Understanding Bundled Transactions & True Object Test for US Sales Tax

The US sales and use tax landscape has different rules and regulations from one state to another, and the tax treatment of bundled transactions presents a challenge for all sellers engaged in multi-state sales. The so-called true object test is the central assessment mechanism businesses and individuals can use to determine the primary purpose of transactions and assess their taxability.

This article delves into general rules, explores changes in multi-state compliance, and provides insight into current trends and potential developments to help taxable persons understand bundled transactions and how the true object test applies to them.

Bundled Transactions: Definition and Examples

A bundled transaction refers to retail sales of two or more products or services, except real estate property and related services. There are two key elements of bundled transactions. The first element is the product, which includes all types of products, such as tangible goods, services, digital services, and other goods or services that an individual US state defines. In addition, products must be distinct and separately identifiable.

The second key element of bundled transactions is the sales price, which must be stated as one price, not an itemized price. In other words, for a transaction to be bundled, the price for two or more distinct and separately identifiable products must be a single price.

For example, a software company may sell software licenses, which are mainly considered tangible goods subject to sales tax, and accompanying installation services. If sold together with a single price without itemization, they are sold as a bundled transaction. Also, a telecommunications provider offering a package including internet services, typically non-taxable, and taxable equipment rental, engages in a bundled transaction for one price.

Determining taxability rules for bundled transactions is not complex when all products included are taxable or non-taxable. However, as presented, the bundled transaction may consist of taxable products and non-taxable services, which complicates the situation for sellers in determining whether the transaction as a whole is taxable or non-taxable. A True Object Test helps determine whether the bundled transaction is taxable.

Understanding the True Object Test

To determine if a bundled transaction is taxable, taxable persons must determine its primary purpose. More specifically, the True Object Test, also known as the de minimis test, primary object test, or essence of the transaction, examines whether the consumer intends to acquire taxable tangible goods or whether the purpose of such tangible goods was incidental, that is, part of the service provided.

The True Object Test should answer the question “what do the consumers want?” If the true purpose of the sale transaction is the tangible good, then the transactions are mostly treated as taxable. In contrast, services are generally not subject to sales tax, unless strictly defined as taxable. Therefore, if the primary purpose of the bundled transaction is service, the transaction is non-taxable, even though a physical or tangible item or product was provided to the consumer as part of the transaction. 

For example, in Colorado, sales tax does not apply to service-based transactions such as cable and satellite TV or radio subscriptions. However, digital content delivered by the service-based companies to consumers is considered taxable tangible goods.

Therefore, applying the True Object Test should determine if the consumer bought the subscription primarily because of the digital content or the service. The transaction is taxable if the primary reason is the digital content. In contrast, if the main reason for the consumer is the service, the transaction is non-taxable.

Managing Multi-State Complexity

Since the US states independently regulate and impose sales and use tax rules, the diversity of tax jurisdictions means that each state defines what taxable tangible goods and services are differently.  Therefore, the first step toward successfully managing multi-state sales is to know which goods and services are taxable in each state.

For example, digital goods and products are taxable in Washington and Texas but tax-exempt in Illinois and Florida.

In addition, some states, such as New York and Iowa, apply a de minimis rule. Under this rule, if the taxable portion of a bundled transaction constitutes a minimal percentage, often 10% or less, of the total sales price, the entire transaction may be considered non-taxable. However, suppose the taxable portion of a bundled transaction exceeds the minimum percentage. In that case, the whole transaction is considered as related to the tangible good and is, therefore, subject to sales tax.

Current and Future Developments

The applicable rules for bundled transactions are constantly changing and adjusting to the evolving technological advancements and changes in consumer behaviour. The rise of digital goods and services significantly impacted state governments' to review, revise, and update their tax codes to address the unique challenges they posed.

Therefore, in 2024, the Multi State Commission, a US intergovernmental state tax agency, released a White Paper on uniform taxation of bundled transactions that include digital products. The research and the paper aim to provide a framework for addressing the bundling issues and ensure that all US states, or most of them, agree on unified taxability rules for bundled transactions with digital products.

One of the most significant issues the White Paper underlines is that current bundling rules often result in non-taxable products being subject to tax. This leads to sellers inaccurately reporting sales and use tax and confusion among consumers about how taxes are calculated.

An additional issue is that the current definition of bundled transactions includes the price element, which, for digital goods, is often variable and negotiable. However, the current definition excludes negotiable and variable prices, meaning that governing bodies frequently treat these transactions as mixed transactions rather than bundled transactions. Ultimately, this results in applying different sales and use tax rules.

One potential solution to these problems is to adopt a Simplified Sales Tax set of rules governing bundled transactions at the federal level, with some changes.

In addition, adopting and implementing the 2019 Digital Goods and Services Tax Fairness Act (DGSTFA), which would set uniform taxability rules for digital goods, could resolve these issues. However, the DGSTFA is still a work in progress, and it is unclear if and when it might be adopted. Moreover, the proposed text of DGSTFA has already been denied on one occasion.

Conclusion

Bundled transactions represent a unique challenge for taxable persons, especially those that include digital goods and services. As US states continue redefining rules in response to changing market dynamics, businesses must remain focused on monitoring for legislative updates, seeking guidelines, and adjusting their practices accordingly.

Nevertheless, businesses with many bundled transactions, or those operating in multiple US states, should establish internal processes for applying the True Object Test to determine if transactions are taxable. This proactive approach will ensure tax compliance, and reduce the risk of costly errors and disputes with tax authorities.

Source: Streamlined Sales Tax, Tennessee Department of Revenue, Illinois Department of Revenue, South Dakota Retail Sales and Service Tax, Sales Tax Institute, VATabout, New York Treasury, Iowa Revenue Department, Multi State Commission