The franchise business model is very popular with Quebec entrepreneurs. The world of franchises does have special tax characteristics however.
This article presents a number of aspects that franchisors and franchisees should know to maximize their tax situation.
Tax treatment of advertising funds
For a new entrepreneur, the franchise business model offers the possibility of joining a network and brand that the general public is already familiar with. As a result, some advertising is often carried out for the franchisees by a central service coordinated by the franchisor.
Generally, the franchisees pay an annual contribution that is goes into an advertising fund. This fund is then used by cover advertising activities on behalf of the group.
Is the franchisee’s contribution to the advertising fund a deductible expense? What about the franchisor who receives the contribution?
The franchise agreement often provides information to better understand the franchisee’s and franchisor’s control of the advertising fund. The Canada Revenue Agency expressed its opinion in a technical interpretation (9819787 Redevances à recevoir, Fonds de publicité) to clarify the appropriate tax treatment for franchisors and franchisees.
The franchisor has no control over the contributions
When neither the franchisor nor the franchisee controls the advertising fund, contributions to the advertising fund are deductible expenses for the franchisees, since they are incurred to earn income. The expense is therefore deductible in the year it is paid or payable.
In the franchisor’s case, if the franchisor made a contribution to the advertising fund, the contribution is deductible, as it is for the franchisee. Since control of the advertising fund is not among the franchisor’s various obligations towards the franchisees, it can be concluded that, even though the franchisor receives the contributions, the franchisor is independent of the fund and the expense is deductible.
For the same reason, the contributions will not be included in the franchisor’s income, since they are not owned by the franchisor. It should be noted that, from an accounting stand point, transactions affecting the advertising fund are generally recognized exclusively on the balance sheet and have no impact on earnings.
The franchisor has control over the contributions
If, based on the facts of the franchise agreement, the franchisor controls the advertising fund, the franchisees’ contributions must be included in the franchisor’s income. Accordingly, if there is a surplus at year-end for future services, the franchisor could set up a reasonable allowance for advertising services to be provided after year.
Additionally, unlike the situation where the franchisor does not control the funds, the franchisor’s contributions are only deductible when the expenses are actually incurred. The franchisor’s contributions are, in fact, amounts reserved for future expenses and are therefore not deductible at the time the contribution is made. The tax treatment for the franchisees’ contributions is the same as in the first situation.
Royalties and management fees
Royalties and management fees are not exclusive to the franchise sector, but they are often an integral part of the franchise agreement.
Royalties are amounts which franchisees pay to the franchisor for the use of certain assets (e.g. trademarks, patents). For the franchisee, the royalty payment is a deductible expense and, for the franchisor, it is taxable income.
In a franchise situation, management fees are often charged for certain services which the franchisor provides to the franchisees (e.g. negotiations with suppliers, inventory management). Since management fees are often used in a corporate group context, the tax authorities often challenge them, particularly in non-arm’s length transactions.
Generally, for an expense to be deductible from a taxpayer’s income, it must be reasonable and incurred to earn income. The first criterion is usually easy to satisfy in a franchise context, because the franchisees’ business objective is to earn income to increase the business’s value for shareholders.
However, the Income Tax Act does not define what constitutes a reasonable expense. The tax authorities positions and case law in this respect provide a number of factors that can be considered in a reasonableness analysis. As a rule, the tax authorities consider management fees to be reasonable if they are representative of the fair market value of the services provided.
If the fair market value of the service is easily comparable, it can serve as a basis to support the reasonableness requirement. Additionally, when the franchisee and franchisor deal at arm’s length, it is more difficult to allege that the transactions would have been carried out at values that differ significantly from the fair market value, since the franchisee and franchisor have different economic interests, that is their respective business’s profitability.
Franchisors often offer a format where they take care of a number of administrative tasks. Combining these tasks often results in significant savings for the franchisees and allows them to focus on their current operations.
The franchisor can charge fees to the franchisees plus a maximum mark-up of 15%, which is usually considered to be reasonable.
The reasonableness of management fees is a question of fact that must be analyzed on a case-by-case basis to ensure that the franchisee can deduct the expense. Special care is required if the separate economic interests of the parties or whether they are dealing at arm’s length is not clear. Additionally, the franchisor should ensure that it has up-to-date documentation to justify the management fees charged.
This article was written in collaboration with Belkacem Berredjem and Marie-Danielle Roy.
19 Aug 2019 | Written by :