Pascal Leclerc
Partner | CPA, CA, LL.M. Tax | Tax

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.

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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.

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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 :

Pascal Leclerc is a tax expert at Raymond Chabot Grant Thonrton. Contact him today!

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You’re on the verge of buying an SME as part of a business transfer and negotiations are coming along well. Before your dream can come true, you’ve probably got one more step: convince the bank to help finance the transaction.

Remember that, first and foremost, when financing a project, the lender’s priority is to minimize its risk, particularly considering that an ownership transfer is a fairly risky event in a business’s life.

That being said, as a transferee (we’re using the singular here, even though you may be several partners), you have an advantage over someone who’s just starting a business. The company you want to buy already has a history, its revenues and profitability, clients, etc. are known quantities. You have tangible information to support your application.

Different criteria

The company’s background is a key element in analyzing a business financing project because different criteria apply depending on how old the company is. SMEs that are less than five years old are generally considered to be more sensitive, as they are riskier.

Lenders also consider the size of the transaction, which will impact their requirements. In the case of smaller transactions (under $500,000), for example, the lender will look at a few key indicators, such as the transferee’s credit and net worth and could require personal guarantees. In this type of transaction, the lender could also analyze the transferee’s ability to inject funds to support the business and cover any contingencies.

A solid team is key

If the lender is satisfied with the financial aspects of the application, he will then undertake a qualitative evaluation. This is when he will take a close look at the quality of the transferee’s management team, including:

-The transferee’s entrepreneurial experience and knowledge of the targeted company. If the transferee is already in the company (family member or employee), the risk is lower, since the transferee already knows the business and its industry;

  • Whether key employees are identified and if they will remain;
  • The transferor’s commitment to stay on to ensure a smooth transition;
  • The presence of an advisory committee, ideally with the transferor on board;
  • Whether the transferee is supported by a professional accountant and is receiving outside help (specialists, mentor, etc.), particularly if he has any managerial weaknesses.
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Make a good impression

The fewer unknowns in the project, the greater the financial institution’s confidence will be. Be prepared and properly supported. You need to carefully plan the business’s transfer and development.

The financial forecasts must be well developed and based on solid assumptions.

Beyond the numbers though, it’s critical that you make a good impression with the lender. You have to prove that you’ve asked yourself the right questions and found solutions to offset any weaknesses. For example, talk about the support you have (transferor’s involvement, advisory committee, support from a professional accountant, etc.), especially if you’re an external transferee and don’t know as much about how the business operates or its industry.

Our team can help you with complex steps, such as evaluating the business, performing the pre-purchase investigation and determining the strategic issues and business plan.

Hint: To accelerate the processing of your financing application, get the lender involved early on, that way the process won’t be delayed if he has additional questions.

The balance of sale

Another key component of the business transfer financing process is the balance of sale. This is the total transaction amount that will have to be subsequently repaid to the transferor, in accordance with the terms set at the time of the sale.

This is often a major issue during the transfer negotiations. The transferor wants to minimize the balance to reduce risks, the transferee wants a higher balance to keep short-term financing requirements as low as possible.

Most of the time, the lender’s preference is that the transaction include a balance of sale in order to limit its fund injection and share the risk evenly between the three parties: lender, transferor and transferee. The balance of sale takes on greater importance with a less-experienced transferee with limited financing. Furthermore, if there is a balance of sale, it’s in the transferor’s interest to stay on board and support the business’s operations, which also reduces the lender’s risk.

The balance of sale is calculated using the debt ratio, and in a business transfer should not be greater than 3:1, i.e., debt should not be more than shareholders’ equity times 3.

In some cases, the balance of sale could be considered as shareholders’ equity if paying the bank loan has priority. Consider a $400,000 transaction with a $250,000 loan, a $50,000 injection from the transferee and a $100,000 balance of sale. The balance can’t be paid until the loan has been repaid, which reduces the lender’s risk. The balance of sale improves the overall financing application and makes it easier for transferees with limited resources to become shareholders.

If you’re planning to transfer your business, our experts can help. Contact them today!

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Intended especially for foreign companies considering investing in Québec, Taxation in Québec: Favourable Measures to Foster Investment provides an overview of the principal tax measures that apply to companies operating in Québec.

In addition to very attractive tax measures, Québec has given Investissement Québec specific tools that enable it to act as a financial partner to businesses. Although this brochure focuses on tax issues, Québec provides businesses with a range of financial solutions that complement those offered by financial institutions. These solutions may include conventional loans, loan guarantees, non-refundable contributions or equity interests.

The information in this brochure was up to date as at April 1, 2019, and does not reflect any modifications that might have been announced subsequent to that date. Monetary amounts are expressed in Canadian dollars.

This brochure is for information purposes only. It does not substitute for legislation, regulations or orders adopted by the Québec government.

For more information, download the document below.

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Under the commodity tax regime, an individual is entitled to claim an input tax credit (ITC) with respect to the purchase of goods and services only if they are used in connection with commercial activities (i.e., in the provision of taxable and/or zero-rated supplies).

A holding corporation whose sole activity is to hold investments could, therefore, not claim ITCs on its expenses since it does not carry on commercial activities because financial services are considered to be an exempt activity.

However, Section 186 of the Excise Tax Act (ETA) provides that a holding corporation that does not make any taxable supplies may claim ITCs on goods and services to the extent it is considered that they were acquired for consumption or use in relation to the shares of capital stock or indebtedness of another corporation that is at that time related to it, if that other corporation carries out commercial activities exclusively (i.e. 90% or more).

Application of this provision has led to considerable discussion with respect to the question of whether a good or a service acquired by a holding corporation can reasonably be considered to be acquired for consumption or use in relation to the shares of capital stock or indebtedness of another corporation.