A Failed Experiment

A FAILED BY SEAN HETZLER EXPERIMENT

While many believe that digital behemoths aren’t paying enough taxes, remedies at the state level could be unfair to media companies.

SUPREME COURT JUSTICE LOUIS Brandeis popularized the idea that individual states can serve as “laboratories of democracy” for the country. In a famous dissenting opinion, Brandeis describes how states are free to try novel social and economic experiments that may otherwise prove too risky for the entire nation.

Indeed, state experimentation has provided the framework for numerous federal laws. For example, the Affordable Care Act, a landmark Barack Obama-era legislative achievement, borrows many aspects from health care reform enacted in Massachusetts and signed into law by Gov. Mitt Romney.

Unfortunately, the latest round of state experiments has cooked up a particularly bad batch of proposals known as digital advertising taxes. They seek to impose an additional, discriminatory financial burden on any company that sells digital advertising.

These tax proposals achieve an impressive feat: they’re deeply unpopular, bad tax policy and unconstitutional. However, despite their significant flaws, the proposals continue to surface in state legislative sessions and represent a challenge that the media industry will be dealing with for years to come.

STATE TAX ACTIONS

As the coronavirus pandemic swept across the U.S., many state governments decided to take the advice of economist Paul Romer, expressed in a New York Times opinion piece, regarding big technology companies; their outsized influence on our everyday lives; and minimal tax payments. (See sidebar, page 12, for more on his views and the international community.)

In some cases, states were looking for additional sources of tax revenue amid plummeting budget projections. In others, there was simply political animus towards big technology companies. Either way, state legislators brought forth several proposals to implement digital advertising taxes.

These proposals largely fell into one of two categories: 1) a new tax on gross revenue from digital advertising; or 2) an expansion of the existing sales tax base to cover digital advertising.

States such as Connecticut, Massachusetts, Maryland and New York embraced the gross revenue approach. Most of the proposals closely resemble taxes enacted across the European Union. Countries in the E.U. have enacted taxes that are essentially a surcharge on digital activity to make sure digital companies are paying what the countries deem is appropriate for the business they do within their borders.

Maryland has the ignominious distinction of being the only state in the U.S. to successfully pass a digital advertising tax as of the time this issue went to press. Its tax is simply calculated as a tax rate times the amount of gross revenue derived from digital advertising services in Maryland. In a surprising twist, the percentage of tax assessed increases depending on the global annual gross revenues of the taxpayer, not gross revenue from digital advertising or gross revenue in Maryland. Presumably, this is an effort to make sure the biggest worldwide digital advertising providers bear the largest tax burden.

However, Maryland’s law does not address some of the most pressing questions that taxpayers have, such as how exactly one should determine which digital advertising is from Maryland. Instead, the law simply states that the Maryland state comptroller shall adopt clarifying regulations.

Other states – including Louisiana, South Dakota, Washington and the District of Columbia – have proposed an expansion of the existing sales tax base to include digital advertising. In contrast to the gross revenue taxes described above, which are assessed on the seller of digital advertising, a sales tax

would be imposed on the purchaser of digital advertising.

Nevertheless, the seller of digital advertising would still be tasked with collecting the tax from customers and remitting the funds to the state tax authority. The sales tax would effectively serve as an across-the-board price hike on the purchase of all digital advertising in the state.

FLAWS IN THE LOGIC

It is likely that many Americans share Romer’s concerns, mirrored by Democrat and Republican lawmakers who have become increasingly hostile to the societal problems that these companies exacerbate. Unfortunately, no matter how noble the goal, digital advertising taxes are fatally flawed and are the wrong way to fix the problem.

The first problem with digital advertising taxes is that they violate several tenets of sound tax policy. Many tax professionals agree that it is economically inefficient to impose tax on business inputs (i.e., items purchased by businesses to facilitate their operations). The classic example involves a retail store that purchases inventory from a distributor before selling those products to individual customers. The store charges sales tax to the individual customers when they make purchases; however, the distributor does not charge sales tax to the store on its purchases.

It is easy to see how a problem will emerge if tax is charged on every step of the transaction. If the distributor charges sales tax to the store, the store has incurred more expense to acquire inventory. All else equal, the store can either decide to “eat” the additional cost and reduce margins or raise prices for its customers.

If prices are raised, customers will still pay a certain percentage of sales tax on their purchases, but a portion of that tax will now be due on sales tax already imposed (i.e., the store’s price increase). This tax “pyramiding” can quickly lead to tax rates that are far higher than the stated statutory rate.

As far as the current tax proposals are concerned, it is difficult to imagine a service utilized more exclusively by businesses than advertising. Whether in the form of a tax on gross revenue or a sales tax, digital advertising taxes are likely to make advertising more expensive for numerous small and medium-size businesses already facing financial struggles.

Media companies will likely also suffer due to a drop in advertising demand. Local media outlets provide a vital public service to the communities they serve and depend on advertising revenue to fund their newsrooms. Again, it is the small and medium-sized businesses who will likely suffer the most, not the technology behemoths that legislators are focused on.

As noted in the sidebar, numerous countries in the European Union have adopted digital advertising taxes to overcome disadvantageous effects of the international tax system. Specifically, the concept that corporate taxation is based on a company’s physical presence as opposed to user location. These countries have a legitimate complaint, and the Organisation for Economic Co-operation and Development has responded by hosting negotiations aimed at overhauling the entire system.

