By Jonathan Liss

Sales and use tax can be a complicated area of taxation. It is not always as simple as paying the 6% sales tax on the price of your salad and pasta dinner at Olive Garden. Even for those who live and breathe sales tax (you know who you are), deciphering the rules regarding the taxation of computer software and digital goods can be a frightful experience. One of the challenges tax practitioners often confront is determining the taxability of a transaction when the sale includes both a product and a service. This is where the “true object” test comes into play.

The true object test (or “essence of the transaction”) is a subjective analysis commonly used by states to determine the taxability of mixed transactions – those transactions involving the taxable sale of tangible personal property and nontaxable services. These transactions are typically presented as one item on a sales invoice. Under the test, if the true object of the transaction is the transfer of tangible personal property, the entire transaction is taxable. If the true object of the transaction is the provision of nontaxable services, the entire transaction is not taxable.

Seems straightforward, right? Not so fast. Applying the test is not as simple as you would think. The true object test seeks to determine the purchaser’s motive in engaging the transaction. Did the purchaser intend to buy the tangible personal property itself, or was the purchaser really seeking the expertise of the service provider? In applying the true object test, it is necessary to consider what the purchaser actually wants and whether the tangible personal property is consequential to the transaction. Sometimes the intent of the purchaser is not entirely clear.

Here is what the Virginia Tax Code provides:

In order to determine whether a particular transaction which involves both the rendering of a service and the provision of tangible personal property constitutes an exempt service or a taxable retail sale, the "true object" of the transaction must be examined. If the object of the transaction is to secure a service and the tangible personal property which is transferred to the customer is not critical to the transaction, then the transaction may constitute an exempt service. However, if the object of the transaction is to secure the property which it produces, then the entire charge, including the charge for any services provided, is taxable.¹

In some cases, the determination of taxability is relatively obvious. For example, if you engaged an attorney for advice and left with a tangible document (such as a will), then you were obviously purchasing a legal service and the will was incidental. On the other hand, if you go to a restaurant for dinner, you are there to buy food, not the services of the chef using his or her expertise in preparing a tasty meal. It is common for sales tax controversies to arise over the taxability of mixed transactions.  

In Appeal of Thomas Conglomerate,² the California Office of Tax Appeals (OTA) held that the true object of the taxpayer’s prenatal imaging business is the sale of ultrasound images captured on tangible medium (such as photographs, CDs, and DVDs). The OTA determined that these were not sales of services, but taxable sales of tangible personal property. The taxpayer had argued that the sale of photos, CDs, and DVDs was incidental to the primary objective of the clinical service of elective diagnostic imaging.

“The fact that customers were required to first obtain a diagnostic ultrasound from a medical provider before receiving an ultrasound from appellant is evidence that obtaining appellant’s ultrasound service was not the customers’ real purpose when purchasing bundled packages from appellant.”³ The OTA found that the tangible personal property was more than incidental and that the true object of the transactions was to obtain photos, CDs, or DVDs.  

In a Virginia Ruling of the Tax Commissioner,⁴ the true object test was applied to rentals of inflatable amusement games, such as moonwalks, slides, and obstacle courses. The taxpayer was seeking a correction to its Virginia sales and use tax assessment. The auditor had concluded that the taxpayer was engaging in taxable rentals of tangible personal property.

In connection with the rentals of the inflatables, the taxpayer furnishes an “operator” who sets up the game, loads and unloads the participants, and takes down the game. The taxpayer had disputed the assessment of tax on rentals of amusement games that were furnished with an operator.  

As stated in the commissioner’s determination, “When the taxpayer rents its games, the ‘operator’ is more accurately an attendant who primarily monitors the operation and use of the game. In applying the "true object" test, the object of the taxpayer's customers is the rental of the game and not the skills of the attendant, as the game can operate with or without the attendant.”⁵ The commissioner agreed with the auditor’s conclusion that the taxpayer was engaged in rentals of tangible personal property that was subject to Virginia sales tax. The ruling also distinguished the taxpayer’s rental transactions from the instance of a crane rented with an operator. A crane rented with an operator is considered a nontaxable service because the true object of the transaction is obtaining the operator’s skills in using the crane.

The Pennsylvania Supreme Court has declined to endorse the use of the true object test, although the Commonwealth Court has used it on several occasions. In Downs Racing LP v. Commonwealth,⁶ the Pennsylvania Supreme Court held that royalty fees paid for the use of intellectual property used in the operation of video poker machines in the taxpayer’s casino were not subject to Pennsylvania sales tax. Downs Racing had also entered into a service agreement for its off-track betting locations in Pennsylvania. This service agreement consisted of the rental of equipment to provide live displays of races and personnel to install, maintain, and operate the equipment. The charges for the equipment rental and the provision of services were not separately stated on the vendor’s invoices. Downs Racing asserted that the payments made under the service agreement were not subject to sales tax because the true object of the transaction was the provision of nontaxable audio-visual services. The Court declined to use a true object test and concluded that Downs Racing failed to establish that the charges under the service agreement were not subject to sales tax.  

There is an almost endless variety of mixed transactions where the true object test would apply. In many cases, it is challenging to determine the taxability of a sales transaction that involves both tangible personal property and services. Of course, we tax practitioners are always up for a challenge!  

¹ Title 23 VAC 10-210-4040 D
² Office of Tax Appeals, State of California – Case No. 18063254 (7-9-2020)
³ Office of Tax Appeals, State of California – Case No. 18063254, page 6
⁴ Rulings of the Tax Commissioner, Document Number 04-194 (10-29-2004)
⁵ Rulings of the Tax Commissioner, Document Number 04-194 (10-29-2004)
⁶ Downs Racing LP v. Commonwealth, 70-71 MAP 2017 (Pa. Oct. 25, 2018)

Jonathan Liss is senior revenue policy analyst for the Philadelphia Department of Revenue. He is also an adjunct professor at Drexel University, Temple University School of Law, and Villanova University School of Law. He can be reached at jonathan.liss@phila.gov.

Sign up for weekly professional and technical updates from PICPA's blogs, podcasts, and discussion board topics by completing this form.