If you have a client who asks about taking up a franchise, one of the first things to impart to them would be to point out that the federal Franchising Code of Conduct (download it here) is the primary piece of legislation covering the franchising area. It imposes strict obligations on franchisors to make sure that franchise agreements are fair.
The ACCC is the government body responsible for enforcing the code. The code also requires both franchisees and franchisors to act in good faith in all their dealings with one another. Another significant point to make is that penalties for failure to comply can be significant.
However, if your client has a plan and is determined to forge ahead, it is also worth pointing out that from a tax point of view, starting and running a franchise business is basically the same as starting and running most other small businesses.
However, there are some additional things that need to be considered for the transactions between franchisee and franchisor. (The person who grants the right to use a business under some brand name or trade mark, and the right to manufacture and distribute their products or services, is known as the franchisor, and the person who receives these right is known as the franchisee).
The franchisor and each franchisee need to have separate Australian business number‘s (ABNs).
Franchise fee deductions
The initial franchise fee or transfer fee taxpayers provide to the franchisor forms part of the cost base for their franchise business as their capital asset. As these fees are capitally invested in the business, a franchisee does not deduct them as business expenses from their annual income tax.
Depending on the circumstances, franchise renewal fees may form part of the franchisee’s cost base. Any franchise renewal fees not included in the cost base may be deductible as a business expense and subject to the prepayment rules. Generally a taxpayer can deduct the fees paid to the franchisor for ongoing training as a business expense.
Payments made to the franchisor will generally also include a goods and services tax (GST) component if the franchisor is GST registered. If in turn the franchisee is GST registered, they will generally be able to claim a GST credit from the ATO for the GST amount included in:
- initial franchise fee
- franchise renewal fees
- franchise service fees or royalties
- advertising fees
- transfer fees
- training fees.
Royalties or interest payments
An agreement to purchase a franchise often includes ongoing payments of royalties, interest payments or levies to the franchisor. These payments typically cover head office expenses, such as administration, advertising and technical support.
Unlike the initial up-front fee, when your client works out their annual income tax liability, they are generally able to deduct payments of royalties, interest payments and levies in the year these are incurred, as they are a continuing expense in carrying on the business.
If your client is a franchisee, they may find that they are required to make royalty or interest payments to non-resident franchisors that are based in another tax jurisdiction. Generally, franchisees are required to withhold a flat rate of 30% from the gross amount of a royalty payment and 10% from the gross amount of an interest payment. However, a double tax agreement with the non-resident’s country of residence may reduce this rate.
Your client will need to pay the ATO the amounts withheld from royalty and interest payments, and report the amount in their activity statement for the relevant reporting period. They will later need to report the total annual amount of royalty and interest payments and amounts withheld using the form PAYG withholding from interest, dividend and royalty payments paid to non-residents – annual report (NAT 7187 for the paper form, but it also can be lodged online).
A franchisee can only deduct the royalty payment to a non-resident as a business expense if they have withheld tax from the royalty payment and the amount has been paid to the ATO.
Ending a franchise agreement
If your client either transfers a franchise to another party or terminates a franchise, they may need to consider both capital gains tax (CGT) and GST consequences.
When they transfer or terminate their franchise, the initial franchise fee or transfer fee that is included in the business’s cost base may be relevant in working out the net capital gain (if any) to include in their annual tax return.
For a more indepth overview franchising and tax, keep an eye out for the May 2018 issue of The Taxpayer journal (included in Tax & Super membership), which is to feature Part 1 of a two part article on franchising. Part 1 details the tax treatment of franchise fees.
Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax Your franchise clients and their tax