Edited version of private advice

Authorisation Number: 1052107755413

Date of advice: 19 April 2023

Ruling

Subject: Deductibility of franchise fees

Question 1

Is the renewal fee specified in the proposed franchise agreement deductible to the franchisees pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

However, the timing of deduction for the renewal fee is subject to the prepayment rules contained in Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

Question 2

If the answer to Question 1 is No, is the renewal fee deductible to the franchisees pursuant to section 40-880 of the ITAA 1997?

Answer

Not applicable.

Question 3

Are the franchise fees specified in the proposed franchise agreement deductible to the franchisees pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

Question 4

Are the licence fees specified in the proposed franchise agreement deductible to the franchisees pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

Question 5

Are the settlement fees specified in the proposed franchise agreement deductible to the franchisees pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

Question 6

Are the IT system subscriptions specified the proposed franchise agreement deductible to the franchisees pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The franchisee entities propose to enter into a franchise agreement with the franchisor and the franchisor's associate.

In entering the proposed franchise agreement, the franchisees will commence operating the franchised business.

The relevant clauses of the franchise agreement govern:

•         the purpose of the franchise agreement,

•         the responsibilities of the franchisor,

•         the responsibilities of the franchisee,

•         the ownership and use of the IP and rights,

•         terms for sale by the franchisor and franchisees,

•         the term of the franchise agreement and further option periods,

•         renewal of the franchise agreements, and

•         the fees that are payable by the franchisees under the franchise agreement.

Specifically, the relevant fees that will be payable by the franchisees under the franchise agreement are listed as follows:

Table 1: Fees payable by the franchisees under the franchise agreement

All fees are to be set having regard to market rates at the time of entry into each franchise agreement. There will be a mechanism for annual increase to account for inflation.

The franchise agreement will be agreed separately with each respective franchisee, however these franchise agreements will contain identical terms and conditions.

The terms of the proposed franchise agreement in their entirety form part of the facts upon which this ruling was decided.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

Question 1

Summary

The renewal fee specified in the proposed franchise agreement is deductible to the Franchisees pursuant to section 8-1 of the ITAA 1997.

However, the timing of deduction for the renewal fee is subject to the prepayment rule contained in Subdivision H of Division 3 of Part III of the ITAA 1936.

Detailed reasoning

Section 8-1 of the ITAA 1997

Section 8-1 of the ITAA 1997 allows a deduction for certain losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

Section 8-1 of the ITAA 1997 provides:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

a)    it is incurred in gaining or producing your assessable income; or

b)    it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(collectively referred to as the "positive limbs")

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

a)    it is a loss or outgoing of capital, or of a capital nature; or

b)    it is a loss or outgoing of a private or domestic nature; or

c)    it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

d)    a provision of this Act prevents you from deducting it.

(collectively referred to as the "negative limbs")

Negative limb in section 8-1 and case law principles

Of the four negative limbs in subsection 8-1(2), the relevant limb is whether the loss or outgoing is capital, or of a capital nature (paragraph 8-1(2)(a)).

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.

Whether expenditure is of a capital or revenue nature is also explained in the following passage from Dixon J in Sun Newspapers:

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.

In relation to franchise renewal fees, the considerations for the determination of the characterisation are explained in Inglewood & Districts Community Enterprises Ltd v FC of T (2011) AATA 607: (2011) ATC 10-202: 84 ATR 688 (Inglewood & Districts Community Enterprises Ltd).

In Inglewood & Districts Community Enterprises Ltd, the Tribunal applied the Sun Newspaper principles having regard to more contemporary authority. The Tribunal stated:

More contemporary authority, however, is to the effect that payments for the use of or the right to conduct business operations in periods commensurate with the obligation to make payment should...be seen to be periodical and recurrent and thus a cost of conducting the business operations rather than a cost of acquiring a profit-making enterprise and lack of permanent ownership of any enduring asset has a role to play in characterising these payments.

Applying these principles to the present circumstances, the Renewal Fees might be seen as an affair of capital by reference to some benchmarks, and as an affair on revenue account by reference to others.

