Edited version of your private ruling

Authorisation Number: 1012590407317

Ruling

Subject: Termination payment and franchises

Question 1

Are payments made for the termination of franchises properly and correctly claimed as allowable deductions in the year of payment under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

Question 2

If not, are the payments deductible over 5 years under section 40-880 or section 25-110 of the Income Tax Assessment Act 1997?

Answer

Yes.

This ruling applies for the following period:

1 July 2013 to 30 June 2014

Relevant facts and circumstances

· The Taxpayer carries on a franchise business.

· It operates corporate stores whereby it incurs all expenses and derives all revenue in relation to that store.

· The Taxpayer has also granted franchises in Australia, whereby the franchisee is granted a non-exclusive licence to operate a franchise.

· The agreement is entered into for an initial period. The Taxpayer receives an initial franchise fee at the outset of the franchise agreement. It also receives recurring royalties and advertising fees, at a percentage of gross revenue of the franchisee store. The franchisee has a right of renewal subject to certain conditions and the payment of a renewal fee to cover costs involved in the relicensing of the franchise.

· The Taxpayer enters into a head lease in relation to the premises and grants an occupancy right to the franchisee by way of a licence. Typically the occupancy licence would be for the same term as the franchise agreement.

· It is noted that under a typical franchise agreement, the franchisee agrees that any goodwill and other rights or interests arising from the franchisee's use of the business name, belong to the Taxpayer. At the end of the franchise, the franchisee is not entitled to receive any payment or compensation from the Taxpayer for any goodwill in connection with the business name, or any reputation developed by the franchisee in connection with the business or the premises. In any case, it is considered that any intellectual property relating to the Taxpayer's business is connected to its existing brand and is unlikely to be generated by individual franchisee stores.

· The Taxpayer has entered into a number of agreements to terminate existing franchises located in large retail complexes.

· The Termination Agreements provide for two events to take place:

o The surrender of the existing franchise agreements and occupancy licences (under which the franchisee effectively sub-leases the premises from the Taxpayer); and

o The sale of the assets of the franchise business to the Taxpayer.

· The Termination Agreement states that the sale is of a going concern for GST purposes.

· The Termination Agreement provides that the amount payable by the Taxpayer to the franchisee consists of an amount payable for stock and the assets of the business.

· The allocation of the balance of the payment is not explained in the Termination Agreements however it is payment for assets of the business including plant and equipment and business records.

· The remainder of the payment after deducting the market value of assets acquired is a fee payable for the termination of the existing franchise agreement. The amount of this payment is subject to negotiation with the franchisee in each individual case.

· The Termination Agreement also imposes restrictions on the franchise, including:

o A confidentiality clause such that the franchisee must not disclose the terms of the termination agreement on the basis that it could harm the business interests of the Taxpayer; and

o A restraint of trade clause which requires that the franchisee must not operate or be involved in supplying similar goods or services within the restrain area.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 40-880.

Income Tax Assessment Act 1997 Subsection 40-880(2).

Income Tax Assessment Act 1997 Paragraph 40-880(2)(a).

Income Tax Assessment Act 1997 Paragraph 40-880(2)(b).

Income Tax Assessment Act 1997 Paragraph 40-880(2)(c).

Income Tax Assessment Act 1997 Paragraph 40-880(2)(d).

Income Tax Assessment Act 1997 Paragraph 40-880(5)(b)

Income Tax Assessment Act 1997 Section 25-110.

Reasons for decision

Detailed reasoning

Section 8-1 of the ITAA 1997 allows an immediate deduction for expenses incurred in the carrying on of a business provided that the expenses are not capital in nature.

The guidelines for distinguishing between capital and revenue were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T (1938) 61 CLR 337: (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 97 (Sun Newspapers).

In Sun Newspapers, Dixon J stated:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay.

Another relevant consideration as described in Sun Newspapers by Dixon J, is assessing the character of the expenditure:

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 outlay to cover its use or enjoyment for periods commensurate with the payment by making a final provision or payment so as to secure future use or enjoyment.

These reasons for decision will first consider what constitutes the Taxpayer's business and its profit yielding structure. It will then consider the character of the expenditure in terms of the above factors.

What is The Taxpayer's Business?

A franchise is an arrangement which allows the franchisee to use the intellectual property, goodwill and business system that is owned by the Franchisor. The term "franchising" covers various forms of co-operation between different corporations.

The Taxpayer utilises the business system it has developed in two ways. Firstly it operates corporate stores whereby it sells products and services to customers, earning 100% of the gross revenue and incurring all expenditure in relation to these sales.

