for major K-12 education initiatives.

It’s no surprise the regulation was immediately contested. After a couple of challenges in state and federal courts in October 2022, a Maryland circuit court struck down the tax, listing three main reasons:

The DAGRT violates the Supremacy Clause of the United States Constitution and the Internet Tax Freedom Act because the Tax constitutes a discriminatory tax.
The Tax violates the Commerce Clause of the United States Constitution because it discriminates against interstate commerce.
The Tax violates the First and Fourteenth Amendments to the United States Constitution because it singles out the Plaintiffs for selective taxation and is not content-neutral.

But the adventure didn’t end there. In May of this year, the Maryland Supreme Court overturned the lower court’s ruling due to lack of jurisdiction. However, ruling instead on procedural grounds. The court did not comment on the constitutionality of the ruling, leaving the door open for further renewed litigation in Maryland—and leaving a lot of states watching and waiting as they craft and revise their own digital ad taxes based on the Maryland outcome.

A Fundamentally Flawed Model

Outside of the constitutionality of the Maryland DAGRT, the imported model itself is complex, confusing and nearly difficult to navigate. Even if a company wanted to comply it would be a monumental challenge to do so for some.

This can be seen even in the foundational elements of the law—that a tax is levied on ad sellers like Facebook, Google, Amazon and other tech and telecommunications companies, whenever a user in Maryland views one of their digital ads. That may seem simple to the lay person, but with the complex encryption technology we have today, including VPN (virtual private network) and users able to mask their IP addresses, it’s incredibly difficult to know where an ad is being served and where users are located, regardless of where the person is based.

The fact that Maryland was the first in the country to enact this kind of tax is especially interesting given the number of jurisdictions people commute through outside of the state. On any given day someone could leave their home in Bethesda, Maryland, stop for lunch just across the border in Chevy Chase, D.C. and then take in some shopping at Tyson’s Corner in Virginia before coming back home to Maryland just a few hours later.

This intrepid traveler could click on a page and view an ad as they’re crossing the border from Maryland into D.C. or coming back into the state from Virginia. Another possibility is that the user navigates back and forth between pages and apps as they’re crossing a jurisdictional border. In every one of these cases, the nexus is nearly impossible to determine, making compliance a nightmare. Consequently, it is probable that this technical conundrum may actually create other spillover tax disputes as certain digital ad taxes may be misapplied to mistaken users due to some of the venue-positioning risks depicted above, among others.

States Watching as More Challenges Anticipated

Even with the state supreme court ruling, the Maryland DAGRT is still very much in limbo, until the case is reintroduced in state court. It is anticipated that more legal challenges will come and, perhaps, compel the Maryland Supreme Court to consider the entirety of the constitutionality of the DAGRT challenge the next time around.

The ripple effects of the DAGRT case have also left states unclear on how to create, implement and manage their own digital advertising tax efforts. Currently, states with some form of digital advertising taxes include Connecticut, Massachusetts, New York and Texas. Arkansas, Connecticut and Indiana have implemented digital taxes on social media transactions. And Massachusetts, New York, Oregon, Washington and West Virginia all tax data mining, personal information usage and/or sales of personal data.

Many of these new policies came in the wake of the 2018 South Dakota vs. Wayfair ruling that paved the way for states and local jurisdictions to implement taxes based on remote (digital) sales of one kind or another, thus, permitting states to enact economic nexus thresholds. While many of those initial laws were created to tax transactions that take place on digital platforms comprising out-of- state remote sellers, states are now also looking for new avenues to collect digital services revenue and undoubtedly, digital ad revenue is indeed, a robust target.

Although it’s understandable that states should be levying taxes that address this new type of digital trade and commerce, this needs to be done fairly, efficiently and equitably balanced, as well as constitutionally rational. These initial digital business activity tax laws will set the foundation for the future of ecommerce in the U.S., and how we tax the digital economy, and they need to be considered with the gravity of that responsibility.

Businesses should be aware that as states become more fiscally creative, there will be more tax complexities and a bigger burden as the patchwork of regulations across the country get sorted out through legal challenges and policy debates. We’re still in the nascent stages of ecommerce and there’s no telling what the future will look like.

Michael Bernard is VP of Tax Content and Chief Tax Officer at Vertex, Inc. George Salis is Chief Economist and Senior Tax Policy Director at Vertex, Inc.