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Interview: The Fight Over Maryland’s Digital Advertising Tax, Part 1

Posted on Nov. 17, 2021

In the first of a two-episode series, Professor Young Ran (Christine) Kim of the University of Utah S.J. Quinney College of Law discusses her views on the federal lawsuit challenging Maryland’s digital advertising tax.

This transcript has been edited for length and clarity.

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: 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 U.S. 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: 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 nondiscriminatory. The plaintiffs also argue that the tax violates the commerce and due process clauses of the U.S. Constitution.

David D. Stewart: Could you tell us about your first guest and what you talked about?

Lauren Loricchio: 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: Now, as a reminder, this is part 1 of a two-episode series. So, be sure to come back next week for part 2. Now, let's go to that interview.

Lauren Loricchio: Thank you for joining us today, Professor Kim.

Christine Kim: 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?

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.

As we all know, traditional profit allocation and nexus rule are becoming increasingly strained in the digital economy. 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 problems.

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. Google also has another set of clients, which is users. Let's suppose that those users, why don't we name him as William? William is in the United Kingdom.

Cash flow exists only between Google in California and advertisers Mercedes in Germany. There is no cash flow or little cash flow between Google and the U.K. user William. The only barter exchange between Google and William is Google offers search engine services or social networking services, and William, the user, offers data.

Traditional income tax systems or a consumption tax system only apply to the transaction between Google and advertisers where cash flow exists. 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.

In the international tax system, the U.S. or California collects revenue from Google's profits. We're going to assume that Google doesn't have physical presence in the U.K. 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 U.K., where William is located.

That's why we created a new term, market countries, as opposed to source countries.

In short, a traditional tax system cannot reward another newly emerged market jurisdiction here in the U.K. where users are located. 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.

In the Maryland situation, there will be users located in Maryland. It's design features is like it's a gross receipts tax and it has a very limited scope. That has ignited a heated debate across the globe. My article examines those policy debates, discusses 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. Many states like Maryland consider subnational digital tax reform. But Maryland's tax is currently now being challenged in the district court, like you mentioned, and I'm working with Shanske and the Democracy Forward Foundation to support the state of Maryland.

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. We plan to further engage in the case, depending on its development.

Lauren Loricchio: 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?

Christine Kim: Yes. The TIA mandates that the state tax litigation like this should be litigated in 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.

In that case, not only federal law, like the 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. That's why the plaintiffs want to circumvent the Tax Injunction Act and move this case to the federal court.

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 mainly argue is that whether the digital advertising and traditional advertising are similar. Maryland tax imposes tax on only online advertisement or digital advertisement and not the traditional advertisement. Thus the discriminatory tax and therefore preempted by the federal Internet Tax Freedom Act.

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: Legal experts have brought up various legal issues with the Maryland tax. Do you believe that the tax is on solid legal footing?

Christine Kim: Yes, a good question. As I mentioned, there might be some design flaws in international digital service taxes and Maryland digital advertisement tax. 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. Those best policies could be different from each other. 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.

Shanske and I do not think that it is unconstitutional or federally preempted. 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 a good solution for capturing profits from large companies like Google and Amazon in places where they don't have a physical presence?

Christine Kim: Yes. As I mentioned, 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.

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 nontaxed portion of the two-sided market using a rough proxy. 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 DSTs, 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?

Christine Kim: Yes. Actually many state tax officials asked me the same question because they are concerned about the ramifications of the global tax deal to state-level digital taxation in the U.S.

I have been monitoring the global development, not just about the global tax deal, but about the other countries' backup plans. 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. 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. 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.

Also, we should pay attention to the terms of the pillar 1 negotiation with individual countries. 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.

I think those five countries got what they want, to preserve DSTs if pillar 1 fails eventually. Even if it doesn't fail, I think the EU is considering an EU-wide new digital levy under a different name. My guess is that DSTs or something similar, but maybe under different name, would not be gone. 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.

I also like to reiterate the distinction between politics, policy, and legality. The global tax deal is about the politics and diplomacy. The U.S. 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. That means it does not make another policy option against the law. 

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.

Of course, I think it is fair that state policymakers are concerned about the global tax deal and keeping an eye on it. That may slow down the momentum for state digital tax movement. But I believe that a new form of digital tax would continue to emerge.

Lauren Loricchio: Do you expect Maryland will prevail in this litigation? Do you expect that other states are going to try to emulate Maryland's law?

Christine Kim: 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 states would closely monitor this litigation.

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. 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?

Christine Kim: I think it depends on the tax incidents eventually. It's definitely an attempt to tax the tech giants or Big Tech. They have been blamed by not paying their fair share of tax to the jurisdiction where users are located mostly. Maybe they felt that the criticism was unfair because market jurisdiction, or the cost of a market jurisdiction, didn't exist in the traditional tax system.

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 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 occurring between the platform economy and the users located market, not the source countries, but market jurisdiction.

That has to be taxed. I think it's a fair attempt to tax the large tech giants who have been criticized to pay their fair share of tax. 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.

Christine Kim: Oh yes. New York is considering data mining tax. It directly targets the side between the platform and the user. That's the side that I raised the problem from tax policy perspective, because it hasn't been taxed because of the lack of cash flow.

Maryland's 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 explicitly targets 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. How many users access the platform per month, rather than the actual usage of their data. 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.

Ideally I think measuring the actual data usage would be the best architecture to target the nontax portion of the platform economy. However, I believe that the proxy of headcount is a legitimate, is a reasonable alternative.

I believe, although the design is different, but both Maryland's digital tax and New York's data mining tax are attempts to capture the nontaxed portion of the digital platform economy.

Lauren Loricchio: Well, thank you so much for joining us on the podcast.

Christine Kim: Thank you so much. It was my pleasure.

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