The Taxpayer's other method of generating income is from granting non-exclusive licenses to franchisees to use the intellectual property, goodwill and business system that the Taxpayer has developed. Its revenue from this part of the business is derived by receiving an upfront franchise payment and ongoing royalty payments.

What is The Taxpayer's profit yielding structure?

In identifying the structure established by the Taxpayer for the earning of profit, reference is made to the statements of Dixon J in Sun Newspapers[3]:

The business structure or entity or organisation may assume any of an almost infinite variety of shapes. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill, that is, widespread or general reputation, habitual patronage by clients or customers and an organised method of serving their needs.

The Commissioner considers that a franchise is an enterprise that is within the scope of the above statement of Dixon J, in that it comprises a low proportion of physical assets and a high proportion of intangible assets, including goodwill.

Goodwill

The High Court of Australia stated in Commissioner of Taxation (Cth) v. Murry [1998] HCA 42 that the attraction of custom still remains central to the legal concept of goodwill, and further that:

· For legal purposes, goodwill is the attractive force that brings in custom and adds to the value of the business. It may be site, personality, service, price or habit that obtains custom: paragraph [13].

· The goodwill of a business is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it: paragraph [24].

· It may be site, personality, service, price or habit that obtains custom: paragraph [67].

· Goodwill is a quality or attribute that derives, among other things, from using or applying other assets of a business, for example, use of a trade mark or a particular site, or from selling at competitive prices: paragraph [24].

· It is more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements: paragraph [24].

· Many of the sources of goodwill are not themselves property. Nor are they assets for accounting purposes. Examples include manufacturing and distribution techniques, the efficient use of the assets of a business, superior management practices and good industrial relations: paragraph [25].

· Other examples are location of the business, a lack of competition resulting from an enforceable restrictive covenant, and statutory monopolies in respect of products of a business such as patents or trade marks: paragraph [26].

· Expenditures such as advertising and promotional expenses are also sources of goodwill: paragraph [27].

The Commissioner considers that the Taxpayer's business structure relies on the intellectual property it has developed which is the main component that makes up its goodwill.

The Commissioner acknowledges that the franchise agreements result in the franchisee not owning the Goodwill of the business, however what the franchisee does acquire is a non-exclusive licence to operate a certain store and utilise the a certain store and utilise the Taxpayer's goodwill it has developed, provided the franchisee complies with the terms and conditions of the franchise agreement.

Therefore whilst the Commissioner agrees that no goodwill belongs to the franchisee, the Taxpayer effectively gives up its right to operate a store in the area using the franchise system that the Taxpayer has developed when it grants a franchise. When the Taxpayer makes a payment to terminate a franchise, it is effectively cancelling the licence so that the full use of the goodwill as it relates to the particular store reverts back to the Taxpayer.

The Commissioner considers the fact that the Taxpayer has control over the premises by way of being a head lessee does not have an effect on whether goodwill is acquired or not. Furthermore, the fact that the Taxpayer has entered into a tenancy arrangement for the lease of the premises does not support the argument that it is simply reorganising the way it operates its business, or that they are not acquiring a new business in its entirety.

Operation of Corporate Stores

It is considered that the corporate stores from which the Taxpayer operates itself, form part of the Taxpayer's profit yielding structure.

Granting and termination of a Franchise

The granting of the non-exclusive licence to the franchisee allows the franchisee to operate its own business subject to the terms and conditions in the franchise agreement for the franchise term.

From an analysis of the terms and conditions it is evident that the granting of the franchise results in the Taxpayer disposing of part of its profit yielding structure by issuing the non-exclusive license to operate its business in a certain location.

The Commissioner considers that by terminating a franchise the Taxpayer is agreeing to accept the surrender of the franchise (a non-exclusive licence) such that it will be able to operate the particular store itself.

Anglo Persian Case

In the Anglo Persian case, the company had contracts with agents for the conduct of its business in remote parts of the world. The agents were remunerated by commission at specified rates. As the business developed, the company from time to time dispensed with the services of such agents, finding itself able to carry on the business more economically directly by its own servants.

Lawrence J stated at 270 that:

"The Company by cancelling the agency agreement, and itself undertaking the future management of its business in Persia, neither enlarged the area of its operations, nor improved its goodwill nor embarked upon a new enterprise; it merely effected a change in its business method and internal organisation, leaving its fixed capital untouched." (emphasis added).

The Commissioner considers that the Anglo Persian case should be distinguished from the Taxpayer's circumstances on the basis that contractual relationship between Anglo Persian and its agents was one of agency, with Anglo Persian contracting its agents to represent it in its dealings with its customers in remote areas. In doing so, Anglo Persian retained its relationship as the principal in dealings with its customers.

