David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: digital advertising taxes, part 1.
The digitalization of the economy has proved to be a tough challenge for tax systems, both globally and here in the United States. We've talked a lot about the OECD's efforts to update the international tax system and to limit the impact of unilateral digital services taxes. But now, we're going to explore the efforts by state governments here in the U.S. to establish digital advertising taxes.
The constitutionality and legality of these taxes remains an open question. Maryland, which enacted a digital advertising tax, is currently arguing this question in court.
To explore both sides of the issue, we'll be dedicating the next two episodes of Tax Notes Talk to highlighting the different parties' arguments for and against the tax.
But before we get to our first interview, I'm joined by Tax Notes reporter Lauren Loricchio for some background on the case. Lauren, welcome back to the podcast.
Lauren Loricchio: It's great to be here.
David D. Stewart: So, to begin, could you start off with a brief overview of what digital advertising taxes do and how they differ from digital services taxes?
Lauren Loricchio: Sure. Maryland's digital advertising tax is the first of its kind in the United States. And it's modeled after the digital services taxes we've seen adopted in other countries. It's a gross receipts tax that applies to companies with global annual gross revenues of at least $100 million and with digital ad revenue sourced to Maryland of $1 million or more. The tax rate ranges from 2.5 percent to 10 percent, depending on the amount of the company's annual global gross revenues.
David D. Stewart: All right. Could you give us some background on the case now about this Maryland tax?
Lauren Loricchio: Sure. First it's important to note that there are two lawsuits we've been covering, that have been filed to challenge this tax. The first was filed by the U.S. Chamber of Commerce, the Internet Association, NetChoice, and the Computer and Communications Industry Association. That case is in federal court. It's been backed by big tech companies like Google and Amazon. It's the one we'll be discussing in this podcast.
The other lawsuit was filed in Maryland circuit court by subsidiaries of Comcast and Verizon.
The plaintiffs in the federal case say the tax unfairly targets digital advertising revenue, and therefore is discriminatory under the Internet Tax Freedom Act. However, some supporters of this tax say digital advertising is different enough from traditional advertising to make it non-discriminatory. The plaintiffs also argue that the tax violates the commerce and due process clauses of the U.S. Constitution.
David D. Stewart: So, you interviewed two people about this case. Could you tell us about your first guest and what you talked about?
Lauren Loricchio: Sure. I spoke with Young Ran (Christine) Kim, an associate professor of law at the University of Utah. We discussed the Maryland digital advertising tax lawsuit in federal court, her role in that litigation, and her research on digital services taxes. She is one of the two tax law professors who filed an amicus brief in support of Maryland.
David D. Stewart: All right. Now, as a reminder, this is part 1 of a two episode series. So, be sure to come back next week for part 2. And now, let's go to that interview.
Lauren Loricchio: Thank you for joining us today, Professor Kim.
Young Ran (Christine) Kim: Yes, thank you for inviting me Lauren. It's my honor to be a guest of this important episode.
Lauren Loricchio: You and Professor Darien Shanske of the University of California, Davis are siding with Maryland in Chamber of Commerce of the United States of America v. Franchot, which challenges Maryland's new digital advertising tax. Can you tell me more about your role in that lawsuit and why you are siding with Maryland?
Young Ran (Christine) Kim: I first wrote an article discussing digital services tax in 2020, published in the Alabama Law Review, and fortunately that piece has drawn significant attention from policymakers, scholars, and commentators. And as we all know, traditional profit allocation and nexus rule are becoming increasingly strained in the digital economy. And traditionally profits have been allocated to source countries where a business had a physical presence. But now we have highly digitalized business models and those businesses can generate profits in market countries without ever having physical presence. That means they can avoid taxation of those profits in market jurisdiction. In addition to this common knowledge among international tax folks, I identified that a platform economy operating a two-sided market causes unique tax problem.
