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Maryland legislature approves digital ad tax delay, digital products amendments

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April 2021

In brief

Legislation passed by the Maryland General Assembly on the last day of the regular session (April 12) delays the state’s digital advertising gross revenue tax by one year and retroactively amends the state’s digital products sales tax provisions. The measure now goes to Governor Larry Hogan (R) for his consideration. [S.B. 787, passed General Assembly, 4/12/2021]

Action item: Taxpayers subject to sales or use tax under the digital products provisions that became effective March 14, as well as taxpayers required to pay a digital advertising gross revenue tax estimated payment on April 15, should monitor the Governor’s action on this legislation. The Governor must act on the bill within 30 days of transmittal or it will become law without his signature.

In detail
Digital products sales tax

On March 11, just days before the March 14 effective date of the state’s sales and use tax on digital products and codes, the Maryland Comptroller issued an expansive interpretation of the law to apply to a broad array of digital goods and services, including software as a service (see PwC’s Insight here.)

Exclusions from the definition of ‘digital product’

S.B. 787 provides several exclusions from the definition of a ‘digital product’:

  • Prerecorded or live instruction by a public, private, or parochial elementary or secondary school or a public or private institution of higher education
  • Instruction in a skill or profession in a buyer’s current or prospective business, occupation, or trade if the instruction
  1. is not prerecorded and
  2. features an interactive element between the buyer and the instructor or other buyers contemporaneous with the instruction
  • A seminar, discussion, or similar event hosted by a nonprofit organization or business association, if the seminar, discussion, or event
  1. is not prerecorded and
  2. features an interactive element between the buyer and host or other buyers contemporaneous with the seminar, discussion, or event
  • A professional service obtained electronically or delivered through the use of technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.

Observation: In general, services are not subject to sales or use tax unless specifically enumerated by Maryland statute. However, the Comptroller’s digital products guidance published in March includes a variety of digital services within its interpretation of taxable ‘digital products’ and adopts a ‘tainting rule’ whereby the entire charge for a bundled transaction that involves the sale of a digital product and a non-taxable service is subject to tax.

In providing specific service exclusions (listed above), S.B. 787 did not explicitly limit the range of other services to which the Comptroller might seek to apply sales and use tax under the broad definition of ‘digital product’ that took effect March 14; that definition is not changed by S.B. 787.

Amendments to custom software provisions

S.B. 787 amends the provision of existing law (not part of the digital products legislation enacted earlier this year) excluding ‘custom computer software services’ from sales and use tax. The amendments specify that the exclusion applies:

  • To “custom computer software, regardless of the method transferred or accessed, or a service relating to custom computer software.”
  • If the custom computer software is created for use by a specific person or contains standard or proprietary routines “requiring” significant creative input to customize, “configure, or modify” the procedures and programs “that are necessary to perform the functions required for the software to operate as intended.” [quoted text added by S.B. 787]

Observation: Prior to the Comptroller’s March 11 guidance, Maryland did not assert sales or use tax on access to prewritten software or prewritten software delivered electronically. S.B. 787 amends the existing exclusion for custom computer software services and specifies that the exclusion applies to custom computer software as well as services relating to such software.

While S.B. 787 expands on the definition of what constitutes “custom” software, it does not address what it means for software to require “significant creative input,” what it means to “configure” or “modify” software, and when such actions are “necessary to perform the functions required for the software to operate as intended.”

Observation: These changes suggest that the Comptroller will maintain its position that “canned or commercial off-the-shelf...software if obtained electronically by the buyer is a digital product and is subject to the Maryland sales and use tax.” It remains unclear how enterprise software will be viewed given the changes to the custom computer services exclusion. Further, it is unclear whether these changes will influence the Comptroller’s conclusion that “the sale of software as a service (SaaS) is also subject to the sales and use tax.”

Clarification of ‘digital code’ definition

S.B. 787 amends the definition of a ‘digital code’ to mean “a number, symbol, alphanumeric sequence, barcode, or similar code” that may be obtained by any means and provides a buyer with a right to obtain one or more digital products.

