Taxation of Digital Products and Services: Evolving Patterns and Recent Developments

Gone are the days of Blockbuster, CDs, and traditional newspapers. In our digital era, a majority of entertainment and news consumption occurs online or through downloads onto our devices.

Across the United States, there is a range of approaches to taxing digital goods and services. While some states already impose broad taxes on these items, others focus on specific categories, such as digital books and music. Some states vary tax rates based on the type of digital goods and services, while a few completely exempt them from taxation. However, many of these states may reconsider their positions in the upcoming year.

In recent years, states have been making significant adjustments to their tax frameworks. Some states have targeted specific digital goods and services to generate additional revenue streams, while others have taken bolder steps. A relatively new area of exploration is the taxation of cryptocurrency and non-fungible tokens (NFTs). New laws and regulations even allow commercial cryptocurrency mining operations to seek exemptions for electricity purchases.

Examining the legislative landscape, we find various changes that states have introduced and emerging trends that warrant attention in our digitally-driven society.

Recent Trends in Taxing Digital Goods

The taxation of digital items like e-books, music downloads, and ringtones is not a new phenomenon. Several states have aimed to subject certain digital goods to sales tax, but the rules differ across jurisdictions. Changes in state regulations can lead to variations in tax rates and exemptions for different types of goods. Consequently, the consistency in the taxation of digital goods among states is not assured. Let's delve into some recent tax alterations in this realm.

Colorado, for instance, has applied sales and use taxes to digital goods. Starting January 2021, Colorado passed legislation defining digital goods as tangible personal property. This expansion of the Colorado Revised Statutes' definition encompasses a broad range of goods, explicitly including digital items regardless of their delivery method. Conversely, Colorado classifies digital goods as "tangible personal property delivered or stored digitally," encompassing videos, music, and electronic books. Due to Colorado's status as a home rule state, localities may have differing tax implementations.

Maryland has taken center stage in the digital arena, especially concerning its sales tax on digital goods and digital advertising. Since March 14, 2021, Maryland has levied a 6% sales and use tax on numerous digital products delivered electronically. This encompasses publications, digital news or entertainment downloads or streams, digitized sound files, access to online content or software applications, and more. Maryland also clarified that electronically obtained canned or off-the-shelf software falls within the digital goods category. A bill enacted in July 2022 further clarified that commercially used software as a service (SaaS) is exempt from taxation.

Effective January 1, 2023, Kentucky is imposing taxes on various services, including software as a service (SaaS). Kentucky refined the definition of prewritten software access services, encompassing scenarios where sellers or third parties maintain possession of the software while granting access to users under different pricing models.

The Emergence of Digital Advertising Tax

States that presently limit digital taxation to goods might expand their scope to include digital services. Early in 2020, this concept began gaining traction as states proposed legislation for taxing digital advertising. One particular state stands out in this regard.

While it's expected that the taxation of digital goods and services will increase post-COVID, timing plays a crucial role. In the initial legislative session of 2020, Maryland passed a gross receipts tax on digital advertising, slated to begin on July 1, 2020 (H.B. 732). This tax covered services like banner, search engine, and interstitial advertising. The scale of taxation ranged from 2.5% to 10% based on annual gross revenues. In May, the Maryland governor vetoed the bill, stating that raising taxes during economic hardship would be imprudent.

Nevertheless, the Maryland story took an unexpected turn. On February 12, 2021, the Maryland legislature overrode the governor's veto, making Maryland the first state to implement a tax on digital advertising. However, this move sparked resistance from groups such as the Internet Association, including members like Amazon, Facebook, and Google. They contested the tax's constitutionality and its inconsistency with federal laws that discourage state-level targeting of online services. A Maryland circuit court judge later ruled, in October 2022, that the tax violated the Internet Tax Freedom Act and the First Amendment. The legal battle continues, potentially influencing other states' decisions on similar taxes.

Understanding Cryptocurrencies and NFTs

States are in the early stages of shaping taxation policies for non-fungible tokens (NFTs). Adapting tax laws to new developments takes time, but a few states have been proactive.

Wisconsin, in its November 2022 tax bulletin, outlined the taxability of NFTs. If the underlying product or service is taxable in Wisconsin, the sale or purchase of an NFT might also be taxable. Minnesota offered similar guidance to simplify NFT taxation and reporting. The state recommended checking the Minnesota Department of Revenue's website for further details.

Washington's approach to NFTs includes not just sales or use tax but also the Washington business and occupation (B&O) tax. Although comprehensive guidance is pending, the Department clarified that purchasing NFTs is generally subject to taxation.

Regarding cryptocurrencies, states are yet to provide extensive guidance. Nevertheless, there have been instances where states addressed this issue. For instance, Minnesota updated its fact sheet covering various forms of payment, including cryptocurrencies. Kentucky introduced a sales tax exemption for electricity used in commercial cryptocurrency mining. Delaware incorporated "virtual currency," including cryptocurrency, into its unclaimed property reporting requirements.

As business innovation continues to create new products and services, NFTs represent one such advancement. States are striving to catch up with innovation and devise effective tax policies. Collaborative efforts between states and businesses will expedite the availability of tax guidance on emerging technologies. Expect more states to provide insights into these technologies, and we'll keep you informed.

Staying Informed

Whether you're involved on the buyer or seller side of digital transactions, it's essential to comprehend the divergent tax treatment of digital goods and services across states, as well as the evolving trends. As technology evolves, so does taxation. With a growing reliance on digital interactions and a constant influx of new digital products, these items have become attractive targets for revenue generation. States are increasingly adept at keeping pace with technology, often inspiring each other to adapt their tax policies.