The first consideration under the Sun Newspapers principles is the character of the advantage sought, incorporating the length of the period for which the rights under the Franchise Agreement were secured upon the renewal, namely five years. The authorities suggest that payments to secure rights that could be enjoyed for five year periods have been regarded as referrable to periods sufficiently short to be characterised as on revenue account. Contracts for periods of two and three years have been described as... not lasting assets... of a relatively short term nature and subject to renewal, even if it is assumed that the relevant contract is the only contract that produced income.

The second consideration under the Sun Newspapers principles is the manner in which the advantage is to be enjoyed. The exclusivity provisions in the Franchise Agreement have the effect that the community bank styled business was, and upon renewal will be, the applicant's only relevant business activity. In these circumstances, the manner in which the Franchise Agreement is enjoyed would be as an important, if not fundamental, element of the structure of the business rather than a contract made in the course of carrying on the business. Absent a renewal (in reality, an extension of the term), the applicant would not have its business at all. This suggests that the renewal of the Franchise Agreement is a renewal of the structure of the business.

Given that five years is considered to be a relatively short period for the purposes of the character of the advantage sought test, and that at the end of the five years the applicant would have nothing, and any renewal will involve recurrence of outgoings, it follows that the Renewal Fees would not be on capital account. Accordingly, these fees will be eligible to be deducted over the life of the service period pursuant to Subdivision H of Division 3 of Part III of the 1936 Assessment Act, on the basis that it would be otherwise deductible under s 8-1 of the 1997 Assessment Act.

Accordingly, it is important to identify the profit yielding structure of the business and to distinguish it from the process of operating the profit yielding structure. Further, it is important to consider the character of the expenditure based on the above factors and principles.

Franchisees' business and profit yielding structure

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

In the present case, the franchisees will utilise the franchise granted by the franchisor and the licence to use the IP owned by the franchisor's associate to operate the franchised business in accordance with the terms and conditions of the proposed franchise agreement. The franchisees will generate income primarily from providing services to their customers under the franchise model, earning gross income on the services provided and incurring expenditures in providing the services.

The franchisees' profit yielding structure relies on the grant of the franchise of the franchisor and the right to use the IP of the franchisor's associate so that they will be able to conduct the franchised business for the term of the franchise agreement, which is five years.

At the end of the five-year term, the franchisees will have the option to pay the renewal fee to renew the franchise for another five years in the manner provided in the relevant clause of the franchise agreement. The option to renew the franchise agreement can be exercised multiple times.

Accordingly, payment of the renewal fee will allow the franchisees to extend or continue their profit yielding structure under the franchise model for another five years and failing to renew may result in the cessation of the franchised business. Further, penalty being the realisation fee will apply if the franchisees continue to operate a business that is the same as or substantially similar to the franchised business without an effective renewal.

Character of the advantage sought

Having regard to the character of the advantage sought, payment of the renewal fee is necessary and essential for the franchisees to secure their rights to continue the operation of the franchised business with the franchise and the licence being granted to them for a period of five years.

Applying the principles of Inglewood & Districts Community Enterprises Ltd, five years is considered to be a relatively short period for the purposes of the character of the advantage sought test. As such, this factor supports the renewal fee being on revenue account.

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

From the above analysis it is evident that the franchisees, upon renewal of the franchise agreement, will continue to hold the rights to operate the franchised business for a period of five years. Absent a payment of the renewal fee, the franchisees would be left with no rights to operate the franchised business. The franchisee may continue to operate a business that is the same as or substantially similar to the franchised business without renewal however doing so would result in a penalty being imposed on the franchisee under the relevant clause of the franchise agreement.

It can be concluded that the manner in which the expenditure is to be used or enjoyed is an extension of the existing franchised business operation for another five years and to avoid the penalty that may otherwise apply.

Considering the principles in Inglewood & Districts Community Enterprises Ltd, this factorsupports the renewal fee being on revenue account.

The means adopted to obtain it

This 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.

In the circumstances of the present case, the renewal fee is not a one-off payment, as the franchisees will have the option to renew the term of the franchise agreement more than once and each renewal will involve a recurrence of the expenditure.

