Tax Focus
Software: Hard Rules
Confusion abounds when it comes to taxing software.
FROM:
MAR-APR 2006 ISSUE | BY
R. JASON RICHE
The complex federal and provincial sales tax rules governing the sales tax treatment of software can cause serious grief for Canadian businesses. The central issue underlying the application of sales tax to software is determining
what is being provided or acquired. How the software is characterized determines its tax treatment.
While it might seem that software should be characterized as intangible personal property (IPP), notably intellectual property (IP), in some cases software is considered tangible personal property (TPP), and, as such, is taxed the same as a desk or a car.
Custom v. Non-custom
Prince Edward Island, Ontario, Manitoba, Saskatchewan, and
British Columbia apply provincial sales tax (PST) to the purchase of TPP.
Non-custom or "off-the-shelf" software is generally considered TPP and is subject to PST. Custom software is regarded as specialized knowledge designed to meet the requirements of a particular purchaser, and is therefore
non-taxable, except in Saskatchewan where all software is taxed.
However, the devil is in the details when it comes to the various provincial rules used to determine whether or not software falls into the custom category. This complexity is increased by the fact that non-custom software can become custom if it undergoes a certain degree of modification.
For example, in Ontario, PST applies to all charges for modifications made to
non-custom software until these accumulated charges exceed the price of the original product. When this threshold has been crossed, the software is considered to be custom.
To further complicate matters, many of the applications the software industry considers custom are not considered as such for PST purposes. The industry generally considers software that builds on and incorporates
pre-existing modules to be custom; however, the provinces tend to characterize software as custom and therefore exempt from PST only if it has been created or modified at the source code level. This requirement poses a real barrier to the ostensible relief from PST for custom software.
Software-related Services
The distinction between what is taxable and non-taxable becomes even more clouded when we consider software related services. Since
non-custom software is considered TPP, the various PST provinces — through complex and differing legislative mechanisms — tax certain services relating to software.
Tax practitioners often refer to this as the "hands on" versus "hands off" issue. Services requiring computer programmers to literally put their hands on the software — such as installing, configuring, and upgrading — are generally taxable, whereas services such as training, planning, and help-desk support are not.
This may seem relatively straightforward, but the detail and complexity of the different provincial rules, the plethora of changing services offered by software providers, and the fact that many taxable and
non-taxable services are often bundled together for a single price make this issue one requiring careful consideration.
Remote Access
Another related issue concerns the taxing of software that is accessed remotely. Remote access to software has received much attention recently because of the expanding popularity of the application service provider or
utility-based software model in which software is centralized on a server and customers are charged a usage-fee for access. This model raises the issue of server and user locations in determining whether or not sales tax applies.
The approach to the issue of remote access differs from province to province. For example, Ontario takes the position that access to
non-custom software located on a server in Ontario is subject to Ontario PST regardless of where the user is. Conversely, if a user is in Ontario and accesses but does not download software on a server located outside Ontario, PST does not apply.
British Columbia takes the opposite position and applies PST to the use of software if the users are in
British Columbia, regardless of the location of the software.
These rules have created some strange results. Vendors who house their software on servers in Ontario and provide access to customers all over the world are required to charge these customers Ontario PST. This gets even more bizarre when the customers of the Ontario software vendor are located in
British Columbia, and so are subject to
double-taxation.
Information Service
A final area regarding PST that causes much consternation circles back to the underlying issue of what is being provided. The right to access information is an intangible right and, as such, is generally not subject to PST.
Often, however, vendors provide a product offering that is not easily identifiable as either software or access to information. For example, this could involve access to an online research tool. Software is involved in order to run the tool, but is the customer provided with access to the software? Or does the service provider use the software to provide the customer with information?
The answers to these questions are not easy to determine. An in-depth understanding of the product is necessary in order to understand the true substance of what is being provided.
It is also important to ensure that all of the documentation supporting the product — customer contracts, purchase orders, and invoices — reflects the true substance of what is being provided in case of an audit.
Value-added Taxes
The GST/HST and Quebec Sales Tax (QST) implications of transactions concerning software and related services are frequently minimized, perhaps due to the general taxability of all items in these regimes. There are, however, several areas where it is necessary to characterize software as either TPP or IPP because different rules will apply depending on the characterization. More specifically, this issue is important for,
inter alia:
1) determining the place-of-supply and whether GST, HST, or GST and QST apply;
2) importing software into Canada; and
3) exporting software and related services from Canada.
Whether software is subject to GST (7 per cent), HST
(15 per cent), or GST
(7 per cent) and QST
(7.5 per cent), depends on how the software is characterized. For example, only TPP delivered or made available in Canada is subject to GST, whereas IPP is subject to GST if,
inter alia, it may be used "in whole or in part" in Canada. Somewhat similar but more complex rules exist to determine if HST or QST apply.
Imported software is treated differently depending on whether it is considered to be TPP or IPP. Generally, software imports considered to be IPP are not subject to GST. If the recipient of the software is engaged exclusively in commercial activities, there is no requirement to self-assess GST on the intellectual property value of the imported software.
Licensed custom software and software provided electronically is considered IPP.
Non-custom software and custom software purchased (as opposed to licensed) is considered to be TPP by Canada Customs and is subject to GST on import.
When it comes to exporting software and software-related services, Canadian policy indicates that
non-residents should not be charged GST, as the
non-resident may not be able to recover the cost. For the most part, IPP that is considered to be IP is not subject to GST when it is supplied to a
non-resident whom is not registered for GST. The tax community has repeatedly questioned whether the restriction on this relief for IPP that is not IP was intentional and, if so, why? There may be some clarity on this point when it comes to software (as opposed to other products) as it appears that the Canada Revenue Agency considers software to be IP for export purposes.
Moreover, determining whether or not
software-related services supplied to a non-resident are subject to GST can be quite challenging. When the service is "in respect of" TPP situated in Canada, the service may be subject to GST. In such situations, GST may be charged to the
non-resident. There is currently no clear guidance on whether or not software is to be considered TPP or IPP in these situations.
And so things are not always what they seem when it comes to determining the
tax status of software and related services. In a complex environment of many different variables and interpretations, take extra care to ensure that no liabilities are created and that the tax burden is minimized.
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R. Jason Riche, BA, LLB, CGA, is a senior manager for Deloitte & Touche LLP in Toronto. E-mail
rriche@deloitte.ca.