Effective date and retroactive application

S.B. 787 provides that the digital products sales tax amendments “reflect the intent of the General Assembly” at the time it enacted the underlying provisions. Since S.B. 787 constitutes emergency legislation, these clarifying (retroactive) changes will take effect immediately upon enactment.

Digital advertising gross revenue tax

Maryland’s first-in-the-nation gross revenue tax on digital advertising took effect on March 14. The tax applies to annual gross revenue derived from digital advertising in the state and is imposed at scaled rates between 2.5% and 10% (beginning with taxpayers that have at least $100 million in global annual gross revenue).

A return only is required from a person that has annual gross revenue derived from digital advertising services in Maryland of at least $1 million. The gross revenue measurement period is January 1 through December 31. Under the tax as enacted, the first annual estimated tax payment is due April 15, 2021 (see PwC’s Insight here).

Digital ad tax delay

Under S.B. 787, the first measurement period for the tax is moved from 2021 to 2022, meaning that the tax first will be measured by gross revenue from digital advertising services recognized in the 2022 calendar year. Further, the first estimated payment will not be due until April 15, 2022.

Observation: Taxpayers need to analyze whether they are subject to this tax and should monitor potential challenges to the tax (there is litigation pending on issues including the federal Internet Tax Freedom Act and the US Constitution’s Commerce Clause). From a compliance standpoint, taxpayers that determine they must remit an estimated payment by April 15, 2021 do not have guidance on sourcing, forms, and how to remit the tax. However, the Comptroller already has announced the passage of S.B. 787 and that “the first quarterly estimated tax payment for the Digital Advertising Gross Revenues Tax is due April 15, 2022 on first quarter 2022 revenues.”

No passthrough of digital ad tax on invoices

S.B. 787 provides that a person who derives gross revenue from digital advertising services in the state may not directly pass on the cost of the digital ad tax to customers “by means of a separate fee, surcharge, or line-item.”

Observation: While the legislation restricts the ability to include the tax on an invoice, advertising providers that wish to pass the tax on to their customers via contract face uncertainty given the lack of sourcing guidance and questions in determining the ultimate market for digital ads.

Exclusions for certain taxpayers

S.B. 787 provides that digital advertising services do not include advertising “on digital interfaces owned or operated by or operated on behalf of a broadcast entity or news media entity.”

  • ‘Broadcast entity’ means an entity that is primarily engaged in the business of operating a broadcast television or radio station.
  • ‘News media entity’ means an entity engaged primarily in the business of newsgathering, reporting, or publishing articles or commentary about news, current events, culture, or other matters of public interest, but does not include an entity that primarily is an aggregator or republisher of third-party content.

Observation: Under the existing law, digital advertising services include advertising on a digital interface (any type of software, including a website, part of a website, or application that a user is able to access). The exclusions in S.B. 787 similarly look at whether digital advertising takes place “on digital interfaces” and tie the liability to whether such interfaces are operated by or on behalf of certain entities. This could have implications for taxpayers that provide digital advertising services in an intermediate capacity and do not actually operate the digital interface on which ads are placed.

The takeaway

Because of questions raised by litigation challenges to the Maryland digital advertising tax under the federal Internet Tax Freedom Act and the US Constitution and the lack of guidance from the Comptroller on how to source digital ad revenue, a delay has been expected. If enacted, S.B. 787 provides a year before taxpayers will need to meet their compliance obligations, potentially with guidance from the courts and the Comptroller. The Comptroller’s Office has announced that it “will publish guidance on the digital advertising gross revenues tax in the future, and will adopt regulations that determine the state from which revenues from digital advertising services are derived.”

While the digital products sales tax changes in S.B. 787 are retroactive, they generally are limited to narrow service exclusions and amendments to the existing exclusion for custom computer software services. If enacted, further guidance from the Comptroller will be critical in understanding how the new law will be interpreted and enforced. The Comptroller’s Office previously stated, “If the legislature makes any retroactive changes to tax collected and remitted under this law, the Comptroller will ensure refund claims are processed as appropriate.”

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Peter Michalowski

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