INSIGHT: Taxation: Impossible—The Problems With D.C.’s Sales Tax Proposals

On July 6, 2020, the D.C. Council (Council) released the Committee Draft of the Fiscal Year 2021 Budget Support Act of 2020 (the BSA). With that draft, the Council first revealed its plan to expand its sales tax to sales of advertising services and personal information. The next day, the Council passed the BSA, including these taxes, on first reading. The Council will vote on the BSA on second (and final) reading on July 28, 2020. The BSA will then be sent to the mayor for approval and then to the U.S. Congress for a 60-day period of passive review. D.C. Code Section 1-206.02(c)(2). We expect that the D.C. Council will issue emergency legislation to apply the BSA prior to the completion of the congressional review. Thereafter, the advertising service and personal information sales tax proposals would abruptly take effect on Oct. 1, 2020.

If the Council’s proposals are enacted, the District would become the first jurisdiction to adopt a targeted, transaction-based tax on personal information and advertising services. As these taxes are unprecedented, taxpayers are not prepared to collect the taxes, separately state them on invoices, or manage exemption certificates. One would naturally assume that the Council would craft detailed legislation to inform taxpayers on how to comply. Instead, the Council’s proposals are frustratingly devoid of essential details.

The proposed advertising service and personal information sales taxes are bad policy and should not be passed. But, if they are, it is necessary that the Council amend the proposals or the Office of Tax and Revenue (OTR) release guidance well in advance of the Oct. 1 effective date. However, it will be impossible for the OTR to issue final regulations by Oct. 1, because of the District’s legislative process and applicable rules for the adoption of regulations. See D.C. Code Section 2-505(a). In comparison, the Fiscal Year 2012 Budget Support Act of 2011, which enacted combined reporting, became effective Sept. 14, 2011. The OTR did not issue final regulations until a year later. Accordingly, the OTR likely would need to issue an emergency regulation or other guidance, such as a Revenue Notice, that provides for the most pressing compliance issues related to the proposed taxes, even if temporary in nature. See D.C. Code Section 2-505(c).

Whatever form the guidance takes, the OTR should already be reaching out to the business community and preparing informal guidance. This article identifies various problematic aspects of the two taxes. The Council and OTR should address these issues to make the taxes administrable. Otherwise, it will be impossible for taxpayers to comply and result in litigation nightmares.

Characterization—the Threshold Issue

Given that the proposed advertising service and personal information sales taxes are new to the District and unique among the United States, the Council and/or OTR should clarify how common transactions would be characterized, i.e., whether a transaction would be an advertising service (or not), the sale of personal information (or not), or something else. Such characterization would have significant District sales tax ramifications, including taxability, sourcing/situsing, and application of the sale for resale exemption.

What is a Taxable Advertising Service?

The advertising services sales tax is broad and applies to “the planning, creating, placing, or display of advertising in newspapers, magazines, billboards, broadcasting, and other media, including, without limitation, the providing of concept, writing, graphic design, mechanical art, photography, and production supervision.” The tax also applies to digital advertising services, defined as “advertising services related to advertisements displayed on a digital interface, including advertisements in the form of banner advertising, search engine advertising, interstitial advertising, or other comparable advertising.”

The tax most plainly applies to activities commonly thought of as advertising, such as the development of commercials, online ads, and print ads, along with charges for placement in media. But because of the tax’s broad scope, it may apply to activities one would not expect to be taxable, including:

• Marketing fees paid to food delivery platforms;

• Marketing and click fees paid to real estate platforms;

• Sign spinners;

• Mid-podcast product promotions;

• Product placement in films and television programs;

• Promoted search results;

• Instagram influencers;

• Online vloggers;

• Infomercials;

• Sponsorships on sports team jerseys, including foreign teams playing an exhibition;

• Naming rights for stadiums and arenas; and

• Sponsorships for non-profit organizations.

There is also a risk that any advertising at the Capital One Arena and Nationals Park would be subject to not just the 3% advertising service sales tax, but additionally the 4.25% arena-specific sales tax. See D.C. Code Sections 47-2002.05, 47-2002.06; D.C. Municipal Regulations Title 9, Section 496.

Advertisements are everywhere in our world and often not where you might expect. The OTR should alert taxpayers to what it considers to be a taxable advertising service. Otherwise, taxpayers must analyze their activities and agonize over whether each could fall under this definition. In a few years, the OTR may begin to issue highly creative assessments.

What is Taxable Personal Information?

In addition to advertising services, the Council would expand the sales tax to sales of personal information. “Personal information” is “information or data that is derived from a person that identifies, relates to, describes, or is capable of being associated with, a particular person.” The definition then lists various examples, including a person’s browser habits and consumer preferences.

