A taxing dilemma

Tax season has sprung – and many software vendors in Ontario do not have their happy faces on, thanks to their provincial government.

About five years ago Ontario’s government changed the rules on what software was deemed PST applicable, according to Bob Horwood, president of ITAC (Information Technology association of Canada) Ontario in Toronto. Shrink-wrapped software was made subject to PST charges, as well as services that applied to that software – such as installation.

As part of these changes, Horwood said, most software was treated as shrink-wrapped and, therefore, subject to PST. Horwood noted that these changes were never widely announced and the rules were only officially finalized in 1999.

“However, the Ontario Ministry of Finance auditors have been reassessing this issue on a retroactive basis – usually to May 1997,” Horwood said, adding this has left some Ontario software vendors open for surprisingly high tax bills and penalties.

Audrey Diamant, partner at PricewaterhouseCoopers in Toronto, who spoke at an ITAC seminar recently, authored a report for PWC on this subject.

“The ORST (Ontario retail sales tax) status of charges for remote access to computer programs is potentially controversial. The guide states…if a taxable program is installed on a computer or server located in Ontario, ORST applies to any access fees charged to customers, wherever located,” Diamant stated in her report.

“If the program is installed on a computer or server located outside Ontario, ORST does not apply to any access fees charged, provided that customers cannot download the program,” the report continued.

“Finance’s interpretation appears to contradict one of the basic principles of the ORST: tax should apply based on consumption or use within the province. One wonders whether Ontario-based servers will become a thing of the past.”

Horwood agreed with Diamant’s assessment, saying we may see far more vendors hosting their applications in other provinces. “It most certainly will drive business away from Ontario. Some companies will go bankrupt and some will be driven to other application service providers (ASP).”

However, Diamant noted that the Ontario government is trying to make sure that inconsistencies in the tax treatment are resolved soon.

“Although the guide is a useful first step in providing much-needed information to the software industry, many contentious issues remain,” she said.

“The May 2001 Ontario budget acknowledged the need for ‘simpler and more effective definitions and rules.’ Consultations promised in the budget recently took place; it is hoped and expected that further developments will occur in the near future.”

Horwood said he expects changes to appear in the next budget.

Revision in works

Elizabeth Doherty, manager commodities tax design unit for the Ministry of Finance in Toronto, said the government is hoping to have several issues resolved for the 2002 budget.

She noted they are looking at ways to model the software taxes on those of B.C., which have been administered for a number of years.

“We are looking at options as to how tax would apply in terms of taxable services,” Doherty said. The Ministry is also working on a deminimis – where there is a piece of software that they would apply tax to bundled with something there is no tax on.

“If the taxable item is less than 10 per cent of the value of the bundle, then there is no tax,” Doherty said. However, this rule does not yet apply to software, although it does exist in other industries.

The government is also looking at modifications to source code. Doherty said that there should be a tax on modifications that exceed the value of the software. Currently, the tax laws state that modifications have to appear on one bill – which will often make the cost of modifications more than the original cost of the software. She said the Ministry is looking at making these modification cumulative.

“It’s a very complicated area,” she said.

Hard hits

Horwood said there have already been casualties from these tax bills, which in at least one case totalled $500,000. In fact, some companies have even gone bankrupt as a direct result of this, he said.

“It depletes the capital of these firms,” Horwood said. “And it’s estimated that it could take as long as 10 years to fight this in court. The net result is that this was not a productive way to go about this.”

He noted that even trying to follow the letter of the law backfired for one vendor, who started charging PST when he realized the law change, only to pique the interest of auditors who then came down hard on him for not charging it in the past.

The other point of this tax treatment to be mindful of is that responsibility for paying PST falls on the shoulders of the Ontario enterprise who has bought software from an American vendor – as the U.S. vendor is not expected to know about PST, where Ontario residents are, according to Horwood.

He said the government needs to admit they did not notify people of policy change in a proper fashion, and he would like to see them stop charging retroactively to 1997 for the taxes.