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Maryland's digital ad tax faces litigation, but tax could see broader adoption

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Maryland's digital ad tax faces litigation, but tax could see broader adoption

Maryland recently became the first state to pass a digital advertising services tax, but analysts are waiting to see what courts think of the law before hitting the panic button.

Earlier this month, Maryland's state legislature overrode a veto from the governor to pass a first-of-its-kind tax on digital advertising revenues. The tax, which Maryland estimates could raise as much as $250.0 million in its first full year, is set to be imposed on certain annual gross revenues derived from types of digital advertising services in the state. It begins at a rate of 2.5% for companies with global annual gross revenues of $100 million to $1 billion and goes up to a rate of 10% for companies with global annual gross revenues exceeding $15 billion. In 2020, the annual gross revenues for major online advertising companies such as Facebook Inc., Alphabet Inc.'s Google LLC, Amazon.com Inc. and Microsoft Corp. each exceeded $15 billion.

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While this will be the first time that leading digital advertising giants have faced a tax of this type, analysts who follow the companies are not yet concerned about broad, negative implications for the companies' businesses — both because of the law's limited jurisdiction and legal challenges. Already, the law is facing a major suit from industry groups.

"At this point, I don't think it is that big of a deal," Michael Nathanson, a senior research analyst at MoffettNathanson who covers leading digital advertising companies, said in an email. "Let's see if other states jump on board and what those tax rates will be. Worth tracking, but we haven't re-thought things yet," he added.

Similarly, Joseph Bonner, a senior analyst who covers communication services and technology at Argus Research, said in an interview that, at this stage, he does not view the tax as a major risk to leading digital advertising companies like Facebook and Google given Maryland's relatively small geographic reach. Maryland represents 1.84% of the total U.S. population, according to the state.

The tax also has unresolved questions regarding its legality. Litigation challenging the law began Feb. 18 when the U.S. Chamber of Commerce and a collection of trade groups representing tech giants in the online advertising space filed suit in federal court in Maryland.

The groups allege the tax is "illegal in myriad ways," and they are seeking a declaration and injunction against enforcement of the law.

"There is no question at all that there will be armies of tax lawyers who will be working for quite a long time dealing with this," said Ryan Maness, senior policy analyst and tax counsel at MultiState, a state and local government relations company, ahead of the lawsuit. "I think the stakes on this are really quite high," he added.

Maryland passed its law at a time when other states — including Connecticut, Indiana, Montana, Nebraska and New York — are eyeing similar bills, he said. It is plausible that additional states will consider legislation if Maryland's law is able to survive legal challenges, Maness said.

"It would be an incentive for more states to levy more taxes like this, which would essentially be an increase in the number of taxes on Silicon Valley," he said.

One claim made by the groups suing is an allegation that the tax is illegal is because it violates a federal statute known as the Internet Tax Freedom Act, which, among other provisions, bans state and local taxation of internet access. The law also bans "discriminatory taxes" on electronic commerce.

“The Internet Tax Freedom Act was created to prohibit precisely what Maryland is doing here by imposing discriminatory charges only for online forms of advertising," said Steve DelBianco, president and CEO of NetChoice, one of the trade groups challenging the law.

Staffers for the Maryland General Assembly had warned of legal risk in their fiscal and policy note on the bill before it passed. And in his own review of the bill, Maryland Attorney General Brian Frosh similarly cited this risk, and said a court's decision on the Internet Tax Freedom Act question could come down to whether the state is seen as taxing online advertising or if it is seen as taxing the sale of online advertising.

"The proposed tax applies to the revenue derived from providing digital advertising services in Maryland regardless of whether the advertiser purchases those advertising services from the taxpayer over the internet or through some other means," Frosh argued.

Despite the legal challenges, Charles Kearns, a partner at the law firm Eversheds Sutherland who advises clients on state and local tax policy, noted in an interview that the tax is actively accruing, and stopping the state from imposing the tax in the meantime will be an uphill battle.

"It's not impossible, but it is very hard to get a preliminary injunction to keep a state from opposing or collecting a tax," said Kearns.

And while Maryland's tax is the first of its kind, Kearns says other states with ambitions to pursue similar provisions are closely watching what transpires in Maryland.

"It's not uncommon for states to adopt copycat bills once a proposal has kind of made it through far enough of the challenges," he said.

If the law does survive and proliferate beyond Maryland's borders, Bonner said the companies could pass on the cost of the tax to their advertisers.

"They could pass 100% of the new tax on to their advertisers but may also choose to absorb some or all of the new tax themselves," said Bonner in an email. "So it could be a wash but we just don't know how much credit they might want to build up with their advertisers," he added.

While the Maryland state legislature is considering mechanisms that, if enacted, would prohibit companies passing on the cost of the tax to customers directly, Kearns said these bills would only prohibit the direct pass-through of the tax as a separate line item. The bills do not prevent indirectly passing on the cost of the tax, through mechanisms like raising prices.