Maryland’s unique digital advertising tax had its day in court today, in the U.S. Court of Appeals for the Fourth Circuit. The tax imposes a 10 percent tax on Maryland-based digital advertising on companies with more than $15 billion in global revenues. It has been challenged by several companies that would owe it, on the grounds that it violates the federal Internet Tax Freedom Act (ITFA) that bars discriminatory digital taxation, the Commerce Clause, and the First Amendment. The case is appealed from a trial judge who refused to hear the challenge and said it should be heard in state court.
A focus of today’s argument - and the basis for the First Amendment challenge - is the tax’s prohibition on passing the tax on to customers. Maryland argues that this violates conduct (the taxpayers can say what they like but cannot put a separate line item on the bill), while the taxpayers say it violates speech (the money gets paid no matter what, all that is prohibited is telling customers what’s going on). Judge Toby Heytens posed hypotheticals to both sides about what would or would not be allowed under this provision and when it becomes “literally a prohibition on what you can say”: creating an internal accounting line that tracks the tax, or sending a letter to customers explaining why their bill has gone up. Judge Julius Richardson asked for clarification on the parties’ stipulation that indirectly passing the cost on through higher prices would be permissible; he said that may not be a natural reading of the statute. If only an unnaturally narrow reading makes the law constitutional, that’s a sign that it may not be.
Judge Henry Floyd elicited concessions from Maryland’s lawyer that this is the only tax based on extraterritorial conduct, the only tax both product- or industry-specific and applying to so few companies, and the only one based on global gross revenues. While none of those may be dispositive by themselves, together they suggest, in his words, “this ain’t a tax, it’s a hammer.” Maryland’s lawyer responded that it is acceptable to set a tax rate based on out-of-state activity, so long as the actual dollars paid is from in-state activity.
The key question the judges face, however, is whether this is a tax or a penalty for purposes of the federal Tax Injunction Act. This law says challenges to state taxes generally cannot be heard in federal court, unless an exception is met. While it may seem odd that ITFA and the Commerce Clause and the First Amendment - all federal enactments - would prohibit a tax but give federal judges no way to say so - that is the curious situation that many taxpayer lawsuits end up in.
But federal judges can hear challenges to penalties. So is it a tax or a penalty? Judge Floyd correctly (in my opinion) observed that the way to answer this is to ask if the revenue raised is primarily for revenue or for punishment. A test cited by both sides, Valero, asks it a different way: is there evidence of a punitive purpose? So we have the taxpayers urging the court to look at the legislative punish-these-four-companies purpose as illustrated by statements by the bill’s sponsor and his star academic witness who inspired the bill as a way to remediate damage by bad actors, and we have the government saying judges should look at the legislative purpose as set out in the statute, not statements by legislative sponsors or the obvious implications of how this tax is uniquely structured. Maryland’s lawyer got audible scoffs from the bench as she pressed that this tax’s only purpose was to fund education, but it is not an easy question what evidence is permissible beyond the anodyne recitations in the bill itself.
The judges were very engaged and knew the subject-matter. As a parallel state court case is mired in administrative appeals, a decision here should come out by the end of the year. If taxpayers win, it would go back to the lower court to actually consider the merits. But whomever loses, an appeal to the full Fourth Circuit or the U.S. Supreme Court is likely. The case is Chamber of Commerce of the United States, et al. v. Lierman, U.S. 4th Circuit No. 22-2275.