In what is possibly the most important state tax decision in the past two decades (aside from Wayfair), the Maryland Tax Court struck down Maryland’s digital advertising tax on Friday. The court held that the tax violated the Commerce Clause and Due Process Clause of the U.S. Constitution, and was also preempted by the federal Internet Tax Freedom Act (ITFA). This decision has the potential to inform the trajectory of digital taxation across the country, as several states have since enacted similar (but different) digital advertising taxes and other novel digital-specific tax regimes. More detail and thoughts below the fold.

Maryland enacted the nation’s first standalone digital advertising tax in 2021, and controversy ensued nearly immediately. A challenge in federal court was largely dismissed on Tax Injunction Act grounds but was eventually allowed to proceed on First Amendment grounds and the 4th Circuit invalidated the passthrough prohibition aspect of the digital advertising tax. In the state courts, a taxpayer’s initial declaratory judgment victory was overturned and then several disputes proceeded simultaneously in the Maryland Tax Court (which is an administrative agency). More than a year after the court conducted the hearings, it published essentially identical opinions in the lead cases (Apple, Google & Peacock).

The Internet Tax Freedom Act (ITFA)

The court first addressed the taxpayers’ assertion that the tax was preempted by ITFA. Congress initially enacted ITFA in the late-1990s to protect the “nascent” Internet economy. ITFA was intended to be temporary but it was extended several times and made permanent in 2016. Although some of us believe ITFA has outlived its useful life and should be amended or repealed, it currently exists as a meaningful restriction on state taxing authority.

Despite being in force for over 25 years, there have been only a few decisions fully addressing and interpreting ITFA (although that is quickly changing). The Maryland Tax Court examined several of the most important ITFA cases but unfortunately failed to undertake a detailed analysis as to how each might apply to the digital ad tax. The court did address the similarity requirement, ultimately holding that:

The ITFA concerns transactions of electronic commerce, not structures or business models or technical operations behind those transactions. Thus, the question is “Are the transactions similar” not “Are the business models similar?” The Court finds that the following test suggested by the Respondent is unpersuasive: “If the services differ operationally, even by one or two characteristics, they are dissimilar and the tax does not discriminate under the ITFA.” … When the proper comparison is made, digital advertising services are similar to nondigital advertising services in all circumstances.

Whether this the right or wrong test remains to be seen, but it is important to note that several other courts have adopted different tests. Most recently, a California appellate court determined that taxing streaming services and not DVD rentals did not violate ITFA because these were not similar as they relied on different methods of delivery—a result that would seemingly be reversed under the Maryland Tax Court’s test.

The Maryland Tax Court also examined two other ITFA-related arguments. The court properly disregarded the argument that ITFA does not provide a private right of action. The argument that ITFA might be an invalid restriction on state sovereignty pursuant to the anti-commandeering doctrine, however, deserved more analysis (although I am biased, given my forthcoming article, Constitutional Commandeering, in the Wake Forest Law Review, and these two recent groundbreaking articles by Bradley Joondeph and David Gamage & Darien Shanske).

Commerce Clause

The Maryland Tax Court also held that the tax violated the Commerce Clause. I have previously recognized the constitutional vulnerability of the Maryland digital ad tax because of its mechanics, most notably the notch-effect tax rate that can rise from 2.5% to 10% based on a taxpayer’s worldwide gross revenues from all sources. The court agreed, holding inter alia, that the tax discriminated against interstate commerce because it violated the external consistency test. Although external consistency is rarely implicated, and internal consistency has become the prevailing test for discrimination, the Maryland digital ad tax rate structure is so severe that it made the best case for an external consistency violation in recent memory. More surprisingly, the court also held that the tax violated the “fairly related” prong of the Complete Auto Transit test, which is also rarely implicated.

Finally, the court held that the tax violated the Due Process Clause based on the same reasoning as the Commerce Clause (which is an analytical approach more commonly asserted post-Wayfair).

What’s Next?

It would be a shock if Maryland did not appeal these decisions, particularly given the cursory and conclusory nature of the ITFA analysis and potential judicial skepticism of constitutional jurisprudence emanating from an administrative body. The likely result on appeal is unclear. My initial thought is that Maryland is unlikely to prevail on appeal, particularly because 1) the ITFA conclusion relied on substantial factual development during the hearings (the procedural posture is interesting, though, as these opinions were the result of motions for summary judgment), and 2) the Maryland digital ad tax rate structure is so severe and clearly based on non-advertising activities outside Maryland (and outside the country). Leading experts feel strongly on each side of the question, however, with Darien Shanske calling the decision “stupendously flawed and an advertisement for why we have appellate review,” and Rick Pomp (a testifying witness for the taxpayers) calling “the decision ‘extraordinarily thorough and rigorous’ and likely to hold up well on appeal.”

The impact of these decisions on other jurisdictions will depend on how other states’ courts view the judge’s depth of reasoning. What is certain, however, is that states will continue to enact standalone digital taxes—whether ad-based taxes, data extraction taxes, or some type of AI-specific taxes—and taxpayers will continue to challenge the legitimacy of these efforts.