Ontario retail sales tax on software: August 30, 2002.

On August 30, 2002, TEI's Toronto Chapter sent the following letter to Brenda Kershaw of the Ontario Ministry of Finance concerning the Province's draft legislation and administrative rules for software and related services. The letter was prepared under the auspices of the Institute's Canadian Commodity Tax Committee, whose chair is Martina Krummen of Air Canada, and was reviewed by TEI's Executive Committee in accordance with longstanding procedures. Carol Felepchuck of IBM Canada Limited contributed materially to the preparation of the submission.

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On behalf of Tax Executives Institute, I want to thank you for the opportunity to provide comments on the draft legislation and administrative rules in respect bf Ontario's Retail Sales Tax (ORST) for software and related services. The Ministry of Finance has been very generous in the opportunities it has presented TEI to provide input on this important subject.

Background

Tax Executives Institute is an international organization of more than 5,300 professionals who are responsible--in an executive, administrative, or managerial capacity--for the tax affairs of the corporations and other businesses by which they are employed. TEI's members represent more than 2,800 of the leading corporations with 53 chapters in Canada, the United States, and Europe.

Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together constitute one of our eight geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

Ontario's Retail Sales Tax Act (ORSTA) currently treats tangible personal property--and the labour provided to "install, assemble, dismantle, adjust, repair or maintain" that property--as taxable. The definition of tangible personal property under the ORSTA includes computer programs. An exemption from tax is provided under ORSTA [section] 7(1) 62 for a "custom" computer program, which is defined as one that is "designed and developed to solely meet the specific requirements of, and that is intended for the exclusive use of, a particular person." ORST Guide #650--Computer Programs and Related Services, at 3 (February 2001).

On July 19, 2002, Finance Minister Janet Ecker announced proposed changes to the retail sales tax treatment of software and related services. The proposed amendments take some important first steps to clarify the treatment of these programs for ORST purposes. Recognizing the administrative and conceptual challenges in this are, TEI urges the Province to examine whether software and related services should be taxed when used as business inputs. Nonetheless, we commend the Ministry for its efforts to clarify the law and are pleased to provide the following comments on the proposed changes, as well as recommendations for additional amendments.

Adoption of a De Minimis Rule

In its December 19, 2001, comments, TEI recommended the adoption of a de minimis rule for software-related services where vendors generally provide non-taxable services with an incidental supply of taxable services. The Institute commends Ontario for proposing the adoption of such a rule, specifying that where taxable and non-taxable services are sold together for a single price, ORST would not apply if:

* the vendor's cost of the taxable services is 10 percent or less of the vendor's cost of the nontaxable service, or

* in the case of a vendor charging for time spent (e.g., hourly or daily rate) for services rendered, the time spent to provide the taxable services is 10 percent or less of the time spent to provide the non-taxable services.

The de minimis rule will help those vendors (and purchasers of these services) who supply what is for the most part a non-taxable service, but includes a nominal component of taxable services. We foresee a problem, however, with the use of the word "cost" in the regulations describing the application of this rule. The draft rule permits services to be provided on a non-taxable basis if the vendor's "cost" of taxable services is 10 percent or less of the "cost" of the non-taxable services provided. If the purchaser of these services is audited concerning the make-up of the services provided, the vendor will be called upon to disclose its costs. This request would not normally be fulfilled in every-day business practice, because vendors are generally very protective of their cost information.

To address this problem, TEI recommends that the term "cost to the vendor" in the description of the de minimis calculation be replaced with the word "value." Value could be substantiated by providing supporting pricing documents or by utilizing cost records and uplifting these by a common profit margin. Such. an approach would protect the confidentiality of the vendor's pricing information, while ensuring that the taxable component of the services is nominal. It would also accord with the July 19, 2002, Backgrounder issued with the draft legislation, which contemplates the appropriateness of using values in respect of the de minimis rule by stating (at page 4) that "the fair value of the taxable services must be reasonable in relation to the total fair value."