So, I'd like to use this example that I created. Let's suppose that Google is in California and Google has two distinct set of clients. The first client is advertisers, and let's suppose that the advertiser is Mercedes located in Germany. And Google also has another set of clients, which is users. And let's suppose that those users, why don't we name him as William? So, William is in the United Kingdom. And cashflow exists only between Google in California and advertisers Mercedes in Germany. And there is no cashflow or little cashflow between Google and the U.K. users William. And their only barter transaction, barter exchange between Google and William, Google offer search engine services or social networking services, and William, the user, offers data. And traditional income tax system or a consumption tax system only apply to the transaction between Google and advertisers where cashflow exist. The barter exchange between Google and William in the U.K. is also a taxable transaction in theory, but it can hardly be taxed because, as I mentioned, there's little to no cash flow.
So, in the international tax system, the United States or California collects revenue from Google's profits. Suppose—Because assuming, we're going to assume that Google doesn't have physical presence in the U.K. And even if we think about traditional consumption tax, like value added tax or sales tax, the source state may collect tax revenue, but the problem is in this transaction, the source state refers to Germany where the advertisers are located, not the United Kingdom, where William is located. So, that's why we created a new term, market countries, as opposed to source countries. And in short a traditional tax system cannot reward another newly emerged market jurisdiction here in the United Kingdom where users are located. So, this is a novel tax problem arising in the platform economy and that's why states like Maryland, European countries, and other countries in the world have started imposing a new tax, such as digital services tax or a digital advertisement tax. Because the existing tax system cannot capture the transaction between Google and the U.K. users.
And in the Maryland situation, there will be users located in Maryland. But in the design feature, it's design features like it's a gross receipts tax and it has a very limited scope. So, that has ignited a heated debate across the globe, and my article examines those policy debates. Discuss whether DSTs could be a new path toward a consumption tax in the international tax regime, and offers ways to overcome certain design challenges that DSTs are facing.
But such global development has important repercussions to domestic tax policy. So, many states like Maryland consider sub-national digital tax reform. But Maryland's tax is currently now being challenged in the district court, like Lauren you mentioned, and I'm working with professor Darien Shanske and Democracy Forward Foundation to support the state of Maryland. And as the first step, we have filed an amicus brief to support Maryland. But the litigation is still in the early stage. It's in the summary judgment consideration. And we plan to further engage in the case, depending on its development.
Lauren Loricchio: So, the plaintiffs in the Maryland lawsuit have argued that the Federal Tax Injunction Act doesn't prevent their challenge and that the lawsuit should be able to proceed in federal court. Can you tell me what the TIA does and whether you think the lawsuit should be allowed to move forward?
Young Ran (Christine) Kim: Yes. The TIA mandates that the state tax litigation like this should go to the— should be litigated in the district court, the state district court, rather than a federal court. But if the state tax is preempted by federal law, then this case can be litigated in a federal court. And in that case, not only about federal law, like federal Internet Tax Freedom Act, but also the constitutional issues such as dormant commerce clause and due process clause can be considered by the courts. So that's why the plaintiffs want to circumvent the Tax Injunction Act and move this case to the federal court.
But however, in our amicus brief, we think that the main focus is on the federal Internet Tax Freedom Act at the early stage of this litigation, because the first step that the plaintiffs argue, mainly argue is that whether the digital advertising and traditional advertising are similar. But Maryland tax imposes tax on only online advertisement or digital advertisement and not the traditional advertisement. And thus the discriminatory tax and therefore preempted by the federal law, federal Internet Tax Freedom Act. So all issues are intertwined, but we strategically decided to focus on the Internet Tax Freedom Act discussion, because, although the issues are all related to the question of whether digital advertising is or not similar to non-digital or traditional advertising, I think the first issue that we should defend Maryland is that the Maryland digital advertising tax does not violate Internet Tax Freedom Act.
Lauren Loricchio: So, legal experts have brought up various legal issues with the Maryland tax. Do you believe that the tax is on solid legal footing?
Young Ran (Christine) Kim: Yes, a good question. So, as I mentioned, there might be some design flaws in international digital service tax and Maryland digital advertisement tax. So, there could be the best policy for digital services tax in general, and there could be the best policy and digital tax in the U.S. sub-national tax policy. And those best policy could be different, different from each other. And it might be possible that Maryland tax is not perfect.
