An Unexpected Tax Bite

If you bought software in Ontario after the spring of 1997, your purchase price may have just gone up by eight per cent. Recently tabled final regulations describe the circumstances in which sales-tax exemptions are available. And in some cases, transactions that were presumed to be tax-exempt are not, and taxes may now be applied retroactively. How did all of this come about?

The current legislative scheme for taxing retail sales of computer software came into being May 7, 1997, when all computer software became classified as “tangible personal property”. Under this scheme, all retail sales of computer software are now subject to the eight per cent Ontario retail sales tax, with only limited exceptions. The vendor is required to collect the tax from the licensee and remit it to the government.

In general, the legislation exempts custom-developed software from tax, but what qualifies as such was left to be defined in regulations. This means that the Government of the day has the ability to make rules defining eligibility for exemption and to change those rules without having to return to the legislature for a change in the statute.

Draft regulations were issued concurrently with the legislative change in 1997 and remained in draft form for two years. Parties to transactions occurring during this period looked to the draft regulations for guidance. The final regulations were released on July 5, 1999. The problem is that the final regulations effectively narrowed the scope of the exemptions, and they are retroactive.

The words used to define the exemptions are highly technical. You should consult your tax advisor to determine the availability of the exemption in any particular case.


In general, custom code does not have to be line-for-line new code to qualify for the exemption. A pre-written program will also be exempt if it has been modified to meet the specific requirements of a particular person, provided it costs less and is priced separately from the customization. If there is a combined price for the customized software, the final price must be more than twice that of the unmodified program. Further modifications to any exempt program are also exempt without regard for these value tests.

All of this is fairly straightforward, but there is one significant complication that arises because the government chose to define “custom computer software” in a narrower way than one would expect. To qualify for exemption, not only must the purchaser show that the program was custom designed and developed to meet the specific needs of the initial purchaser, but under the final regulations there is the added requirement of demonstrating that the custom-designed program was intended for the exclusive use of the person for whom it was designed. A customization that is intended to be included in future upgrades appears not to qualify for exemption, even for the person for whom the customization is initiated. Moreover, the new regulations define a “modification” as a change to the original source code. Customizations without the use of the source code do not qualify for tax-free treatment.

The interim regulations addressed the exemption without reference to these additional requirements. This means that some transactions completed after May 6, 1997, seemingly PST free, do not qualify for exemption under the new regulations and are subject to PST. Ongoing lease contracts, however, entered into prior to May 6, 1997, escape PST even if the licence fees would be subject to tax under the new regulations. These leases are grandfathered until such time as the lease is renewed.

Ministry of Finance officials have confirmed that the new regulations have retroactive effect, but the ministry has not indicated how the retroactive tax will be collected.

Gabe Takach is a partner at the Toronto law firm of Tory Tory, where he heads up the firm’s technology contracting practice. He can be reached at