Ontario retail sales tax on software: August 30, 2002

Tax Executive, The, Sept-Oct, 2002

Modifications to Custom Programs

Section 7(1) 62 of the ORSTA provides an exemption from taxation for computer programs "designed and developed to meet the specific requirements of the initial purchaser." A custom program need not be developed "from scratch"; an existing program that has been extensively modified may also qualify for the exemption. Under Regulation 1012, a "modification" is limited to "changes to the original source code."

Under the proposed changes to clause 14.2(2)(c) of Regulation 1012, only separate billings for modifications made after July 19, 2002, can be accumulated to attain custom status. TEI submits that it is unfair to disallow the billings for modifications performed before July 19, 2002, on which tax was paid or payable, in determining the cumulative cost of the modifications. We recommend that the exemption be relaxed further to allow the accumulation of all billings for modifications.

In addition, in respect of the accumulation of modification expenses, a transitional rule may be required to clarify whether billings for modifications commenced but not completed before July 19, 2002, are governed by the existing 1997 modification rules or the proposed treatment (i.e., whether such billing would qualify in determining the cumulative cost of the modifications).

To achieve equity among all methods of contracting and to ensure consistent ORST treatment for all custom software created through subsequent modifications, once the cumulative value of modifications has exceeded the price of the original software license, both the original software--and the modifications performed to date--should be eligible for full tax relief. At the very least, billings pertaining to a single contract for the supply of software and modifications should be eligible for tax-exempt treatment on all billings that have been or will be created under the contract, once it is clear that the value of the modifications has exceeded the value of the software license. This clarification recognizes the fact that at the time software or modifications are being acquired, it is not uncommon for suppliers and their customers to lack specific details on the scope or costs of the modifications.

Finally, TEI remains concerned about restricting the current definition of modifications to changes of the source code. In the current technology environment, generic modules are customized to the user's needs even though the purchaser, or other third party, does not have access to the software provider's original source code. Given the existing restrictive definition of modifications, it is unlikely that many taxpayers would benefit from the proposed cumulative approach since the work done on modules will not qualify as modifications. We therefore strongly suggest implementing a rule that permits both configuration and installation services to be included in the price of modifications for determining whether custom software has been created (similar to the rule in British Columbia).