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Paying Taxes on Royalties: Franchisees set to lose millions

01 March 2006   (0 Comments)
Posted by: TaxFind™
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Paying Taxes on Royalties: Franchisees set to lose millions

Franchises are major role players on the South African restaurant and fast food scene. In fact,  with a massive turnover of close on R130 billion per annum and employment provision for almost 300 000 people, this industry sector shows an annual growth of more than 20% per year. A recent ruling by the Cape Tax Court could, however, place a serious tax burden on the shoulders of the franchisee and might even place small businesses in jeopardy.

Royalties or franchise fees relate to the fees franchisees have to pay to franchisors. Until recently, royalty payments have for the most part been considered to be tax deductible, if paid for the use of rights. Franchise fees are seen as an expense which forms part of the day-to-day running expenses of a taxpayer. It is also considered to be closely connected to the trade of the franchise operation and is therefore seen as a revenue expense, akin to paying rent for the premises in which your business operates. 

A ruling in the Cape Tax Court, otherwise known as the ITC 11454 judgement, did, however, state that the comparison between rentals and royalties is not a good one and ruled that the payment of a royalty for the intellectual property use gives structure and goodwill which is essential to the business’s operations. The court also found that royalty expenditure was related to expenses incurred in setting up a business (like franchise fees) and was therefore capital expenditure.

In essence, it boils down to the fact that royalty payments are now considered to be capital in nature and therefore not tax deductible. The question is how this ruling will affect franchising? 

First and foremost, it should be stated that the ITC 11454 judgement has been widely criticised by tax specialists and was considered as being incorrect. It is hoped that it would go on appeal, but in the meantime SARS could pursue the disallowance of expenditure similar to royalty payments such as franchise fees.

The effect on franchising operations

What are the implications for South African franchises, should this tax ruling hold? When working with an estimated turnover of 5%, the total annual turnover of ongoing franchise fees that franchisees pay to franchisors in South Africa is close on R6.5 billion per year. 

If going back over five years and adjusting the sum by 20%, the total franchise fees that franchisees had to pay franchisors over this period would be in the region of R21.7 billion. If SARS started aggressively pursuing the principles of the ITC 11454 ruling, the franchise industry would have to pay R6.51 billion in tax arrears. If penalties and tax interest are added to this figure, this would boil down to an estimated total arrears tax of R1,185 million per franchisee. These calculations are based on the statistics cited above and the estimates and averaging have been done to illustrate the point.

Preparing for a SARS enquiry

Franchise operations can prepare themselves for possible SARS enquiries in the following way. SARS would probably first request information from franchisors about all their franchisees. This would be done in terms of section 74A of the Income Tax Act, 1962. Franchisors should then ask for what administrative purposes the information is required and in respect of which specified taxpayers. SARS is not allowed to extract information from taxpayers unless they can show that a set of facts exists that matches one of the subsections of the definition "for the purposes of the administration of this Act”. If they cannot show this, they are not entitled to the information. It should also be borne in mind that SARS can only extract information in respect of specified and named taxpayers and to ask franchisors for a list of all their franchisees, would not strictly fall into the provisions of section 74A of the Income Tax Act.

Should SARS be able to name the specific taxpayers on which they would like information, it would be advisable to seek appropriate legal advice to answer the following questions in detail:

· What do the contracts say?

· What was, and is, the true intention of the parties?

· Are there any tax opinions to back  up the contracts?

· Can the contracts be amended to reflect the true intention of the   parties?

· What is the split between the initial  fees and the monthly or annual   payments?

· How was this calculated and why was there a split?

· Have the various elements attached to "the rights” been   properly described, in other words,  what was meant by the rights of the franchisee?

· Have the provisions of section 11(f)  or 11 (gA) ever been applied and  are they relevant to the facts at   hand?

· What are the amounts of franchise  fees paid over the past years?

· How has this been disclosed in the  financial and the tax returns?

· Can SARS ever say that there has  been non-disclosure or inaccurate  disclosure?

· Can it be said that part of the franchise fees payable can be allocated to the acquisition of the right to exclusive use area and the  intellectual property?

· Other questions that might arise in consultation.

Once SARS has concluded their investigation into the royalty payments of a franchisee, the taxpayer could ask SARS for a letter containing their findings, before they issue an assessment. Based on careful analysis of the above information, it would be in the taxpayer’s best interest to give reasons why SARS’s intentions to disallow royalty payments are incorrect. The way to do this is by giving a fully motivated oral and written presentation aimed at convincing SARS that they were wrong. In this presentation it is important to emphasise that SARS cannot raise additional assessments now without carefully considering the presentation made by the taxpayer. Should SARS have ignored the new facts or arguments the taxpayer raised in the presentation, the taxpayer could have the additional assessments set aside in court.

The above procedures are accepted within SARS, even though they are not set out in any tax legislation. A legitimate expectation has therefore been created in favour of taxpayers.

Paying attention to initial contracts

Close attention should be paid to what is meant by the rights of the franchisee when setting up the initial contract. These rights will usually include the initial right to operate in a particular area of business, as well as the use of the franchisor’s intellectual property, including trade marks, trade name, patents, copyrights, designs, permitted name, software and know-how.

The fees payable in a typical franchise agreement would be (a) an initial start-up fee that is payable for the exclusive use area, (b) an initial start-up fee to acquire the right to use the intellectual property and (c) ongoing fees payable to maintain the use of both (a) and (b).

The exclusive use area fee (a) is a capital expense because it was made to set up an income-producing business and will therefore not qualify for a tax deduction.The initial fee paid for the right to use the franchisor’s intellectual property (b) is also arguably a capital expense because it was made to create and income-producing business and would therefore also not be tax deductible.There is however provisions set out in section 11(f) of the Income Tax, 1962 that the franchisee can state to claim  a deduction. Professional advice should however be sought before applying for these provisions to ensure that the facts submitted by the taxpayer fall in these.

The issue that is now the subject of uncertainty is (c), the ongoing fees payable to maintain use of the exclusive use area and the use of intellectual property. There are several cases where royalty payments were disallowed as deductions, based on errors made by the taxpayers in their tax planning.

The uncertainty around the disallowance on tax deductions for royalties will continue until the judgement in the tax case ITC 11454 has gone on appeal. In the meantime, franchise operations are urged to seek professional assistance from professional tax attorneys to get clarity on this issue.

Source: By  TaxTALK 

 



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