Edited version of private advice

Authorisation Number: 1052100100876

Date of advice: 30 March 2023

Ruling

Subject: Deductibility of franchise fees

Question

Is the franchise fee amount paid to the franchisor deductible under 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

1 September 20XX

Relevant facts and circumstances

The company (you) was established on XX July 20XX.

X is the sole director and shareholder of the company.

In September 20XX the company entered into an agreement (Franchise agreement) with Franchisor, to provide business coaching services.

Under Clause X.X of the Franchise agreement:

The Franchisor in consideration of the payment of the Franchise Fee which is to be paid by the Franchisee to the Franchisor ... grants to the Franchisee who accepts a nonexclusive right to operate the Franchised Business within the Territory and a nonexclusive right to use the Franchise image, the Franchise System, the Brand, the Trade Marks and the Intellectual Property in the conduct of the Franchised Business for the Term. The Franchisor will, on receipt of the full amount of the Franchise Fee and prior to Commencement Date or as available, supply to the Franchisee the Initial Training Program. ....

Clause X.X of the Franchise agreement states:

The Franchisee shall pay the Franchisor the Franchise Fee as specified in the Schedule and the Franchisor will comply with Clause X.X to supply various items therein.

The Franchisor delivered personal business coaching/mentorship training activities subsequent to receiving the Franchise Fee payment.

Item X of the schedule of the Franchise agreement provides:

(a)  Franchise Fee is amount $XXX plus GST;

(b)  Deposit $X plus GST is paid prior to issue of the Franchise agreement and balance $XX plus GST payable 7 days prior to commencement date;

(c)   Franchise Fee includes initial training.

Item X of the schedule of the Franchise agreement provides information on Initial Training Program.

You paid the franchise fee amount on XXXX.

You provided a breakdown of the services provided for the Franchise Fee payment:

•                     Business Coaching and Professional Development Mentorship Training (initial training) to be $XXX

•                     Right to use Franchisor's intellectual property to be $XX

•                     Right to renew licence for further five years at a discounted price to be $XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question

Is the franchise fee amount paid to the franchisor deductible under 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The franchise fee amount paid to the franchisor is not deductible under 8-1 of the ITAA 1997 as it is capital in nature.

Detailed reasoning

Revenue or Capital

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows you to claim a deduction for a loss or outgoing that is incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business to gain or produce assessable income. These deductions are limited by the exclusion of losses or outgoings that are capital, private or domestic in nature.

Generally, the costs connected with an acquisition, establishment or enlargement of a business are capital expenditure and are not deductible.

In John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510 it was noted that:

To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income, such a payment in the case of a trading company occurs at a stage too remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense.

The decision in Associated Newspapers Ltd and Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 provides guidelines for distinguishing between capital and revenue expenditure. This case considered the issue of whether expenditure in establishing, replacing and enlarging the profit-yielding structure itself was capital. The test laid down in this case involved three elements:

•                     the nature of the advantage sought

•                     the way it is to be used or enjoyed

•                     the means adopted to get it.

In regard to the first two elements, the courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with the view to bringing into existence an asset or an advantage for the enduring benefit of the trade or business.

This principle was followed in United Energy Limited v. Federal Commissioner of Taxation (1997) 78 FCR 169; 97 ATC 4796; (1997) 37 ATR 1, where the Full Federal Court held that franchise fees charged by the Victorian government in respect of electricity distribution companies, were not deductible. The Court said that the essential character of the advantage gained by the franchise fee was immunity from competition for a specified period from other distribution companies for customers in the licence area. The immunity was of enduring benefit to the taxpayer and the fee was therefore of a capital nature.

The third element involves consideration of the way the outlay is made, that is, is it a periodical payment covering the use of the asset or advantage, or a single and final payment made for the future enjoyment of the asset.

In Labrilda Pty Ltd v. Deputy Federal Commissioner of Taxation (1996) 65 FCR 119; (1996) 96 ATC 4303; (1996) 32 ATR 206, the taxpayer paid an up-front accreditation fee for participation in the Team Pak Program conducted by the principal, Mobil Oil. Under that program Mobil granted the right to the taxpayer to carry on its service station business using the 'Mobil System'. The specific program was designed to provide its participants with necessary training, marketing advice, advertising, promotion and other such assistance in setting up the business.

The majority in that case concluded that the taxpayer's expenses in relation to the above were of capital nature and not deductible as outgoings incurred in carrying on of the business. The expenses were more concerned with the business structure and characterised as expenditure which established the profit-yielding subject of the taxpayer's business.

Application to your circumstances

In your case the franchise fee payments are not regarded as operating or working expenses of the business. The essential character of the advantage gained by the company was the nonexclusive right to operate the franchise business within the Territory and a nonexclusive right to use the Franchise image, the Franchise System, the Brand, the Trademarks and the Intellectual Property in the conduct of the franchise business. These are of enduring benefit to the company.

As part of your Franchise agreement, the franchise fee amount includes initial training and is paid prior to the commencement of the franchise business. In your application, you contented that the circumstances associated with your initial training are similar to the circumstances described in TR 98/9 and your view is that the amount representing the fee for initial training would be deductible under section 8-1 of the ITAA 1997.

Taxation Ruling TR 98/9 Income tax: deductibility of self-education expenses provides that a deduction is allowable for self-education expenses if a taxpayer's current income-earning activities are based on the exercise of a skill, or some specific knowledge and the subject of the self-education enables the taxpayer to maintain or improve that skill or knowledge.

However, this ruling provides the Commissioner 's views on when self-education expenses are allowable as deductions to individuals under the Income Tax Assessment Act 1936 (ITAA 1936)and ITAA 1997.

In your case, the specific franchisor training (initial training) is part of the franchise fee. It is considered that the initial training is a prerequisite to a new income-earning activity as a franchisee. The franchise business commenced after you made the franchise fee payment which covered initial training as part of the Franchise agreement.

As this expense is incurred prior to a business actually commencing it cannot be characterised as a working expense or form part of the cost of the business's trading operations. It is part of a cost associated with putting or bringing an income earning operation into existence. Nor can the cost be said to be an expense in the carrying on of a business as it relates to a cost in establishing a business structure which is not a cost associated with carrying on a business.

In conclusion, you are not entitled to a deduction for the franchise fee totalling $XXX (including initial training) because the expenses were incurred at a point too soon to be regarded as incurred in gaining or producing assessable income and are capital in nature. As a result, the outgoing is not deductible under section 8-1 of the ITAA 1997.

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