We note that the same section of the Backgrounder also requests industry input on the alternative forms of documentation that could be used to substantiate the value of taxable and non-taxable services. TEI suggests that any records used by a business in the development of its pricing, cost-tracking, or billing activities be considered acceptable documentation in determining the value of taxable vs. non-taxable services. Documentation will vary from company to company and it is important for the government to accept the available business records maintained for other purposes, rather than requiring businesses to create additional documentation.

In addition, there may be situations where a contract subject to the de minimis rule when originally written is amended to add services or projects that would place it outside the application of that rule. TEI recommends that a clarification be issued to provide that only services delivered after the contract is amended are subject to the taxation rules for services that do not meet the de minimis test. Similarly, where a contract is amended to permit services to qualify for the de minimis test, only services provided after the contract is amended would be eligible for the application of the rule.

Presently, the de minimis rule applies only to services relating to a computer program. Because these types of services can be included in a more comprehensive contract for other services or goods, the draft should be clarified to apply the de minimis rule to services relating to a computer program provided within the context of a broader supply.

Taxable Services

The proposed legislation would clarify the definition of "taxable services" to include (in clause (c.1) of subsection (1.1) of the ORSTA) "labour provided in respect of the installation, configuration, modification or upgrading of a computer program, as those expressions are defined by the Minister." The proposed changes to the definition will assist in providing a clearer picture of the types of activities subject to the ORSTA. TEI has two concerns about the proposed definition in the legislation and regulations.

First, we find the use of the term "in respect of" to be extremely broad and fear that it could capture consulting services provided to advise a customer on the use of a computer program. TEI recommends that the term be deleted and the clause restated as: "labour provided to install, configure, modify or upgrade a computer program, as those expressions are defined by the Minister." (1)

Second, the proposed change in subsection 1.1(1) of Regulation 1012 relating to the definition of a "taxable service" defines installation, configuration, and upgrading of a computer program to include the words "work done to." These same words do not appear in the subsection's definition of "modification" of a computer program, which has been used administratively for some time. Inclusion of these words seems unnecessary. TEI is concerned that their inclusion will cause the definitions to be interpreted too broadly, encompassing services that are advisory and consulting in nature. We recommend that the words "work done to" be deleted.

Finally, we note that although these new definitions represent a move in the right direction, it will continue to be a difficult, if not impossible, task for vendors to collect the appropriate amount of tax and for purchasers to know exactly what the tax burden will be.

Non-Taxable Services

Proposed subsection 1.1(3) of Regulation 1012 provides a list of non-taxable services that contains only four items. According to the explanatory notes, the proposed provision is not intended to represent a comprehensive list of non-taxable services. For greater clarity, TEI recommends that the list of non-taxable services include a fifth item referring to "other activities that may be determined by the Minister."

According to the current RST Guide #650, assistance or support, either in person, over the phone, electronically, or via e-mail--but not "hands-on"--is a non-taxable consulting service. The word "hands-on" is subject to interpretation and should be clarified in either the legislation or the updated Guide to provide that the term includes the performance of a taxable service either on site or remotely, but does not include the provision of advice in person or by electronic means.

Testing

The ORSTA defines "tangible personal property" to include computer programs and "taxable services" to include "labour provided to install, assemble, dismantle, adjust, repair or maintain tangible personal property, and any contract for the service, maintenance or warranty of tangible personal property." The Act does not, however, define the following terms: installing, assembling, dismantling, adjusting, repairing or maintaining tangible personal property. RST Guide #650 attempts to clarify these terms. Among the services that the Guide states are non-taxable are "testing and diagnostic services, provided no further work is performed at the same time (see below for additional clarification)." The Guide provides:

   If you perform testing and diagnostic services at the same time as you
   provide taxable labour, such as those listed under taxable services (see
   page 7), you must charge RST on the total charge. You cannot separate the
   amounts on your invoice in order not to charge RST.