Therefore, this factor adds weight to the conclusion that the renewal fee is revenue in nature.

Conclusion

For the reasons outlined above, it is considered that the renewal fee specified in the proposed franchise agreement is deductible to the franchisees pursuant section 8-1 of the ITAA 1997 on the basis that:

•         the renewal fee is necessarily incurred in the operation of the franchisees' business for the purpose of gaining or producing assessable income, and

•         the renewal fee is not capital, private or domestic in nature.

However, the timing of deduction for the renewal fee is subject to the prepayment rules contained in Subdivision H of Division 3 of Part III of the ITAA 1936, on the basis that it would be otherwise deductible under section 8-1 of the ITAA 1997.

Question 2

Summary

Not applicable.

Question 3

Summary

The franchise fees specified in the proposed franchise agreement are deductible to the franchisees pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

In the present case, the franchise fees are payable by the franchisees for the utilisation of the IP and systems owned by the franchisor that are granted to the franchisees in their conduct of the franchised business under the proposed franchise agreement. The amounts of the franchise fees will be calculated as a percentage of gross income in respect of franchised business, subject to a cap.

In applying section 8-1 of the ITAA 1997:

•         the franchise fees are necessarily incurred by the franchisees in carrying on the franchised business for the purpose of gaining or producing their assessable income

•         the franchise fees are revenue in nature as they are recurring costs for assets and services necessarily used in the day-to-day operation of the franchised business, and

•         none of the negative limbs apply to the franchise fees on the basis that the amounts are at market rates.

Therefore, the franchise fees are deductible to the franchisees under section 8-1 of the ITAA 1997.

Question 4

Summary

The licence fees specified in the proposed franchise agreement are deductible to the franchisees pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

The licence fees are payable by the franchisees monthly in arrears for the utilisation of the IP owned by the franchisor's associate that is granted to the franchisees in their conduct of the franchised business under the franchise agreement. The amounts of the licence fees will be calculated as a percentage of gross income in respect of certain aspect of the franchised business.

In applying section 8-1 of the ITAA 1997:

•         the licence fees are necessarily incurred by the franchisees in carrying on the franchised business for the purpose of gaining or producing their assessable income

•         the licence fees are revenue in nature as they are recurring costs for assets and services necessarily used in the day-to-day operation of the franchised business, and

•         none of the negative limbs apply to the licence fees on the basis that the amounts are at market rates.

Therefore, the licence fees are deductible to the franchisees under section 8-1 of the ITAA 1997.

Question 5

Summary

The settlement fees specified in the proposed franchise agreement are deductible to the franchisees pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

The settlement fees are payable by the franchisees on certain sale contracts. The amount of the settlement fees will be a fixed amount for each sale contract upon such contract achieving settlement.

In applying section 8-1 of the ITAA 1997:

•         the settlement fees are necessarily incurred by the franchisees in carrying on the franchised business for the purpose of gaining or producing their assessable income

•         the settlement fees are revenue in nature as they are recurring costs associated with the conduct of the franchised business, and

•         none of the negative limbs apply to the settlement fees on the basis that the amounts are at market rates.

Therefore, the settlement fees are deductible to the franchisees under section 8-1 of the ITAA 1997.

Question 6

Summary

The system subscriptions specified in the proposed franchise agreement are deductible to the franchisees pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

The system subscriptions are payable by the franchisees on a monthly basis in consideration of the franchisor making available to the franchisees the franchisor's IT systems for the franchised business. The amount of the system subscriptions will be fixed amounts determined based on the number of users and the related business activities.

In applying section 8-1 of the ITAA 1997:

•         the system subscriptions are necessarily incurred by the franchisees in carrying on the franchised business for the purpose of gaining or producing their assessable income,

•         the system subscriptions are revenue in nature as they are recurring costs associated with the conduct of the franchised business, and

•         none of the negative limbs apply to the system subscriptions on the basis that the amounts are at market rates.

Therefore, the system subscriptions are deductible to the franchisees under section 8-1 of the ITAA 1997.