But the point is the legal matter, because now we're talking about litigation. The legal matter is whether Maryland's digital tax is unconstitutionally imperfect or federally preempted by the federal laws, such as Internet Tax Freedom Act. And Professor Shanske and I do not think that it is unconstitutional or federally preempted. So, we would like to make a distinction between policy and legality. If we keep those distinctions in mind, then I do not think that the Maryland tax would be held unconstitutional or preempted by the ITFA. So, I believe the Maryland tax is on solid legal footing.
Lauren Loricchio: Do you believe taxes, such as the Maryland tax and DSTs, are they a good solution for capturing profits from large companies like Google and Amazon in places where they don't have a physical presence?
Young Ran (Christine) Kim: Yes. So, it's—as I mentioned, it's the lack of physical presence is also important. But the fact that Google or Facebook are a newly emerged platform economy, where they are operating in a two-sided market. And the one side of that two-sided market, which is the part of transaction side between the platforms such as Google and users such as William, has not been captured by the traditional tax system is the important justification of this digital service tax or digital advertising tax. So, as I mentioned, the design of the current tax, like DSTs or a digital advertisement tax might not be perfect, but we believe that as a matter of law, it is a legitimate attempt to capture those non-taxed portion of the two-sided market using a rough proxy. And that would be— that would make the Maryland's tax on solid legal footing, as well as the digital services tax.
Lauren Loricchio: An international agreement was recently announced that would require OECD member countries to remove digital services taxes, and agree not to introduce those measures in the future. What do you think that means for state efforts to impose digital advertising and other digital services type taxes?
Young Ran (Christine) Kim: Yes. Very good question. So, actually many state tax official asked me the same question because they are concerned about the ramifications of the global tax deal to state level digital taxation in the United States. And I have been monitoring the global development, not just about the global tax deal, but about the other countries' backup plans. And the EU is actually planning to introduce the EU-wide new digital levy after the global deal, even before we reached this global tax deal. And I think they know that they might have to repeal DSTs. But my guess is that they are likely going to do the same thing, but under a different name. Also, I'm not sure whether the global deal will get through Congress. We cannot get pillar 1 as a tax treaty because the GOP will not agree. And maybe we can try an executive agreement with a majority vote in both houses, but there still needs to be an override of several articles of tax treaties.
And also we should pay attention to the terms of the pillar 1 negotiation with individual countries. So, the terms are actually like this: the U.K., France, Italy, Spain, and Austria will keep their digital taxes for now. But if the OECD global tax deal is implemented by 2023, then the countries will offer a credit to refund those digital services tax. So, I think those five countries got what they want to preserve DSTs if pillar 1 fails eventually. So even if it doesn't fail, I think the EU is considering an EU-wide new digital levy under a different name. So, my guess is that DSTs or something similar, but maybe under different name, would not be gone. And well, in some way, it is inevitable in my opinion, because we're living in a world where the newly emerged platform economy is thriving and traditional tax system, either income tax or consumption tax, can lawfully tax both sides of the platform.
And I also like to reiterate the distinction between politics, policy, and legality. The global tax deal is about the politics and diplomacy. So, the United States is pushing the European countries to repeal or pause DSTs because it can. But the outcome is also a political product, not a legal product. So, that means it does not make another policy option against the law. So, in other words, the pillar 1 agreement does not make the existing DSTs against the superior EU law. If it is going to be repealed, then it's gone because of the changed political mood. In the U.S. sub-national context, the international agreement does not and cannot make the state digital tax unconstitutional or preempted by a federal law. So, of course, I think it is fair that state policymakers are concerned about the global tax deal and keeping an eye on it. And that may slow down the momentum for state digital tax movement. But I believe that the new form, a new form of digital tax would continue to emerge.
Lauren Loricchio: Do you expect Maryland will prevail in this litigation? And do you expect that other states are going to try to emulate Maryland's law?
Young Ran (Christine) Kim: So, well, I cannot make a prediction because I'm not a judge. But what I can do is that I hope that Maryland should prevail and the other state would closely monitor this litigation. And maybe other states may offer a better architect digital taxation. But as a professor who submitted this amicus brief, I hope and I believe that Maryland would prevail, but it's hard to predict. But, I believe that this is an inevitable movement to have a new form of digital taxation.
