By Matt Graham, JD CPA.
In the world of professional services, the intersection of artificial intelligence and sales tax law is becoming a high-stakes endeavor. As AI weaves itself into more traditional services, a clear, non-taxable human-driven offering can begin to look more like a standardized, product-like experience.
Historically, tangible goods are typically subject to sales tax and services are not, with many exceptions. The previous shift from a goods-based economy to a services-based economy may revert back towards a goods-based economy as many services previously performed by people are being taken over by AI.
The HVAC Repair Example
The best way to explain this issue is through an example.
Let’s say your local HVAC repair service adopts AI. Instead of having their repairman look at the unit and determine what the issue may be, their AI repairman uses your phone to identify the problem, look up and order the replacement parts, and schedules the installation by a human repairman. Instead of a fee for having the repairman come to inspect the unit for a diagnostic analysis, the company just charges you a flat fee for the installation services.
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The labor is no longer wholly manual, and the human is just the final step in the process. If deemed the core of the transaction, that added layer of automation could become taxable, depending on the state. The big question is “where is the line?” In other words, how much AI involvement is needed to change the application of sales tax to the transaction?
The True Object Test
When a service has both characteristics of a taxable and non-taxable offering, the tie-breaker analysis is usually the “true object test,” a long-standing, legal doctrine used by many states. The true object test asks the question: what was the customer really buying?
The test is straightforward; if the main object of the transaction is a taxable product and the service is incidental, the whole thing is taxable. However, if the true object is a non-taxable service, the sales or use tax may not apply.
This analysis falls apart quickly in the face of emerging AI-enabled business models. When a meaningful portion of a service is being automated, standardized, or delivered digitally, the true object may shift in the eyes of state tax authorities.
Going back to our HVAC example, if the new AI-enabled diagnostic and repair service is performed for a customer in Pennsylvania, repair services for HVAC systems in real property are generally not subject to sales tax in the state, but even the slightest integration of software into the service could make it taxable.[1] Pennsylvania has its own version of the true object test, which looks at the “essence of the transaction.”[2]
In this case, the issue is unclear, but an argument could be made that the true object was the non-taxable service of restoring the HVAC system to working order, which requires the installation of the replacement part. However, a state tax auditor might say there was some element of taxable service provided with the true object being unclear, resulting in the entire transaction being subjected to sales tax.
The Practitioner’s Risk
Practitioners who fail to spot this nuance expose themselves to significant risk. Taxing agencies aren’t bound by the label on the invoice, they care about what’s being delivered, how it’s being delivered, and whether it fits within the definitions of taxable products or services under their statutes or administrative guidance.
Advisors should be aware that many states have been shifting toward broader interpretations of “digital goods,” “automated services,” or “software services” over the last decade and many of these moves have nuances that are not easy to spot. This trend heightens the risk of classification errors as AI becomes an increasingly core part of how services are delivered.
As we look forward, it appears inevitable that this transformation isn’t stopping at software. Imagine a scenario where not only does AI diagnose the HVAC issue, but a physical robot arrives on-site to perform the repair. How would that be taxed?
This is the future practitioners must begin preparing for. Even if your client’s AI product still has a human in the loop today, what happens when that human becomes optional? And at what point does the transaction’s tax character flip?
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Matt Graham, JD, CPA, is a senior manager at Baker Tilly, formerly with Moss Adams. He has provided consulting services since 2014 and regularly assists clients with state and local tax matters including audits, appeals, refund claims, voluntary disclosure, amnesty, private letter rulings, planning, structuring, tax incentives, nexus analysis, and sales taxability analysis. Matt primarily focuses on technology, fintech, and blockchain companies, but he also works with a broad range of industries including manufacturing, construction, and financial services.
[1] Pa. Code 31.6(a)(5) (exempting repairs to realty from taxation); Pennsylvania Sales And Use Tax Ruling, No. SUT-17-002, 05/17/2017 (imposing sales tax on a database service because the search function was considered software).
[2] Deschert LLP v. Pennsylvania, 922 A2d 87, 998 A2d 575, 07/20/2010.
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