This tax seems targeted to the sale of a particular individual’s personal information. But, based on the operation of D.C. sales tax law, it would also apply to corporate information. The definition of a “person” includes not just individuals, but also partnerships, corporations, etc. D.C. Code Section 47-2001(i).

Taxpayers should be aware that the District may impose the personal information sales tax to sales of corporate information. The lack of OTR guidance puts some companies in a bad position: collect sales tax knowing the Council did not intend to tax them or wait for the OTR to reveal their position on audit.

Sourcing

In our view, the biggest issue with the proposed advertising service sales tax is sourcing. The sale of a service is usually sourced (or sitused) to the location where the purchaser receives (i.e., makes first use of) the service. See, e.g., Streamlined Sales and Use Tax Agreement (SSUTA) Sections 310.A, 311.B (describing the model sourcing rules adopted by the agreement’s 24 member states). This makes sense where the transaction is between two parties: the buyer and the seller. But advertising is different. Advertising services are inherently three-party transactions. The advertiser purchases advertising space from the publisher. The viewer then witnesses the advertising.

Taxpayers may be able to glean the OTR’s approach from its current regulations. For example, data processing and information services are taxable if delivered to the buyer in the District. D.C. Mun. Regs. Title 9, Section 460.7. If performed, purchased, or delivered outside of the District but subsequently brought into the District for use or consumption, the services are subject to the District use tax, provided that no sales tax was required to be paid to the other jurisdiction. Id. at Sections 474.5, 475.8. Also, data processing services and information services delivered outside of the District for use within other jurisdictions, as well as for use within the District are subject to a prorated share of the District use tax, provided that no sales tax was required to be paid on that prorated share to other jurisdictions. Id. at Sections 474.5, 475.9. If sold and delivered by the vendor to locations outside of the District, the services are exempt from the sales tax. Id.

In the absence of guiding regulations, the District must determine where the advertiser makes first use of the service. Typically, the buyer (here, the advertiser) will receive the service at its commercial domicile. But see 34 Texas Administrative Code Section 3.330(f) (allowing customers that conduct business at locations both within and outside Texas, to source a portion of a data processing service outside of Texas with “any reasonable method for allocation which is supported by business records”). But the District may determine now whether the advertising service is instead used when witnessed by the viewer. The service would then be sourced to the viewer’s location. That treatment would echo the SSUTA’s method for sourcing sales of advertising and promotional direct mail. Those sales are generally sourced to the jurisdictions to which the direct mail is to be delivered to the recipients. SSUTA Section 313. See also Georgia Code Section 48-8-77(d)(1).

If the District chooses to source to the viewer’s location, it must find a way to pinpoint that location. For digital (i.e., online) advertising services, the publisher may be able to determine the viewer’s location by IP address. See, e.g., Missouri Private Letter Ruling No. LR 7314, Missouri Department of Revenue (Nov. 4, 2013); Washington Administrative Code Section 458-20-15503(402)(d). However, IP address usage has its own problems. Viewers can avoid geolocation through use of a VPN. Also, IP address locations are not entirely accurate and may mistake someone located in Maryland or Virginia for D.C.

Alternatively, the District may use a proxy for viewer location. One option is for the OTR to use the population of District residents to nationwide. Another option would be for the OTR to use an audience-factor equivalent. For broadcasting, the OTR may permit the use of Nielsen figures to determine the audience.

For sales of personal information, D.C. faces another problem: should the sale be sourced to the location of the person whose personal information has been sold or the purchaser’s location? And if the personal information is corporate information, which corporate location should be used?

As just one possible avenue for relief from these difficult sourcing issues, the OTR may consider adopting a multiple points of use (MPU) exemption certificate, similar to the rules initially set forth in the SSUTA (but since repealed) and adopted by a handful of states, for advertising service and/or personal information transactions. Former SSUTA Section 312 (repealed Dec. 14, 2006); see, e.g., Minnesota Statutes Section 297A.668, subd. 6a; Ohio Revised Code Section 5739.033(D); Washington Revised Code Section 82.08.0208(4); Code of Massachusetts Regulations Title 830, Section 64H.1.3(15).

Generally, under the MPU rules, a business that purchases certain items for “concurrently available” use in more than one jurisdiction may apportion the sales price of such MPU transactions and remit any sales or use tax on a direct-pay basis, if the purchaser provides the seller an MPU exemption certificate. States that provide for an MPU exemption certificate relieve the seller of the obligation to collect and remit sales tax on the transaction. Because MPU exemptions require that the object of the transaction be “concurrently available for use in multiple jurisdictions,” it follows that only purchasers of electronically transferred items (e.g., digital goods or software) or services may present an MPU exemption certificate to its seller.