Lauren Loricchio: I wonder what sort of ramifications do you think the lawsuit could have for efforts to tax large tech companies like Google and Amazon?
Young Ran (Christine) Kim: So, I think it depends on the tax incidents eventually. And it's definitely an attempt to tax the tech giants or big tech. And they have been blamed by not paying their fair share of tax to the jurisdiction or countries or states where users are located mostly. And maybe they felt that those criticism was unfair because market jurisdiction, or the cost of a market jurisdiction didn't exist in the traditional tax system. So that's why I explained at the beginning of this episode that we actually had to create it, the new term market jurisdiction, as opposed to source jurisdiction, because the market jurisdiction didn't— the concept of market jurisdiction didn't exist in the traditional tax system. It wasn't actually subject to the tax system at all. But now we know that there is a barter transaction occurred between the platform economy and the users located market, not the source countries, but market jurisdiction.
And that has to be taxed. And that my— I think it's a fair attempt to tax the large tech giants who has been criticized to pay their fair share of tax. And it could be a challenging journey to have this role as an established tax system. However, I think it's an important policy effort to implement this kind of a new tax in our tax system, especially when we go through this pandemic where this platform economy is really thriving during the pandemic, despite the fact that many other brick and mortar economy has been suffering significantly.
Lauren Loricchio: There's another proposal that's been introduced in New York state that would impose a tax on consumer data. I don't know if you're familiar with that one, but I wondered if you have any thoughts on that.
Young Ran (Christine) Kim: Oh yes. So, New York is considering data mining tax. And it directly targets the side between the platform and the user. So, that's the side that I raised the problem from tax policy perspective, because it hasn't been taxed because of the lack of cashflow. And Maryland digital tax uses the gross receipts as a proxy and attempts to tax the one side of the platform economy between the platform and the users. But New York directly target, explicitly target the barter transaction side between the platform and economy. But they are considering a different tax base, which is the usage of the data by the users.
However, the New York data tax is measured by the head count. So, how many users access the platform per month, rather than the actual usage of their data. And I talked about this with the New York policymakers and the main reason to use the head count instead of the data usage is the administrative reason. And so, ideally I think measuring the actual data usage would be the best architecture to target the non-tax portion of the platform economy. However, I believe that the proxy of headcount is a legitimate, is a reasonable alternative. So I believe, although the design is different, but both Maryland digital tax and New York data mining tax, are attempt to capture the non-taxed portion of the digital platform economy.
Lauren Loricchio: OK. Well, thank you so much for joining us on the podcast.
Young Ran (Christine) Kim: Thank you so much. It was my pleasure.
David D. Stewart: And now, coming attractions. Each week, we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?
Paige Jones: Thanks, Dave. We are excited to announce the submissions period for the Christopher E. Bergin Award for Excellence in Writing is now open! This annual award recognizes superior student writing on unsettled questions in tax law or policy. Eligible students must be enrolled in an accredited undergraduate or graduate program during the academic year. Visit taxnotes.com/students for more details.
Also, in Tax Notes Federal, J. Harold McClure provides a hypothetical case study to explore Coca-Cola and Medtronic and illustrate how badly comparable uncontrolled transaction analyses tend to understate arm’s-length royalty rates. Shannon Jemiolo and Ian Redpath examine the requirements for qualified conservation contributions and assess the IRS’s current stand on syndicated conservation easements. In Tax Notes State, Steven Wlodychak reviews a ruling in which the Maine Board of Tax Appeals upheld a decision that a Maine resident was not entitled to a tax credit against his Maine personal income tax for his share of a new passthrough entity tax paid to another state. Orly Mazur and Adam Thimmesch explore the role of the state income tax in capturing foreign income from digital transactions and examine the relationship between state and international efforts to impose targeted digital taxes. In Featured Analysis, Marie Sapirie examines how the IRS can mitigate taxpayer information disclosures by IRS-approved contractors and subcontractors. On the Opinions page, Robert Goulder and Jeffery Kadet discuss the House Ways and Means Committee proposal to eliminate key features of the subpart F regime.
David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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