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The Low Down On Royalties: What Can the Franchisee Do

Wednesday, 01 March 2006   (0 Comments)
Posted by: TaxFind™
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The Low Down On Royalties: What Can the Franchisee Do

Franchising is a popular way of doing business.Not only does it offer the buyer of the franchise the advantage of the franchisor experience and assistance, it also believes that entering into a francising agreement provides the chance to start a business with greater efficiency  proven products or methods public recognition and higher expectation of success.

The initial investment of a franchise can range from a few thousand Rands to hundreds of thousands.In addition, there may be royalty fees that range from none to 18 percent of sales.One of the hottest controversies in franchising at the moment is the landmark judgment by the Cape Tax Court that found that royalty payments were capital in nature and therefore not tax deductible.This ruling could impact negatively on franchising in South Africa and the franchise industry should prepare itself for possible investigation by SARS that could disallow expenditure similar to royalty payments such as franchise fees in the meantime.

Generally, royalties only form a small part of the fees paid by franchisees to their franchisors.But according to Brenda Macqueen, chairperson of the Franchise Association of Southern Africa (FASA), this tax court ruling could have grave consequences for franchisees, should it be applied to the letter. Says Brenda: "At the moment we are waiting to see whether anything will come of this.Up to now no franchise has been affected by the ruling and we hope that the matter will be resolved, once the case goes on appeal.It should be realised that royalties are not capital in nature and that a large amount of royalties are applied to support services.”It is, however, always safe to be prepared, rather than to ignore the issue and be caught unawares.This is especially true when running a high risk operation, such as a franchise.

Go through the checklist below to see where you are at risk:

Are you prepared for a tax audit by SARS? 

•Do you have all your documentation in  place?

Do you have a clear picture of the royalties you have paid to date?

•When last did you revisit your contact with the franchisor? Does this contract truly reflect the intentions of the franchisee and the franchisor? 

•Have you specified what makes up the applicable % management/ royalty fee? 

•Have you specified the different components, as some components may not be of a capital nature and therefore be tax deductible, such as marketing, training and software update expenses?

Revisiting your contract

The first step is to add an addendum to the contract if royalty payments were intended for education, marketing or more.There is nothing stopping the taxpayer from rectifying his statement or agreement. Secondly, it is important to specify whether the money paid for training is going to initial or ongoing training, as the former is of a capital nature whilst the latter is not.Don’t abuse your tax deductibility by automatically putting the applicable% royalty fee into education or marketing.

Realise that certain items associated with the royalty fee may not be tax deductible, such as exclusivity fee payable upfront when starting a franchise.The latter is not a payment for the use of intellectual property but a right of exclusivity, or where the royalty was structured as part of the purchase price for the acquisition of the right to conduct the business.And finally, don’t tear up agreements or you could face fraud charges and face a possible jail term.

It might be a good idea to enlist the help of a tax expert at this stage.Not only will it empower you as franchisee with all the information you need, it will also show that you had the intention to do the right thing, should a SARS audit come your way. 

What are capital allowances?

Capital allowances are a relief from income tax and are based on the capital expenditure incurred on the provision and installation of certain fixed assets in a building that suffer wear and tear, as well as on various types of properties, including certain industrial buildings and hotels.

Almost all commercial property owners and investors who incur capital expenditure are entitled to claim capital allowances either by purchasing or refurbishing an existing property, by carrying out alteration or extension works or by developing a new building, but many fail to realise their full entitlement or even claim at all, ultimately resulting in a loss of significant tax savings.

Capital allowances in some form are available in virtually every property used for business.There are many types of tax allowances on property expenditure including wear and tear allowances on machinery, plant, implements, utensils and articles, amongst others.Every building contains fixed assets, which qualify for wear and tear allowances, such as air-conditioning equipment, hot water installations, lifts, escalators, carpets, furniture and fittings, to name a few.Less obvious assets may also qualify, for example, emergency lighting, fire alarm systems and security equipment.

Source: By TaxTALK



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