Based on the Guide, testing provided separately from any taxable labour performed apparently qualifies as a non-taxable service. The draft legislation, however, significantly reduces the scope of this exemption. In this regard, draft subsection 1.1(3) of Regulation 1012 states that "[t]esting a computer program, unless the testing is done in connection with the installation, configuration, modification or upgrading of a computer program," is a non-taxable service. Since testing is generally carried out in relation to the installation, configuration, modification, or upgrading of computer programs, it appears that testing would almost always be taxable. Based on the policy expressed in the Guide, the draft legislation should explicitly amend the clause to state:

   Testing a computer program, unless the testing is done at the same time as
   and in connection with the installation, configuration, modification or
   upgrading of a computer program.

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).

Other Recommendations

There are other changes to the current statute and administrative rules that should be considered to simplify the law and its administration.

(a) Related Parties. Paragraph 7(1) 62 of the ORSTA exempts from tax "[c]omputer programs designed and developed to meet the specific requirements of the initial purchaser, but only in such circumstances as the Minister may prescribe." Section 14.2 of Regulation 1012 requires that the computer program be "designed and developed solely to meet the specific requirements of, and that is intended for the exclusive use of, a particular person" or be a prewritten program that is "modified solely to meet the specific requirements of a particular person."

These rules are inconsistent with the principle of tax neutrality and fairness under which the tax treatment of an item does not vary because of extraneous factors, such as corporate structure. In many cases, for regulatory or other reasons a business must be incorporated as a separate corporate entity rather than operate as a division. Under the regulation, a corporation composed of several divisions qualifies as a "particular person" because it is considered one legal person. A computer program purchased by a corporation for use by itself and its wholly-owned subsidiaries, however, does not qualify as a custom computer program. This outcome is inequitable where the parent wholly owns the subsidiaries because the tax is applied on the basis of the corporate structure rather than the nature of the supply. TEI recommends that the draft legislation define "particular person" to include members of corporate groups that would otherwise qualify for the exempt transfers between related persons in subsections 13(3) to 13(5) of Regulation 1013.

(b) Server Location. Ontario currently imposes ORST if a server is located in the Province, including cases where software is loaded onto a server in Ontario and then accessed by a remote user. TEI is concerned about this policy, which may clearly result in double taxation since other provinces tax computer software licenses based on place of use. We suggest that the current rules be readdressed to avoid double taxation.

(c) Exclusive Licenses. In today's technology world, vendors often do not grant an exclusive license to a purchaser of software because they wish to retain their rights in a library of codes for future use. Because this could become a recurrent audit issue, we suggest that Ontario clarify that the granting of an exclusive license may not be required to qualify for the custom software exemption provided in section 7 (1) 62 of the ORSTA.

(d) Bundled Services. We continue to be concerned about the burden placed on both vendors and purchasers of software-related services where bundled supplies of taxable and non-taxable services (not subject to the proposed de minimis rule) have been erroneously billed on a non-taxable basis. Because of the inherent complexity in these service offerings, we strongly encourage the Ministry to permit an unbundling of taxable and non-taxable services on an after-the-fact basis, subjecting only the taxable component of the supply to ORST.

(e) RST Guide #650. RST Guide #650 presently provides excellent information on the ORST treatment of computer programs and related services. We believe, however, that it should be expanded. For example, there is a need to define terms such as data management. Explanations of the tax treatment of different types of query or report-writing services would also be helpful. Finally, the use of common industry terms in the Guide would assist all parties in interpreting and complying with the administrative guidance.

Conclusion

TEI's Toronto Chapter appreciates this opportunity to present its comments on the draft documents created by the Ministry in respect of the ORST on computer and related services and would welcome a chance to meet with the Ministry to discuss the issue. We commend Ontario for its efforts to streamline what will undoubtedly continue to be a difficult area. We look forward to working with you on these and other issues.

If you have any questions, please do not hesitate to call me at 905.858.5379, the chair of the Chapter's Commodity Tax Committee, Phil W. Riley, at 905.548.4475, or the vice chair of TEI's National Commodity Tax Committee, Carol Felepchuk, at 905.316.6685.

(1) The change in tense in the draft legislation would also require an amendment to the tense used in the definitions in the regulation, which would be consistent with the tense used in the preceding clause (c).