Edited version of your written advice

Authorisation Number: 1051255760114

Date of advice: 2 August 2017

Ruling

Subject: Franchise Fees

Question 1

Is the franchise fee a fully deductible business expense under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Can the expense be treated an advance expenditure as per section 82KZMD(2) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2016

The scheme commences on:

1 July 2015

Relevant facts and circumstances

Company A is an Australian Proprietary company, with director A listed as the sole director.

In 20xx, a form was submitted by company A and director A to the franchisor in order to facilitate the purchase of an existing franchise business from the then owner, company B and director B. The expiry of the existing franchise agreement between company B and franchisor was 20xx. The form requested an extension to the company B agreement for 5 years.

An agreement for the sale and purchase of a business was entered into between company A and company B.

A franchise agreement was entered between the franchisor and company A as Franchisee. The expiry date of the contract was the date upon which the premises lease expires or 2017, whichever is sooner.

In 2016 a new franchise agreement was entered between Franchisor and company A as Franchisee. The expiry date of the contract is the earlier of the date upon which the premises lease expires or 10 years from the start date of 2016.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Subdivision H of Division 3 of Part III

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

The issue of whether a loss our outgoing is on capital or revenue account has been considered by the courts in various cases, most notably in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. F.C. of T. (1938) 61 CLR 337 at p. 363, where Dixon J made the following statement:

"There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment."

In applying Sun Newspapers Ltd v FC of T principles to your situation, we must consider the content of the original and subsequent contracts entered into relating to the purchase and operation of the business and franchise, those being;

● the agreement for the sale and purchase of business and franchise between company B and director B and company A and director A, hereafter referred to as the business purchase agreement

● the original franchise agreement between Franchisor and company A as Franchisee, hereafter referred to as the original franchise agreement

● the new franchise agreement between Franchisor and company A as Franchisee, hereafter referred to as the new franchise agreement.

An amount was paid by company A to the franchisor, which you state is a renewal fee, is classified in the new franchise agreement as a franchise purchase fee. As discussed in ATO Interpretative Decision ATO ID 2001/87, Income Tax, Deductibility: General Licence Fee (Franchise Agreement), despite the amount being called something other than a renewal fee we must clarify what the payment actually represents in order to determine the essential character of the fee.

The first consideration, as per the principles of Sun Newspapers Ltd v FC of T, is the character of the advantage sought, which incorporates the length of the period for which the rights under the franchise agreement were secured upon the renewal.

It was determined in Inglewood and Districts Community Enterprises Limited and Commissioner of Taxation [2011] AATA 607 (Inglewood) that 5 years may be a sufficiently short period for the purposes of the character of the advantage sought test to allow consideration of renewal fees on revenue, being a periodical and recurrent cost of conducting business, as opposed to the cost of acquiring a profit making enterprise. The period of 10 years however is not considered to be a relatively short period for the purposes of the character of the advantage sought test as it is considered capital in nature due to the advantage having an enduring benefit, being the creation or enhancement of the business structure of the taxpayer and the right to carry on that business.

The standard contract period with the franchisor’s franchises is that of 10 years and as per the contract schedule, your new franchise agreement has been entered into for a period of 10 years. While your original franchise agreement was for a period of 5 years it is noted that the original franchise agreement was entered into to take over the unexpired term of an existing contract which was in place between company B and director B as franchisee and Franchisor. The Franchise changeover form indicates that there was a period of approximately 17 months as the remaining term of the company B franchise contract. An extension of 5 years to that contract was requested via this form at that time. Thus the timeframe of the original franchise agreement was dictated by the existent extension provisions in the company B franchise contract as opposed to being the usual regular timeframe of the franchisor’s franchise agreements.

When dealing with contract renewal both the original franchise agreement of 2011 and the new franchise agreement of 2016, state that the renewals are “possible” where the franchisor gives written notice to the franchisee stating it will renew the franchise and on what terms. There are no timeframes for renewal options supplied in the contracts or costs/amounts per term of renewal stated or implied. When considering the Inglewood case there was a specific schedule of renewal periods, being the first renewal period of 5 years and a second renewal period of 5 years, with costs per term clearly stated. As such it is considered that the nature of the new franchise agreement entered into is that of a capital asset and not a regular outlay or extension of the original franchise agreement which would be more aligned to classification as revenue in nature.

In applying Sun Newspapers Ltd v FC of T principles to your situation, the second consideration is the manner in which the advantage was to be enjoyed.

At paragraph 2 of the purchase agreement the purchase price for assets includes the plant and machinery required to undertake the franchise business.

At paragraph 8 of the purchase agreement the assets company A purchased from company B are categorised as being free and unencumbered. Item 5 of the schedule of the new franchise agreement states Leased Assets (as per part 4 of the agreement) are being not applicable as the assets are owned permanently, and independently of the franchise agreement, by company A in their own right. Paragraphs 53.6 to 53.15 of the new franchise agreement discuss the scenario whereby the franchisee may continue to occupy the premises after the expiry or termination of the agreement and operate their own independent business. As such it is considered that company A could therefore continue to operate a business with these enduring assets after the agreement period finalised and independent of the franchise scenario.

You have also mentioned the aspects of exclusivity and secondary business activities being conducted as a factor in determining the nature of the renewal fees of the contract. The original and new franchise agreements both discuss (at paragraph 38 of the original franchise agreement and paragraph 22.2 of the new franchise agreement) scenarios where the franchisee has been granted second or multiple franchises. There are also no terms in the original or new franchise agreement which restrict the ability of company A to be a multi-purpose vehicle, own assets other than those directly permitted in the agreement, provide guarantee or security to any party whatsoever or own certain shares. This differs from the terms of the Inglewood contract as outlined by Senior member O’Loughlin at paragraph 7 (c) of his decision which states that the applicant and it’s employees are restrained from engaging in other businesses in competition with Bendigo’s business and/or Bendigo’s products and services and references other restrict terms in the Inglewood contract. As such it is considered that the original and new franchise agreements do not restrict company A in their ability to have secondary business activities.

The ATO view on the treatment of the franchise renewal fees as explained in the Decision Impact Statement on Inglewood, where it was found that the franchise renewal fees under the Bendigo Bank Community bank model were of a revenue nature, is particularly specific to their unique circumstances. Your circumstances differ from those of Inglewood in several instances as discussed above. Given that 10 years is not considered to be a relatively short period for the purposes of the character of the advantage sought test, the secondary business opportunities for company A are not restricted to the same level as other agreements, such as that entered into by Inglewood, and that at the end of the 10 years company A would still have more than 'nothing’ on which a business could be run, it follows that the renewal fees would be on capital account. As such the franchise renewal fee paid by company A is not considered a deductible business expense under section 8-1 of the ITAA 1997.

Question 2

You will not be eligible to deduct the franchise renewal fees over the life of the renewal period pursuant to Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) as the expenses are considered to be a capital expenses, and as such would not be deductible under section 8-1 of the ITAA 1997 which is a prerequisite for the application of section 82KZMD of the ITAA 1936.

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