More states strive to tax online ads despite the challenges

Taxes on digital advertising are gaining steam in the United States, despite having no clear path to enforcement and questionable legal standing. The most recent proposal comes out of the Bay State.

Massachusetts Bill H.4179, An Act Establishing a Tax for Online Advertising, would levy a 6.25% excise tax on gross revenue from digital advertising services by “persons with revenue from digital advertising services provided within the commonwealth.” The first $1 million in revenue from digital advertising services provided in the commonwealth each year would be exempt from tax.

The bill defines “digital advertising services” as “advertisement services on a digital interface, including”

• Banner advertising
• Interstitial advertising
• Search engine advertising
• “Other comparable advertising services”

A digital advertising service is “provided within the commonwealth” if received on a device with an IP address located within Massachusetts. As defined in H.4179, an IP address is “a unique string of characters assigned to each device connected to a computer network using the Internet Protocol for communication.”

The tax proposed under H.4179 is considerably more straightforward than digital advertising taxes introduced in (and abandoned by) Massachusetts earlier this year. Or, as Scott Peterson, vice president of government relations at Avalara puts it, “it’s woefully light on details.” That could be problematic because there’s no simple way to tax online advertising.

Complicating factors include:

• Legality: Can a state tax single out one form of advertising to tax?
• Liability: Who will pay the tax?
• Location: How can a state ensure it sources digital ads correctly?

As Massachusetts takes another stab at getting a digital ad tax to the governor’s desk, Maryland is preparing to defend its groundbreaking digital advertising tax in court. It’s being challenged by the Chamber of Commerce of the United States of America and, separately, by Comcast and Verizon.

According to the American Bar Association, “Maryland’s law is problematic in numerous ways,” including but not limited to the following:

• It could violate the Internet Tax Freedom Act by taxing electronic commerce without imposing a similar tax on nondigital advertising revenues.
• It could run afoul of the First Amendment and violate the dormant Commerce Clause by discriminating against out-of-state businesses in favor of in-state businesses.
• It could impede speech on certain platforms.

Peterson believes “the constitutional challenges of taxing digital advertising and exempting all other forms of advertising are overwhelming.”

If Maryland’s digital advertising tax is found to be unconstitutional or in violation of federal or state law, the American Bar Association predicts “other states’ taxes may fall as similarly violative.”

On the other hand, should Maryland win in court (twice), it will pave the way for other states to enact similar laws. 

Massachusetts would tax any digital advertising services on a “digital interface,” which is defined “any type of software, including a website, part of a website, or an application that a user may access.”

Presumably this would affect companies like Google, Facebook, and YouTube because much of their revenue is generated from online advertising. But what about:

• Hulu or similar streaming service providers?
• National and local newspapers?
• Other websites that generate revenue through advertising?

Peterson believes “no one really understands what digital advertising is” at this point. “Does Hulu have gross revenue from providing digital advertising services when all they’ve done is provide a medium over which someone else presented the advertising?”

Washington, D.C., abandoned its first pass at a digital advertising tax in part over concerns it would adversely affect community newspapers and other local businesses. As the Tax Foundation noted at the time, “a large retail chain with locations in the District likely could not be taxed on advertising purchases, but a smaller regional chain based in the District could.”

And there’s this elephant in the room: Will companies pass the cost of this tax on to consumers?

Massachusetts H.4179 doesn’t delve into this matter. Maryland’s law prohibits taxpayers from “directly” passing on the cost of the tax to customers who purchase digital advertising services, but it doesn’t prohibit companies from charging customers for digital advertising services or putting up a paywall for content currently offered for free.

Digital ads target consumers wherever they go. To ensure they only tax revenue generated from online ads displayed within state borders, both Massachusetts and Maryland plan to use IP addresses to determine the location of the ad displayed — whether that’s a desktop computer in an apartment in Annapolis or a mobile phone owned by a Texan exploring Cape Cod.

All internet-connected devices have an IP address that’s assigned by the internet service provider (ISP). According to NortonLifeLock, IP addresses reveal the geolocation (e.g., area code, city, and ZIP code) of  internet-connected devices and change every time a device connects to a different Wi-Fi network or router. They’re the reason a person searching for “pizzerias” in Baltimore sees different results than a person searching for “pizzerias” in Boston.

IP addresses don’t reveal the user’s street address or name. In fact, the location linked to an IP address is generally that of the nearest ISP server. In theory, this could cause Massachusetts to tax an ad on a device in New Hampshire that’s connected to an ISP in Massachusetts. It’s also why my mobile phone provider sometimes thinks I’m in Canada when in fact I’m in the U.S. on the wild coast of Washington’s Olympic Peninsula.

How can a state verify the accuracy of an IP address? What happens if an ad appears on a device using a virtual private network (VPN), which, according to NortonLifeLock, “changes your IP address completely, placing your geolocation hundreds or maybe thousands of miles from where you actually are accessing the internet.” How can a state ensure companies are taxed on revenue generated from digital ads on devices located in the state, not another state? These are the types of questions Maryland, Massachusetts, and any other state seeking to tax digital advertising will need to answer. 

There are other issues as well. Maryland’s digital ad tax lacks clear sourcing rules, which the Maryland Comptroller is currently working to establish. It relies on a yet-to-be-determined apportionment formula to determine revenue from in-state digital advertising sources.

Yet as Scott Peterson notes, “apportionment may not be the biggest challenge this type of tax faces.” The global minimum tax deal could pose a more serious threat because it calls for the standstill and removal of provisions related to existing digital services taxes. Though Maryland’s tax applies to annual gross revenues derived from digital advertising services in the state, it uses variable tax rates that increase along with the taxpayer’s global revenue. The American Bar Association points out that those global annual gross revenues are “from whatever source (including non-advertising revenues),” which “has the obvious effect of increasing an affected taxpayer’s apportionment percentage and liability.” Taxing revenue from a taxpayer’s global activities, advertising or otherwise, could violate the Commerce Clause.

Despite all the above, Maryland intends to enforce its digital advertising tax on January 1, 2022, if it can. Massachusetts is one of several states interested in following Maryland’s lead. Others include:

• Connecticut
• Indiana
• Montana
• New York (A734, S1124, S302)
• Texas
• Washington
• Washington, D.C.
• West Virginia

Could the fate of digital advertising taxes mimic that of online sales tax? States tried for decades to win the right to tax sales by out-of-state sellers, were repeatedly blocked from doing so, and finally won when the Supreme Court ruled in favor of the state in South Dakota v. Wayfair, Inc. (June 21, 2018).

Peterson says maybe, “but this tax is poorly thought through. The constitutional challenges are serious and very different from the challenges brought up in Wayfair. In Wayfair, the courts had long acknowledged the transactions were taxable. The issue in Wayfair was the mechanism for getting the tax collected.”

Whatever happens with digital advertising taxes in the future, we’ll cover it at the Avalara Tax Desk.