Artificial intelligence as a service allows companies to use advanced AI models and tools through cloud platforms or application programming interfaces without building their own systems. This model has accelerated adoption in sectors such as healthcare, finance and logistics. However, state tax regimes have not kept pace with technological innovation. For private equity firms and operating companies, understanding these rules is critical during due diligence, purchase price negotiations and post-close compliance planning. Missteps can lead to unexpected liabilities, eroding deal value and increasing regulatory exposure.
Texas: Taxing AIaaS Under ‘Data Processing’
Texas imposes sales and use tax on data processing services under Texas Tax Code Section 151.0035, which includes activities such as “computerized entry, retrieval, search, compilation, manipulation, or storage of data.”
The state comptroller’s interpretation of this provision, meanwhile, has expanded over time, culminating in amendments to 34 Texas Administrative Code Section 3.330 effective April 2025. These amendments introduced an “ancillary test” that focuses on the seller’s activities rather than the buyer’s intent, broadening the scope of taxable services. Under this framework, AI inference services — such as providing predictions or recommendations via API — are treated as software-as-a-service and classified as taxable data processing. The tax applies to 80 percent of the service charge, with a 20 percent exemption intended to support technology sector growth. The state rate plus local rates generally push the effective tax burden to 8.25 percent.
Recent private letter rulings reinforce this expansive interpretation. For example, in Private Letter Ruling 202508025L, the comptroller determined that mobile app fees for fuel discount programs constituted taxable data processing because they involved data compilation and manipulation. This ruling illustrates the comptroller’s willingness to classify services as taxable even when data processing is ancillary to the primary transaction.
Why Texas’ Approach Is Controversial
The Texas Supreme Court has given the “essence of the transaction” test. This doctrine aims to determine whether a transaction is subject to sales or use tax by looking towards the ultimate object or purpose of a transaction based on the buyer’s intent — not the activities of the seller. In other words, if a buyer intends on purchasing a taxable item, then the transaction is subject to sales tax.
Industry groups, including the Texas Taxpayers and Research Association, argue that the comptroller’s interpretation exceeds statutory authority and undermines the essence of the transaction test by focusing on the seller. TTARA contends that the rule effectively legislates through administrative action, creating uncertainty and imposing compliance burdens that discourage technology investment in Texas.
The controversy centers on three issues: First, the scope of taxation now encompasses services that were historically exempt, such as certain analytics and AI-driven insights; second, compliance complexity has increased, particularly for bundled services and multistate transactions, where sourcing rules are ambiguous; and third, the economic impact is significant, as higher costs may influence decisions about where to locate operations or invest in technology infrastructure.
Indiana: AIaaS as a Non-Taxable Service
Indiana takes a markedly different approach. Under Revenue Ruling #2025-02-RST, generative AI services accessed via web or API are not subject to sales tax. The rationale is that these offerings are considered services and not tangible personal property or specified digital products, which are taxable in Indiana.
Indiana’s position aligns with its long-standing policy that SaaS accessed remotely without permanent ownership is exempt from tax. This interpretation means that charges for AI chatbot subscriptions, predictive analytics APIs or similar services are not taxable. Indiana’s framework provides clarity and consistency, reducing compliance burdens for businesses operating in the state.
Why These Differences Matter
The divergence between Texas and Indiana is not merely academic. It has tangible consequences for private equity firms and operating companies. From a deal structuring perspective, tax exposure in Texas can materially affect a company’s valuation. Buyers must account for potential liabilities when negotiating purchase price adjustments and working capital true-ups. Failure to identify accrued but unpaid sales tax obligations can lead to disputes after closing and financial surprises.
From a compliance standpoint, Texas’ ancillary test creates risk for businesses that do not correctly classify AIaaS offerings. Undercollection of tax can result in penalties and interest, while overcollection may strain customer relationships.
Indiana’s exemption reduces these risks, but multistate sellers must remain vigilant as other jurisdictions consider similar rules. Strategically, these differences influence decisions about entity location and operational footprint.
Locating AI operations in Indiana may reduce tax burden, while Texas’ rules necessitate robust compliance systems. Agreements should also be carefully drafted to clearly define the scope of any services and pricing to manage or mitigate exposure under Texas’ ancillary test.
TTARA Commentary and Industry Pushback
As previously mentioned, TTARA has been outspoken in criticizing the comptroller’s broadened interpretation. The association argues that the recent amendments and the addition of the ancillary test “disavows the essence of the transaction test” and imposes costs beyond the intent of the Legislature.
Under this regulatory regime, businesses face uncertainty and higher compliance expenses, which could deter technology investment and innovation in Texas. Industry stakeholders have urged the Legislature to clarify the statutory framework, but until such action occurs, companies must navigate a complex and evolving landscape.
Practical Guidance for Private Equity Firms
Private equity firms should incorporate state tax analysis into their due diligence process. This includes reviewing the target company’s AIaaS offerings, customer contracts and historical compliance with Texas sales tax rules. After closing, firms should implement tax compliance software capable of handling multistate operations and train finance teams on Texas’ ancillary test and sourcing requirements.
Risk mitigation strategies may include negotiating indemnities for tax liabilities that occur prior to closing and evaluating restructuring options to shift taxable activities out of Texas. These steps can help preserve deal value and reduce exposure to unexpected liabilities.
Conclusion
The fragmented state tax landscape for AIaaS underscores the need for proactive planning. Texas’ aggressive stance contrasts sharply with Indiana’s exemption, creating compliance challenges and strategic considerations for private equity firms and operating companies. As states continue to grapple with taxing emerging technologies, businesses must stay informed and agile to manage risk and capitalize on opportunities.
Comparison Table: State Approaches to AIaaS Taxation
| State | Tax Treatment | Basis |
| Texas | Taxable as Data Processing (80% base) | Texas Tax Code §151.0035; Rule 3.330 |
| Indiana | Non-Taxable Service | Revenue Ruling #2025-02-RST |
Josh Prywes is an attorney at Winstead PC, where he advises clients on a broad spectrum of tax and business matters related to joint ventures, mergers, acquisitions, and both domestic and cross-border restructurings. He frequently represents investors and operators in real estate and private equity joint ventures, handling partnership agreements, key employee arrangements, and development agreements. Josh also counsels tax-exempt organizations as they navigate complex legal and tax issues. Drawing on experience from both private practice and Big Four accounting firms, he structures acquisitions, dispositions, capital raises, business separations, and other significant business events with a commitment to protecting client interests and optimizing tax outcomes.
John Laughlin is a tax attorney at Winstead PC, where he provides federal income, state, and local tax advice on a broad range of transactions. His practice includes mergers and acquisitions, private investment fund formations, real estate developments, and other complex matters. John also represents nonprofit organizations in obtaining tax-exempt status and supporting their ongoing operations. His experience spans partnership and LLC formations, corporate formations, and corporate reorganizations across diverse industries.