Maryland breaks new ground in taxing digital realm.

• Author: McCann, Bridget

On Feb. 12, 2021, Maryland's General Assembly enacted two bills over the veto of Gov. Larry Hogan that make major changes in the state's tax code. One is a sales tax on digital products and the other is a digital advertising tax.

The first bill, H.B. 932, expands the existing sales and use tax base to include "digital products," effective March 14, 2021. The second bill, H.B. 732, establishes a new digital advertising gross revenue tax--the first in any state. The effective date subsequently was delayed from 2021 until 2022. The digital advertising tax applies to annual gross revenue derived from digital advertising in Maryland and is imposed at scaled rates between 2.5% and 10%.

The two bills reflect separate and distinct trends in state taxation of the digital economy, and each raises significant compliance issues for businesses. While the sales tax on digital products reflects a continuing trend of state consumption tax base expansion in the digital arena, Maryland's interpretation of a "digital good" may be viewed as one of the most extensive iterations of such base expansion efforts in recent years. Additionally, the digital advertising tax is a new state gross revenue tax regime that seems to follow foreign digital service taxes (DSTs) enacted to address perceived shortcomings in international corporate income tax rules.

This column begins by discussing Maryland's sales tax on digital products and then focuses on the digital advertising tax.

Historical taxation of digital products

Traditionally, states imposed taxes on sales of tangible personal property and specifically enumerated services. In the past, most items that are now delivered digitally were transferred via tangible medium (e.g., compact disc). However, as more products and services began to be delivered digitally rather than in tangible format, some states looked for ways to tax these digital versions in order to protect their tax bases. For example, some states pursued taxation of digital products if they were the "digital equivalent" of tangible personal property.

Colorado is a recent example following a long line of states taking this approach. Colorado legislation enacted last year includes "digital goods" within the definition of "tangible personal property" and provides that "the method of delivery does not impact the taxability of a sale of tangible personal property." This includes compact disc, electronic download, and internet streaming. The legislation states it "codifies the Department of Revenue's long-standing treatment of digital goods, as reflected in its rule, and neither expands nor contracts the definition of 'tangible personal property.'" (1) Unfortunately, prior to the Colorado legislation and a corresponding regulation (2) that had been adopted earlier in the year, there was no clear guidance or support for taxpayers to rely on when making taxability decisions, other than experience or anecdotal reports that the department was taking a taxable position on audits.

Foreseeing the confusion that the taxation of digital goods could bring, the Streamlined Sales Tax (SST) project sought to bring simplification and harmonization to sales and use taxes, and to digital commerce specifically, when in 2007 it provided "specified digital products" definitions and rules for adoption by member states. For SST purposes, "specified digital products" means electronically transferred (other than via tangible storage media) "digital audio works," "digital audio-visual works," or "digital books." Computer software, which is classified as tangible personal property, and telecommunications, which is classified as a service, are excluded from the "specified digital products" definition. Twenty-four states have passed conforming legislation adopting these definitions when they choose to tax or exempt such products in their state's tax codes.

Observation: SST member states may tax digital products more broadly, but they must do so outside of the SST definitions. For example, Washington state imposes sales and use tax on these digital categories but also imposes sales tax on a category not defined by SST, "digital automated services." This is consistent with the SST framework, which binds states to following the SST definitions where applicable but allows states to tax (or exempt) other goods and services through separate, statespecific definitions.

Maryland's unique defnition of digital goods raises questions

Rather than following the approaches of other states that tax digital goods, Maryland defined digital goods in its own manner. Rather than specifically identifying in its statutes what constitutes a digital product subject to sales and use tax (the SST approach), Maryland's statute broadly defined a "digital product" as a product that is obtained electronically by the buyer or delivered by means other than tangible storage media through the use of technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities. The statute includes a list of certain digital products but does not limit taxation to those listed products. (3)

When the law was first enacted with an effective date in 30 days, taxpayers and practitioners assumed that Maryland would be taxing items in a manner similar to other states that had expanded taxation to digital goods. For example, most taxpayers and tax engine software providers assumed that cloud...