Showing ads on Netflix could chill communications tax collections

After years of saying it would absolutely, positively — well, probably — never air ads during its programming, Netflix launched its Basic with Ads plan to subscribers in 12 countries at the beginning of November 2022.

The reason is simple: Now that pandemic restrictions have eased, fewer people are stuck at home binge-watching “Stranger Things” or “Bridgerton.” That’s led to falling subscriber numbers — and revenue.

The change has been talked about since Netflix’s earnings report from the first quarter of 2022.

What hasn’t been talked about much is how this change could affect state and local government collection of communications taxes on streaming services.

Among major streaming platforms, Hulu pioneered ad-supported content. Netflix and others are following suit as they face headwinds in subscriber growth.

An internal memo leaked to The New York Times in May 2022 said Netflix would roll out a new lower-price, ad-supported tier in the fourth quarter of that year. The move would come in conjunction with changes designed to limit password sharing.

Senior executives confirmed the following month that the company was moving quickly to roll out the ad-supported service option. Netflix debuted the tier on November 1, 2022, to subscribers in Canada and Mexico. Two days later, it expanded the service to the U.S., Australia, Brazil, France, Germany, Italy, Japan, Korea, and the U.K., then followed up with Spain shortly after.

Netflix gained 1 million U.S. subscribers for the new tier within the first two months, Bloomberg reported. They account for about 20% of new sign-ups. Analysts predict the ad-based service could eventually bring in 15 million to 30 million customers in the U.S.

No one quite knew what to expect when the decision was first announced. We now know Netflix partnered with Microsoft’s Xandr to provide digital advertising, but reports indicate it’s considering other options including bringing ad services in-house.

Industry watchers say the streaming market is saturated and the only way to sustain revenues is to offer subscribers a lower-cost ad-supported option. HBO did this with its HBO Max streaming service then rebranded the service as Max on May 23, 2023. Today you can watch it ad-free for one monthly rate, or pay less to watch programs with breaks for advertising.

Netflix leaders had opposed such a move in the past. They argued that building up an advertising business to take on giants like Google, Facebook, and Amazon, which dominate the digital advertising space, would complicate their business and take focus away from their core mission of developing must-see streaming content.

However, industry analysts seem to think this is the future of streaming services: offering viewers the ability to opt for commercial-free services or those with commercials.

Max made the move about two years ago; Disney+ launched a lower-cost, ad-supported option in the U.S. on December 8, 2022, with plans to roll out globally in 2023. Peacock, Paramount+, and Discovery+ all came into the market with these sorts of mixed premium and ad-supported options.

Another factor facing Netflix and its premium rivals is the growth of fully ad-supported services that stream free content.

There are a mix of business models for these free services: Some are affiliated with the companies that build video monitors, while others are affiliated with larger streaming services, television networks, or movie studios. Most provide a mix of older content — classic Hollywood movies and TV shows — with some newer shows. For example: If you were wondering what happened to Judge Judy, she’s on Amazon Freevee (the rebranded IMDb TV) as both star of her own rebooted show and executive producer of a new one.

While Netflix remains the leading streaming platform in the country, its market share is declining. By contrast, smaller, ad-supported services are gaining new subscribers faster, data indicates. And that’s not terribly surprising: With all the economic uncertainty right now, canceling a premium streaming service that we’re not watching as much as we did in 2020 is an easy way to save money, especially when we can find potentially interesting shows on a free-to-watch ad-supported service.

States and local jurisdictions are still adjusting to the way streaming services have cut into the tax revenues they had come to expect from cable television service providers. We’ve written about this often in recent years, as American states and Canadian provinces enacted new “Netflix taxes” on digital streaming services, or went to court in attempts to extend existing taxes to cover the new technology.

Now, just as some of that seems to have been settled, changes in the industry and our broader economy are combining to bring streaming service revenues down, which means communications taxes that are attached to revenues from subscriptions are no longer going to bring in as much as governments anticipated. 

States and local jurisdictions may have to go back to the drawing board (again) on streaming taxes, which likely will create new uncertainty and complexity for players in the industry.

Remember that state sales and use tax laws can also apply to digital services and products. To better understand how to minimize the risk of communications taxes and state sales tax, check out our on-demand webinar about streaming tax complexity.

This post has been updated; it was first published in July 2022.