However, U.S. states do not suffer from the same issue. Many, including Maryland, already base their corporate taxation on the market for a company’s services (in this case, where the users who receive advertising are located). Accordingly, any revenue derived from digital advertising is already subject to corporate tax and need not be taxed twice.

Not only are they bad policy, but digital ad taxes also violate federal law. The Permanent Internet Tax Freedom Act (PITFA) bans U.S. states from imposing discriminatory taxes on electronic commerce. By their nature, digital advertising taxes only apply to online transactions and do not capture their offline counterparts, such as advertising in a newspaper or magazine. Therefore, digital advertising taxes clearly discriminate against electronic commerce and run afoul of PITFA.

Finally, and perhaps most damning, digital advertising taxes violate the dormant Commerce Clause of the U.S. Constitution. Generally, this clause requires that a state tax be “externally consistent.” Under that requirement, a state is only permitted to tax

ORIGINS OF THE TAX

TO UNDERSTAND TODAY’S DIGITAL ADVERTISING TAX LANDSCAPE, IT IS helpful to know where the idea began. Nobel prize winning economist Paul Romer is widely credited with beginning the U.S. movement with a 2019 New York Times opinion piece. In it, Romer argues that dominant digital platform companies, including Facebook and Google, are eroding the shared values and norms on which democracy depends by creating a haven for misinformation and hate speech.

He notes that the digital giants have generated enormous profits from a business model that relies on the collection of user information to sell targeted advertisements. In Romer’s view, it is imperative that Americans wrest power away from these digital platforms. However, instead of tackling the problem through antitrust law or regulatory actions, which are either poorly suited to the problem or sufficiently undermined by industry meddling, he suggests that a new tax may be the most efficient approach.

This new tax would be a modern-day panacea for all the ills caused by big technology, in Romer’s opinion. It would incentivize a move towards “healthier” ad-free, subscriptionbased revenue models; grant easier access to new market entrants; and discourage mergers and acquisitions that stifle competition. However, as far as implementation is concerned, Romer only vaguely suggests that states impose a “type of sales tax on the revenue a company collects for displaying ads to residents of the state.”

The current batch of state proposals also borrow heavily from ideas born on the other side of the Atlantic. In recent years, governments have become increasingly concerned that the digital giants of the world are paying less corporate income tax than their non-digital counterparts.

They note that current international tax rules generally impose corporate tax in the country where a company has a physical presence as opposed to where its customers are located. Therefore, it is possible to be a U.S.-based digital company with numerous French users (and enormous profits from advertising to those users), but still pay a relatively low level of French tax.

In response, many countries in the European Union have enacted digital services taxes in addition to their existing corporate income tax regimes. These taxes effectively impose a surcharge on digital activity in the country and are intended to make sure multinational digital companies are paying their “fair share.”

the portion of revenues that reasonably reflect activity in the state.

However, as previously discussed, the percentage of tax due in Maryland is based on a taxpayer’s global annual gross revenue. That means two companies with identical Maryland digital advertising sales could have wildly different tax liabilities based on foreign activity that has no relation to Maryland. Despite this clear violation of the external consistency requirement, several other states have borrowed the Maryland approach when drafting their own proposals.

REVISING THE PLANS

No less than a week after Maryland’s digital ad tax law was enacted, four trade associations filed a federal lawsuit to challenge it, citing the flaws discussed above. Maryland lawmakers provided some relief to taxpayers by passing a follow-up bill that delayed the implementation of the law for a year and exempted certain broadcast and news media entities. However, the central issue remains and will surely lead to years of contentious litigation.

Due to the litigation that has embroiled the Maryland tax, some states have wisely decided to table their proposals until they have a clearer idea how to proceed. However, other states have attempted to circumvent the legal issues with alternate approaches.

For example, the District of Columbia proposed an expansion of its sales tax to all forms of advertising, regardless of how it’s delivered. That approach certainly avoids the discrimination against electronic commerce that plagues other taxes on digital advertising but does nothing to avoid the policy concerns.

In contrast, New York proposed a tax that focuses not on digital advertising, but instead on the collection of consumers’ personal data. As with other initiatives, this proposal is intended to target business models favored by big technology companies. Sadly, the proposal is sufficiently broad to sweep in other unsuspecting businesses as well.

With the notable exception of Maryland, all the digital advertising taxes proposed by states in 2020 and 2021 to date were eventually shelved or defeated. Many states embraced these taxes during the height of the pandemic, but additional funds provided by a faster-than-expected economic recovery and historic federal stimulus spending lessened lawmaker’s appetite for tax increases. No less than a week after Maryland’s Nevertheless, many legislators digital ad tax law was enacted, four trade associations filed a federal still have a bone to pick with big technology, and they may conclude that, despite legal and policy conlawsuit to challenge it. cerns, tax is the most effective tool at their disposal. Pending the results of Maryland litigation, many experts expect to see a fresh wave of proposals in 2022. Media companies should be ready to express their concerns at the local level and make their voices heard. Only through activism and resolve can we finally prove that digital advertising taxes are an experiment gone wrong. Sean Hetzler is a senior director and leads the corporate tax department at TEGNA Inc. He can be reached at shetzler@tegna.com.

Insure dreams come to life.

Chubb has helped filmmakers and media companies make dreams come to life for more than 50 years. We provide a level of protection and service that comes from knowing your industry and understanding your needs. Visit us online at chubb.com. Chubb is the only commercial insurer endorsed by MFM.

©2021 Chubb. Coverages underwritten by one or more subsidiary companies. Not all coverages available in all jurisdictions. Chubb®, its logo, and Chubb. Insured.SM are protected trademarks of Chubb.