Does Kentucky sales tax apply to AI-powered software?

Yes, Kentucky sales and use tax applies to AI-powered software if it is prewritten, whether downloaded or accessed online.

Are prewritten software access services taxable in Kentucky?

Yes, services that provide access to prewritten software are treated as tangible personal property and are subject to sales tax.

Is custom software exempt from Kentucky sales tax?

Yes, software specifically designed and developed for a particular customer can qualify as custom software and is generally exempt from sales tax.

Does the delivery method affect software taxation in Kentucky?

No, it doesn’t matter if the software is delivered physically or accessed remotely; what matters is that it qualifies as prewritten software.

Are modifications to prewritten software taxable in Kentucky?

Yes, unless the customization charges are separately stated on the invoice, modifications to prewritten software remain taxable.

How does Kentucky define taxable software with AI components?

Even if the software adapts responses using AI, it is still considered prewritten software for tax purposes and is subject to sales and use tax.

Kentucky Sales Tax Rules for AI Software

The Kentucky Department of Revenue (DOR) published a newsletter that focuses, among other critical matters, on how the state's sales and use tax rules apply to sales of prewritten computer software and prewritten computer software access services, including those with AI components. With this newsletter, the DOR primarily aims to provide practical information to assist taxable persons in fulfilling their sales and use tax obligations.

Sales Tax Rules for AI-Powered Applications

The DOR highlighted that, in Kentucky, sales and use tax applies to both prewritten computer software and prewritten computer software access service, as they are treated as tangible personal property. Consequently, these software and services are subject to sales tax when sold at retail and delivered to the purchaser, including by download or other electronic means.

For sales and use tax to apply, it is irrelevant whether the software is delivered in a tangible form or accessed remotely over the internet, as long as the product qualifies as prewritten computer software. Even when prewritten software is modified or enhanced for a customer, those changes remain taxable unless the customization charges are separately stated on the invoice.

Although today's software products frequently incorporate AI capabilities, including the ability to adapt outputs or responses based on user-provided data without explicit reprogramming, this adaptive functionality does not convert the software into custom software, which is tax-exempt. Therefore, software that includes AI components is treated in the same manner as any other software application and must be analyzed under the statutory definition of taxable prewritten computer software.

Conclusion

The DOR interpreted Kentucky sales and use legislation to mean that, unless the software is specifically designed and developed for a particular purchaser and qualifies as custom software, the sale of AI-enabled software remains subject to sales and use tax as prewritten computer software. How the software is delivered to the customer, whether as a download or accessed remotely as SaaS, is insignificant in this context.

Source: Kentucky Department of Revenue