Utah, Maryland and Illinois are dissimilar states in many ways, but they have this in common: they are the first three states to impose digital advertising taxes.
It’s a short list that may be getting shorter, as the Maryland Tax Court just struck down that state’s tax (pending appeals), ruling that it violated the federal Internet Tax Freedom Act and the U.S. Constitution’s Commerce Clause and Due Process Clause. Similar legal challenges are already pending in Utah and are expected to be filed in Illinois soon.
Utah’s targeted advertising tax is not identical to Maryland’s, but it shares key characteristics that make it vulnerable to the same challenges that sank Maryland’s tax, starting with a clash with the Internet Tax Freedom Act (ITFA).
Under ITFA, states are prohibited from levying taxes on electronic commerce that are not generally imposed on transactions involving “similar” property, goods, services or information “accomplished through other means.” For instance, a state can’t tax streaming fitness classes if it doesn’t tax classes at the local gym. And it can’t tax digital advertising if it doesn’t tax television and radio ads, billboards and marketing mail.
Utah lawmakers tried to fend off this challenge by avoiding the phrase digital advertising, instead favoring “targeted advertising.” The intent was twofold: one, to define a class of advertising that only includes electronic ads but doesn’t use the terms “electronic” or “digital” outright; and two, to highlight a purported distinction that extends beyond a digital-analog divide. It’s clever but unconvincing.
Utah’s tax does not actually tax anything other than digital advertising, and courts care about substance, not form. Eschewing the word “digital” can’t save the tax. Focusing on “targeted” ads, moreover, is highly unlikely to be sufficient to make digital advertising dissimilar to offline advertising for ITFA purposes, especially since offline ads, like direct mail, can be heavily targeted and tracked as well.
The Maryland Tax Court took up just that question, as Maryland officials sought to defend the tax by arguing that its base was “programmatic” and “targeted” advertising based on personalized consumer data.
The court rejected this distinction, looking to advertising’s purpose (paid messages to attract business) rather than to differences in business models in determining whether digital and analog advertising were sufficiently similar for a digital advertising-only tax to constitute discrimination against e-commerce under ITFA. When Utah’s tax goes to court, it is unlikely to fare any better.
Defenders of Maryland’s tax tried several further arguments against applying ITFA, all of which fell flat with the Maryland court. And ITFA wasn’t Maryland’s only problem, nor is it Utah’s.
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Maryland’s digital ad tax has a graduated-rate structure that is not based on the amount of gross revenue generated in Maryland but rather on the advertising platform’s worldwide gross revenue. This means that the amount of tax owed in Maryland is based on factors entirely outside Maryland. That sort of extraterritorial taxation is unconstitutional, as the Maryland court affirmed.
Utah’s tax doesn’t adjust the rate based on revenue outside the state, but it does determine taxability based on extraterritorial factors. An advertising platform is only taxable if it derives at least $1 million from targeted advertising in Utah (constitutional) and $100 million worldwide (unconstitutional).
By conditioning taxability on out-of-state revenue, Utah improperly includes extraterritorial factors and discriminates against out-of-state businesses, both of which conflict with Commerce Clause jurisprudence.
The Maryland Tax Court’s decision is a warning to Utah and other states that have imposed, or are considering, digital advertising taxes. The Maryland decision can be appealed, but that only delays an almost inevitable outcome. Eventually, Maryland will have to refund years of collections under an illegal tax.
The Maryland decision is a preview of the fate of the Utah tax. If lawmakers keep it on the books, the result will be a long, costly legal challenge the state is very likely to lose, with the state required to refund all collections with interest.
And for what? A digital advertising tax may sound good, but advertising platforms already pay corporate income tax on the Utah share of their profits, and advertisers pay taxes on their profits and collect sales tax when the advertising yields a taxable sale. There’s no loophole to close. The digital advertising tax simply imposes an additional layer of tax that is passed along to businesses that advertise in Utah (many of which are in-state) and to their Utah consumers.
The tax is economically misguided. It is also, as the Maryland ruling shows, legally flawed. The question, after the Maryland decision, is whether Utah officials want to spend time and money mounting a likely futile defense of this poorly designed tax in court.
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