Irrespective of the sourcing rule adopted by the OTR, or even whether an MPU exemption certificate is permitted, the OTR should allow sellers and purchasers to establish a “reasonable, but consistent and uniform, method of apportionment” supported by the parties’ books and records. E.g., Minn. Stat. Section 297A.668, subd. 6a(c); Ohio Rev. Code Section 5739.033(D)(2).

Sale for Resale Transactions

The OTR also should clarify the application of the sale for resale exemption to sales of advertising services and personal information. Foremost, the OTR should confirm that the exemption is available.

The issue is more complex for sales of personal information. Under District law, “personal information” must be either tangible personal property or an enumerated service. See D.C. Code Section 47-2001(n) (defining “sale at retail”). But the BSA does not clarify which it is, impacting a potential sale for resale exemption. The District allows an exempt sale for resale in three circumstances:

1. The person purchases tangible personal property or taxable services for the purpose of resale or rental in the same form;

2. The person purchases tangible personal property or taxable services to incorporate as an attachment to, or as a material part of other tangible personal property to be produced for sale or rental by manufacturing, assembling, processing, or refining; or

3. The person purchases taxable services to use or incorporate in the same form as a material part of other services to be provided for sale or rental. D.C. Mun. Regs. Title 9, Section 414.5.

Personal information is more likely to be taxable as tangible personal property. Unlike the enumerated services, it is not expressly called out as a “service.” Further, personal information is rooted in “information or data” and treating personal information as tangible personal property distinguishes this tax imposition from the sales tax on information services. D.C. Code Section 47-2001(n)(1)(N). But this conclusion is not free from doubt. One may contend that personal information cannot be tangible personal property because it is not “corporeal personal property of any nature.” Id. at Section 47-2001(s).

Because the third sale for resale exemption applies to only services, if personal information is tangible personal property, that exemption would be unavailable for sales of personal information when incorporated into a service. For example, a company may purchase personal information and then incorporate it into an advertising service it sells to a third person. Both the purchase of the personal information and the sale of the advertising service would be subject to a 3% sales tax.

The OTR’s regulations on data processing and information services muddy the waters, explaining that, if the service or information was sold to the customer on a magnetic tape or cassette tape, the tape could be purchased with a resale certificate. D.C. Mun. Regs. Title 9, Sections 474.6, 475.7. The OTR must address sales for resale in any guidance or regulation.

Related Party Transactions

Analogous to the sale for resale issue, the OTR should be aware that taxpayers may engage in multiple aspects of the advertising process with one or more related parties. Unless an exemption applies, each advertising service performed by each entity would be taxable. To avoid imposing a 3% sales tax on numerous related entities all performing an advertising service as part of a broader advertising campaign, the OTR must add an exemption for sales between related parties.

The District does not provide a general exemption for sales to a related party. However, the District has already recognized this problem for data processing services and provides a specific exemption for data processing services sold between members of an affiliated group. See D.C. Code Sections 47-2001(n)(1)(N)(iii), 47-2201(a)(1)(K)(i). The District should add the same exemption for sales of advertising services.

Information Service vs. Personal Information

The District has imposed sales tax on information services since 1989 (currently at a 6% rate). Id. at Section 47-2001(n)(1)(N). An information service sale could resemble the sale of personal information. The District should explain the contours of each tax to ensure that taxpayers do not confuse the two and pay the wrong tax rate.

“Information services” is defined as “the furnishing of general or specialized news or current information, including financial information, by printed, mimeographed, electronic, or electrical transmission, or by wire, cable, radio waves, microwaves, satellite, fiber optics, or any other method in existence or which may be devised,” along with “electronic data retrieval or research.” Id. at Section 47-2001(n)(1)(N)(ii). But there are also exclusions from the tax:

• Information sold to a newspaper or a radio or television station licensed by the Federal Communication Commission, if the information is gathered or purchased for direct use in newspapers or radio or television broadcasts;

• Charges to a person by a financial institution for account balance information; or

• Information gathered or compiled on behalf of a particular client, if the information is of a proprietary nature to that client and may not be sold to others by the person who compiled the information, except for a subsequent sale of the information by the client for whom the information was gathered or compiled. Id.

