After my recent article on goodwill, a question has arisen regarding the tax implications of franchise fees. There seems to be a perception that franchise fees paid up-front should automatically be treated as being capital in nature and, therefore, not taxable on receipt in the franchisor's hands, and not tax deductible in the franchisee's hands.
However, it is important to remember that, for tax purposes, the name of the charge can not determine its nature.
Equally, what might be capital in one person's hands, can as easily be revenue in another's.
It is the taxpayer's intention that will be the starting point for determining the nature of a payment or a receipt.
To illustrate this, let's take the example of a car. If you are in the business of buying and selling cars, the cost of those cars will be deductible in your hands and the proceeds from their sale will be taxable.
They will be considered to be revenue in nature because you are dealing with them in terms of a profit making scheme.
But if you are not in the business of buying and selling cars, and you buy a car for your everyday private use, the car will be a capital asset and its cost will not be deductible in your hands. And equally so the proceeds on its sale will not be taxable in your hands.
Let's go back to franchise fees paid up-front, that is, initial franchise fees.
The initial fee should cover the costs incurred by the franchisor in setting up a new franchise and time spent on it.
It may also include the costs of supplying assets which have a prescribed "look" to the business. Generally, the higher the initial fee, the lower the ongoing management fees.
From a franchisee's point of view, the ongoing management fees are more important, since it is these fees that will ensure the franchisor's continued support.
The franchisee would normally need to be given a breakdown of the initial franchise fee.
If you are the franchisor, and you have developed a business formula which you are able to franchise, you may have embarked upon a profit making scheme of selling franchises. In accordance with this business you will provide certain services to your franchisees, in return for an initial franchise fee and ongoing management fees. These fees will generally be viewed as being revenue in nature and, therefore, taxable in your hands.
Look now look at the franchisee. If you are paying an up-front amount for an entitlement to use a franchise formula, to set up the business, to be provided with the necessary knowledge to enable you to operate the franchise in accordance with the requirements into the future, and to acquire specified fixed assets from the franchisor, which you will use in the business, the fee would probably be capital in nature in your hands, since it would constitute the cost of acquiring the underlying assets to operate your business (which have a long-term enduring benefit).
Consequently, it would be a capital expense and therefore, probably, not deductible in your hands. (There is a provision in the tax legislation that may allow it to be deducted over a period of time, but I suggest you contact an advisor to see if this would be so.)
Remember, though, that, in all cases the nature of the receipt or payment, for tax purposes, would depend on the circumstances and the terms of the agreement.
The monthly management fee for the provision of regular support services will be a recurring payment in terms of which no long-term enduring benefit or asset is given or acquired.
The amount would, therefore, be revenue in nature in both the franchisor and the franchisee's hands and therefore taxable and tax deductible, respectively.
But there are no hard and fast rules. Suffice it to say the term "franchise fees" may mean many things and, as a consequence, may have a number of outcomes from a tax point of view.