If you operate a franchised business, there are a number of tax and business issues that you face that are unique to franchisees.
Although starting and running a franchise business is basically the same as starting and running most other small businesses, there are some additional things that need to be considered
First of all, there is the terminology. A franchisor grants the right to use their business brand name or trademark and the right to produce or distribute their product or service. A franchisee receives the right to use a business brand name or trademark and the right to produce or distribute the franchisors product or service.
Secondly, both the franchisor and each franchisee need to have separate Australian business number’s (ABN).
The initial franchise fee or transfer fee you pay to the franchisor forms part of the cost base for capital gains tax purposes for your franchise business. As these fees are, in effect, capital invested in your business, you do not deduct them as business expenses from your annual income tax.
Depending on the circumstances, your franchise renewal fees may also form part of your cost base.
Any franchise renewal fees not included in your cost base may be deductible as a business expense and subject to the prepayment rules. Generally, where the renewal fees are for a relatively short period, at the end of which you would have nothing and any renewal would involve a recurrence of the fees, the renewal would be deductible as a business expense.
The prepayment rules cover expenses incurred in a current income year under an agreement for something to be done, in whole or in part, in a later income year. This alters the timing of a deduction for certain prepaid expenses that would ordinarily be immediately deductible in full in the year they were incurred. The subsequent timing of such a deduction can generally be made over an “eligible service period”, which in most cases means the period during which the agreement is in force.
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 you work out your annual income tax liability you can deduct payments of royalties, interest payments and levies in the year you incur them, as they are a continuing expense in carrying on your business.
Generally, you can deduct the fees you pay to the franchisor for ongoing training as a business expense.
You need to register for GST if the turnover of your business is, or is expected to be, $75,000 or more. This is the turnover of your business alone, do not take the results of the franchisor into account.
The payments you make to the franchisor will generally also include a goods and services tax (GST) component if the franchisor is GST registered. If you are GST registered, you will generally be able to claim a GST credit from the ATO for the GST amount included in:
- the initial franchise fee
- franchise renewal fees
- franchise service fees or royalties
- advertising fees
- transfer fees
- training fees.
Transferring or terminating a franchise
If you transfer a franchise to another party or terminate a franchise, you need to consider both capital gains tax (CGT) and GST consequences.
When you transfer or terminate your franchise, the initial franchise fee or transfer fee that is included in your cost base (see above) will be taken into account in working out your net capital gain or capital loss to include in your annual tax return.
You may, depending on the original franchisor business that takes you on as a franchisee, find that you are required to make royalty or interest payments to non-resident franchisors that are based in another country.
The ATO generally requires that franchisees 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 franchisor’s country of residence may reduce this rate. Check with a registered tax adviser if this is an issue.
You will need to pay the amounts withheld from royalty and interest payments to the ATO, and report these amounts in your activity statement for the relevant reporting period. You will later need to report the total annual amount of royalty and interest payments and amounts withheld to the ATO.
A franchisee can only deduct the royalty payment to a non-resident franchisor as a business expense if you have withheld tax from the royalty payment and the amount has been paid to the ATO.
What if there are disagreements between you and the franchiser?
The federal Franchising Code of Conduct 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. Penalties for failure to comply can be significant.
Mark Chapman is director of tax communications at H&R Block.