This can be contrasted with the Taxpayer's circumstances whereby it granted a non-exclusive right to enable a franchise to operate using the Taxpayer's business system so as to service its own customers. Whilst the franchisee is required to operate its franchise under strict terms and conditions as outlined in the franchise agreement, this does not change the fact that the right provided by the Taxpayer requires the franchisee to operate the business as their own and on the basis that they earn all profits and bear all of the risks which are normally associated with running your own business.

Conclusion

The termination of the license will result in the profit yielding structure of the Taxpayer's business expanding as it will now be able to operate the business in the franchise area that is being surrendered and provide the goods and services to the customer.

Prior to termination of the franchise, the franchisee was able to use the Taxpayer's franchise system to service its own customers. The Taxpayer's role was to maintain and develop the franchise system to assist the franchisee increase sales and profitability. In return for this, the Taxpayer was entitled to receive royalty payments from the franchisee. The customers of the franchise were those of the franchisee and not the Taxpayer. The Taxpayer's contractual obligations were with the franchisee not the customers who purchase goods and services from franchised store.

The Commissioner considers that granting of a franchise would result in the Taxpayer reducing its profit yielding structure and the subsequent termination would result in the expansion of its profit yielding structure.

Character of the advantage sought

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213 - 214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

As stated by Dixon J in Sun Newspapers, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

The Commissioner has considered the commercial reality of the transactions against the requirements of the contractual terms such that neither is the sole deciding factor but a factor to be considered. As such, the Commissioner has focussed on what the Taxpayer got in return for the expenditure, in accordance with the comments of Windeyer J in BP Australia Ltd. v. Federal Commissioner of Taxation [1965] ALR 381 [8]:

Regard ought therefore to be had to what it was sought to acquire and to the relation of that to the taxpayers undertaking or business. These, rather than the form of the transaction or the mechanics of the acquisition, are what appear to me to be deciding factors. In other words, it is what the particular taxpayer got for his money, rather than how he got it that is important.

In considering the nature of the advantage sought, the Taxpayer states that:

The Taxpayer is not seeking to terminate all of its franchise agreements, but has identified selected stores where it considers that it can generate more revenue by managing those locations as corporate stores as opposed to franchises. Typically, The Taxpayer is better positioned to operate stores which are located in large retail complexes.

From the above statement it is clear that the nature of the advantage sought is to terminate the franchise agreement so that they can operate in locations where they consider they can maximise profits.

Your contention that you may re-franchise the store in the future to claim that the advantage created does not have an enduring benefit may support to some extent the character or nature of the advantage sought, however the following reasons indicate that the purchase of the franchise does have an enduring benefit:

1) The one off termination allows the Taxpayer to operate the store as a corporate store for an indefinite period of time. Had the Taxpayer not paid the termination fee, the franchisee could have been granted a franchise renewal for a significant period of time; and

2) There is no evidence to support that after termination of the franchised stores, the stores were or would have been re-franchised to another franchisee.

Further evidence to support the fact that the character of the advantage sought was to acquire a going concern is evident in the termination agreement which provides that the parties agree that the sale will be a going concern for GST purposes.

This supports the conclusion that the nature of the advantage sought was for the Taxpayer to acquire a going concern, which it considered would be more profitable to it than by allowing the franchisee to operate the store.

From the above evidence, the Commissioner is of the view that the Taxpayer's main purpose for terminating the franchised stores was so that it could maximise profits for an indefinite period of time and that it could do this by terminating the franchised store.

The manner in which it is to be used, relied upon or enjoyed

According to Dixon J in Sun Newspapers, when considering the manner in which the expenditure is to be enjoyed, regard must be had to the recurrent nature of the returns it produces.

From the above analysis it is evident that what the Taxpayer acquired, upon terminating the franchise agreement, was a going concern by virtue of the fact that the franchisee no longer held the license to operate the franchise and that now the Taxpayer could operate the store as its own corporate store.

By terminating the franchise the Taxpayer was successful in acquiring a business structure that would result in increased profits as compared with receiving its income by way of royalties.

Therefore it can be concluded that the manner in which the expenditure was to be used and relied upon or enjoyed was by effectively acquiring a going concern that would result in regular returns in the way of sales of goods and services from the running of the particular store.

The means adopted to obtain it

The final consideration as described in Sun Newspapers by Dixon J, in assessing the character of the expenditure requires analysis of the means adopted to obtain the benefit and whether this payment related to the expansion of the profit yielding structure or whether the outlay was more akin to an ordinary business expense that could be matched with regular returns.

