A federal judge this week heard oral arguments in a lawsuit challenging Maryland’s digital advertising tax. This is one of two lawsuits challenging the tax, with Maryland seeking to block both on procedural grounds.
The tax, passed in May 2021 over Governor Larry Hogan’s veto, was designed by its sponsors to apply to only about a dozen large out-of-state big tech companies, ostensibly to raise $100 million per year for education spending but in reality to punish large advertising companies that use a targeted advertising digital advertising model with which the sponsors (and supportive academics) disagree. As a result, it is structured unusually:
It applies not to profits but to all gross revenues derived from digital advertising in Maryland. What precisely is advertising “in Maryland” was left to subsequent regulations to define (and those regulations left things even more confused).
There are multiple rates on an increasing scale based on the company’s annual global revenues: 2.5 percent for companies with $100 million or more in global revenue; 5 percent for companies with $1 billion or more in global revenue; 7.5 percent for companies with $5 billion or more in global revenue; and 10 percent for companies with $15 billion or more in global revenue. The rates are not marginal rates like most other taxes, but apply from the first dollar.
Any taxpayer who annually earns $1 million or more from digital advertising in Maryland must file a tax return.
Failure to file a return results in fines and penalties up to five years’ imprisonment.
A later bill added three amendments: broadcast and news media are exempt, taxpayers are prohibited from passing the tax on to their customers, and the start date of the tax was made January 1, 2022.
The federal lawsuit, Chamber of Commerce, et al. v. Franchot, D. Md. Docket No. 21-cv-410, challenges the Maryland legislation on four independent grounds:
Violates the Permanent Internet Tax Freedom Act (PITFA) for taxing digital advertising but not non-digital advertising. Signed into law by President Obama in 2016, PITFA bans state taxes that discriminate against interstate commerce. The law defines a discriminatory tax as any levy imposed on internet-based goods and services that is not imposed on non-digital equivalents. The Maryland tax does exactly that, being imposed on digital advertising but not non-digital advertising. In his memo, diplomatically describing the Maryland tax as “not clearly unconstitutional,” Maryland Attorney General Brian Frosh expressed the most concern about a challenge under PITFA.
Impermissibly burdens interstate commerce in violation of the U.S. Constitution’s Commerce Clause by being structured to tax out-of-state companies discriminatorily. Under Supreme Court precedent, states cannot impose taxes that burden interstate commerce by taxing or otherwise penalizing out-of-state activity while leaving identical in-state activity untaxed or unpenalized. Maryland is seeking to do this, importing tax revenues while exporting tax burdens by designing its tax to apply only to digital advertising service companies with large global revenues and thereby excluding in-state competitors.
Violates the U.S. Commerce Clause by harming diplomatic negotiations on global digital taxes. American officials are currently enmeshed in negotiations over the French digital service tax and proposed Europe-wide or global digital taxes. Maryland enacting a similar tax while our diplomats are resisting foreign attempts to oppose them is counterproductive. In 1979, the U.S. Supreme Court held that state taxes that prevent the United States from “speaking with one voice when regulating commercial relations with foreign governments” violate the Foreign Commerce Clause.
Violates the U.S. Constitution’s Due Process Clause by seeking to regulate conduct outside of Maryland. The lawsuit alleges that because the conduct targeted by the law is almost exclusively undertaken by out-of-state companies, it amounts to Maryland impermissibly regulating extraterritorial conduct.
When the lawsuit was filed, Maryland quickly invoked the federal Tax Injunction Act (TIA) as a defense. The TIA is a short federal law: “The [federal] district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.” Maryland says this is a tax under the TIA, this lawsuit seeks to halt its collection, and Maryland has adequate remedies available to those who wish to challenge the law. (This is belied by the other lawsuit, brought in state court, where Maryland is arguing that the taxpayers lack standing to challenge it until they pay the gargantuan tax and then sue for a refund.)
The judge, in asking the parties to prepare for oral argument, thus focused on three questions: (1) whether Maryland’s law is a tax covered by the TIA; (2) whether Maryland has a “plain, speedy, and efficient remedy”; and (3) whether plaintiffs can challenge the portion of the law banning passing the tax forward to consumers, if they can’t challenge anything else.
The government attorneys argued that the Maryland charge is a tax, as it is revenue-raising, for a public purpose, and imposed by the Legislature. The revenue is substantial, the charge applies to many entities, and it pays for general government services, referencing the factors from Valero Terrestrial Corp. v. Caffrey on distinguishing taxes from fees. On the punitive purpose, the government attorney said nothing in the law suggests it is aimed at anyone, and the pass-through ban just bans directly passing the tax forward; companies can still do so indirectly by raising prices.
Michael Kimberly of McDermott Will & Emery argued for the plaintiffs. (Full disclosure: this is my former firm and I worked on the complaint in this case when I was there.) Kimberly conceded the tax is imposed by the state, but argued it is unlike a typical tax in that it is narrowly targeted to single out particular companies for what legislators considered wrongful conduct, and that it is unusual and designed to be burdensome. The pass-through ban has only a punitive explanation, and the harsh tax rates and comments by the sponsors illustrate the punitive purpose. Kimberly also argued that Maryland provides no speedy remedy, estimating it would take five to seven years to get a final ruling out of state courts.
The judge asked several questions of both lawyers as to the evidence of Maryland’s punitive nature, as well as how intertwined the assessment and the pass-through ban are. The government predictably argued that the judge should conclude the charge is not a tax and dismiss the entire case; the plaintiffs responded that a challenge to the pass-through ban should be able to stand as an independent claim. Maryland warned the judge that a ruling against them would gut the TIA and that the judge should dismiss the action on grounds of comity even if the TIA does not apply; plaintiffs in turn warned the judge that if Maryland won on TIA grounds, the state could ban all sorts of conduct in the tax code but being insulated from constitutional challenges.
The case was filed a year ago, and the argument lasted 90 minutes, so it’s clear the judge wants to be cautious in issuing her ruling. What the argument did make clear is that government lawyers are increasingly trying to use the TIA as a way to escape all judicial review of controversial tax enactments; a recent decision by the U.S. Supreme Court against the IRS may begin turning the tide against such positions. Maryland’s law is clearly unconstitutional and violates PITFA, if the judge can get past the procedural obstacles the state is placing in her path to prevent her from reaching that result.