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Ruling

Subject: Franchise fees

Question 1

Are you entitled to an immediate deduction for the payment of a franchise fee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the franchise fee deductible over the term of the franchise agreement under the prepayment provisions?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· the application for private ruling, and

· the documents provided in response to a request for further information.

You operate a franchise.

An initial fee was paid to set up the franchise. This fee was capitalised.

You have paid another amount in relation to the franchise agreement which spans a number of years.

The fee is described as a non recurring fee.

As per the franchise agreement, you have not been offered a renewal term.

Therefore if you wish to continue holding the franchise, technical and trade mark fees will once again be payable on the expiration of the agreement.

If you do not pay these fees, you would be left with nothing and unable to operate the franchise.

Reasons for decision

Question 1

Summary

The payment of the franchise fees is not regarded as an operating or working expense of the business. The rights obtained in relation to this payment have an enduring benefit and are regarded as being capital in nature. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the 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, enlargement of a business or the acquisitions of fix capital assets are not deductible. The costs of acquiring a business would not be considered as a cost of carrying on a business for the purpose of gaining assessable income, unless it is an operating expense.

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, ie, 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; and

· 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 brining 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 a 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 you paid a franchise fee for a franchise arrangement.

The essential character of the advantage gained by you was the right to operate using the franchisor's trade mark, systems and for the provision of technical assistance. These are of enduring benefit to you and therefore the franchise fee is considered capital in nature. The franchise fee was paid in a single payment for the future enjoyment of these benefits.

The payment is not regarded as an operating or working expense of the business. The rights obtained in relation to this payment have an enduring benefit and are regarded as being capital in nature. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997.

Question 2

Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) applies to expenditure incurred by a taxpayer in a year of income that cannot be wholly deducted in the expenditure year. Instead the taxpayer can deduct, for each year of income during which part of the eligible service period for the expenditure occurs, an amount worked out using the formal in paragraph 82KZMF(1)(b) of the ITAA 1936.

In your case, the fee is considered to be capital in nature and not deductible under section 8-1 of the ITAA 1997. Therefore the prepayment provisions do not apply.