The Commissioner does not agree with your reasoning that the payment is part of the Taxpayer's ordinary business activities in organising its method of operating existing stores for the reasons outlined in the profit yielding structure section above.

In Labrilda Pty Ltd v. DFC of T 96 ATC 4303, 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 structure of the taxpayer's business.

The Commissioner considers that the payment of a lump sum clearly relates to the termination of the franchise agreement, which enables the Taxpayer to expand its profit yielding structure to an area where it does not have the right to operate a store. Furthermore, whilst not determinative, the fact that the payment is made as a lump sum indicates that the payment was made as a "once and for all" payment for more of a capital purpose.

Conclusion

From analysing the above factors it is considered that the payment to terminate a franchise is not a deductible under section 8-1 of the ITAA 1997 on the basis that the character of the expenditure is capital in nature.

Question 2

Summary

The termination payments made by the Taxpayer are deductible over a 5 year period pursuant to section 25-110 of the ITAA 1997 to the extent that the payment relates to the termination of the licence to use the intellectual property.

Detailed reasoning

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

Paragraph 40-880(5)(b) provides that you cannot deduct anything under section 40-880 for an amount of expenditure you incur to the extent that you can deduct an amount for it under a provision of 'this Act' other than section 40-880. In this case it is necessary to consider sections 8-1 and 25-110 of the ITAA 1997.

As the expenditure incurred by the Taxpayer is capital expenditure (see Question 1), the expenditure is not deductible under section 8-1 of the ITAA 1997.

Section 25-110 of the ITAA 1997 provides a 5-year write-off for capital expenditure incurred to terminate a lease or licence (including an authority, permit or quota) that results in the termination of the lease or licence if the expenditure is incurred in the course of carrying on a business or in connection with ceasing to carry on a business subject to exceptions contained in subsections 25-110(3) to 25-110(6) of the ITAA 1997.

As the capital expenditure was incurred to terminate a non-exclusive licence for the purposes of section 25-110 of the ITAA 1997, the expenditure is deductible under section 25-110 of the ITAA 1997.

Section 25-110

Section 25-110 of the ITAA 1997 provides a 5-year write-off for capital expenditure incurred to terminate a lease or licence that results in the termination of the lease or licence if the expenditure is incurred in the course of carrying on a business or in connection with ceasing to carry on a business, subject to exceptions contained in subsections 25-110(3) to 25-110(6) of the ITAA 1997.

The payment of the termination fee incurred by the Taxpayer secured the termination of the franchise agreement and the termination was an integral part of The Taxpayer's business structure.

The payment enabled the Taxpayer to terminate a pre-existing franchise agreement so that it was able to operate the franchise as one of its own corporate stores.

In that context, the payment 'goes to the character and organisation of the profit-earning business and not to be an incident in the operations by which it is carried on': refer Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634; 8 ATD 190. This makes the payment an affair of capital.

The franchise agreement entered into between the Taxpayer and the franchisee conferred contractual rights and obligations on both the franchisor and the franchisee. The nature of a franchise prescribes that the payment terminated the various rights and obligations that collectively constitute what the franchisee acquired under the franchise agreement the right to use the intellectual property in operating the franchise during the term of the agreement, and the contractual right to use the services of the franchisor for purposes advertising and marketing of their products, management assistance and training.

In short, a franchise may include but be wider than a licence, which would appear to be the case here. See Bob Jane T-Marts v FC of T 99 ATC 4437; the definition of 'franchise agreement' in Trade Practices (Industry Codes Franchising) Regulations 1998 Reg 3; FC of T v United Aircraft Corporation (1943) 68 CLR 525.

The words 'to terminate a lease or a licence' in subsection 25-110(1) of the ITAA 1997 entail a direct link between the incurrence of the deductible expenditure and the termination of the lease or licence. In other words, deductible expenditure is that which has been incurred for the purposes of causing or inducing the termination of the lease or licence and has the consequence of having done so. The payment incurred by the Taxpayer was for terminating all of the rights and obligations under the franchise agreement. So the payment to the franchisee to terminate the franchise was paid by the Taxpayer to terminate not only the licence to use the intellectual property but also the contractual obligations under the franchise agreement.

In these circumstances, it is reasonable to infer that only that part of the payment that can be said to be paid 'to' terminate the licence to use the intellectual property and result in its termination is eligible for deduction under section 25-110 of the ITAA 1997. Apportionment of the payment would therefore be required.

In making this apportionment of the payment, the method used must be reasonable and what is reasonable will often depend on the particular circumstances.

Based on the information supplied by the Taxpayer, it is considered that none of the exceptions contained in subsections 25-110(3) to 25-110(6) of the ITAA 1997 apply in this case.