If an item could conceivably be both the sale of personal information and an information service, the OTR should confirm at which tax rate the taxpayer must collect: 3% or 6%. Certainly, as there is only one sales tax, the rate would not be a combined 9%. One can look to the OTR’s recent regulations on the taxability of other services to determine how the District might approach the issue. For bowling alley or billiard parlor services and health club services, the District embraces a primary purpose test. D.C. Mun. Regs. Title 9, Sections 424.5, 427.10. The OTR might apply a primary purpose test here, as well.

And because of confusion between sales of personal information and information services, there is the risk that the OTR might broadly interpret the personal information sales tax and apply it to items previously expressly excluded from taxation under the information services sales tax. The Council should uphold the policy reasons behind the information service exclusions and also apply them against personal information sales taxation.

Bundling

There are at least two bundling issues with the Council’s sales tax proposal: (1) advertising services or personal information sold with non-taxable items; and (2) advertising services or personal information (taxed at 3%) sold with other taxable items (taxed at 6%).

The District currently excludes from a taxable “retail sale” “[p]rofessional, insurance, or personal service transactions which involve sales as inconsequential elements for which no separate charges are made,” unless otherwise taxable. D.C. Code Section 47-2001(n)(2)(B). “Sales as inconsequential elements” are “deemed to include any sales of tangible personal property made in connection with professional, insurance, or personal service transactions where the sales price of the tangible personal property is less than ten percent (10%) of the amount charged for the services rendered in the transaction.” D.C. Mun. Regs. Title 9, Section 403.2.

Also, for bowling alley or billiard parlor services and health club services, the OTR permits a service provider to overcome the “primary purpose” presumption by separately stating to the customer a reasonable charge for the taxable services. Id. at Sections 424.5, 427.10. The service provider’s books must support that apportionment “based on the cost of providing the service or on a comparison to the normal charge for each service if provided alone.” Id. The OTR would adjust the charges “[i]f the charge for nontaxable services is unreasonable when considering the cost of providing the service or a comparable charge made in the industry for each service….” Id.

Given the complexities surrounding characterization and taxability of advertising services and personal information, as well as the potential rate differences among those items bundled with other taxable transactions (e.g., information services, data processing services, and/or digital goods), the Council should enact, or the OTR should provide for, a books and records unbundling rule. See, e.g., SSUTA Section 330.C (providing for books and records unbundling in transactions involving telecommunication service, ancillary service, internet access, or audio or video programming service); Ga. Code Section 48-8-2(31)(G) (providing a general rule books and records unbundling in transactions for taxable and non-taxable transactions). Taxpayers need to be able to distinguish these items from both non-taxable items and items taxed at the regular 6% rate.

Credit for Taxes Paid

As it can be uncertain how to source the sale of advertising services and personal information, if other states begin to tax these activities, they could make different sourcing decisions. It is essential that the District provide a credit for taxes paid to other states on the same transaction; otherwise, one sale could be subject to multiple taxation, in violation of the Commerce Clause of the U.S. Constitution.

The District currently allows a credit or refund against the use tax paid on the portion of tangible personal property that was purchased initially solely for use or consumption outside the District. D.C. Mun. Regs. Title 9, Section 405.14. But the Council should confirm the availability of a credit for advertising services and personal information.

However, a credit against another state’s sales or use tax is not enough. For example, the Maryland legislature recently passed its Digital Advertising Gross Revenues Tax. On May 7, 2020, Governor Hogan vetoed the tax, but it will take effect if the legislature overrides the veto in early 2021. Because the Maryland digital advertising tax is a gross revenues tax instead of a sales tax, a digital advertising service could be subject to both District sales tax and Maryland gross revenues tax simultaneously, as the Maryland tax may not be creditable against the District tax.

Conclusion

For the reasons outlined above, the Council’s proposed advertising service and personal information taxes should be reconsidered by the District’s policymakers. The proposed taxes would increase economic burdens on nearly every business in the District. Those burdens may be direct, as would be the case with advertising firms and any purchaser of ads, or indirect, as advertisers likely would be required to increase retail prices to account for their increased advertising costs. Specifically, the compliance burdens may be significant in some cases, especially for multistate businesses. Accordingly, OTR should issue well-reasoned guidance, taking into account stakeholder concerns, so that taxpayers can reasonably attempt to comply.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Todd Lard is a partner at Eversheds Sutherland in the Washington office and a nationally known state tax lawyer with significant experience and insight into state tax policy, digital economy, and communications tax issues.
Charlie Kearns is a partner in Washington and advises Fortune 500 clients on all aspects of state and local tax policy, planning, and controversy.
Charles Capouet is an associate in the Washington office and advises clients on the full range of state and local tax matters, including sales and use, excise, income and transfer taxes.