3/28/2003 - FRANCHISE TAX
TAX CONSIDERATIONS IN FRANCHISING
by Aki Chencinski, C.A.
The Canadian tax consequences surrounding franchising in Canada may be both complicated and extensive. These consequences are different for the franchisor and the franchisee. Further, there are additional considerations if either the franchisor or franchisee is a non-resident of Canada.
In the limited space available, this chapter will primarily examine the tax treatment of franchise fee arrangements, for both franchisor and franchisee, whether a resident or non- resident of Canada. There are of course a myriad of other tax issues applicable to the franchise arrangement that generally may relate to any business. These may include any of the following.
• What is an appropriate structure to carry on the business? Choices include a corporation, a partnership, a joint venture, a proprietorship, or a hybrid structure such as a LLC. Non-residents will need to consider branch tax and withholding tax implications of the chosen structure.
• How should the business be capitalized? If borrowings are involved, what arrangement best maximizes interest deductibility and minimizes cost of repatriation?
• The classification of various expenditures, as either deductible or to be capitalized, including various start-up costs.
• The utilization of losses incurred in a business. Generally business losses may be carried back three years and carried forward seven years to be applied against income in those years.
• The definition and treatment of capital assets. Currently gains and losses on capital assets are half taxable. Capital losses, however, can only be applied against capital gains in the current year and, if unused, carried back three years or forward indefinitely, but only against capital gains.
• Provincial income tax issues. Ontario and Quebec maintain their own tax filing system. In many respects, these provincial systems follow the federal rules, but both have some significant departures from the federal rules. The other provinces collect their tax through the federal system.
• The implications of selling the franchise business, either the franchisor selling the entire business, or a franchisee selling its business, if permitted. There are different implications when shares of a company are sold, compared to the sale of the underlying assets of a company.
• Federal and provincial capital tax imposed on corporations. Capital includes accumulated earnings, share capital, contributed surplus, and loans and advances, whether from third parties or from shareholders and related parties. The federal system (at $10,000,000) and the provincial systems (at various amounts) provide a threshold under which no capital tax is payable.
• Sales tax issues. With some limited exceptions, all commercial activity in Canada is subject to a value added tax. This tax, the Goods and Services Tax (“GST”) is applicable to all jurisdictions in Canada except Nova Scotia, Newfoundland and New Brunswick. In these provinces, a Harmonized Sales Tax (“HST”) is imposed. The GST rate is 7% and the HST rate is 15%. The HST combines the GST and the provincial sales tax for the province. The GST and HST are flow-through taxes so that only the end user actually bears the cost of the tax. All non-HST provinces except Alberta impose their own retail sales tax.
The preceding, as well as many other issues, requires consideration before embarking on a new franchise arrangement. The remainder of our comments will be directed to the treatment of the various fees usually found in a franchise arrangement.
FRANCHISE AND SIMILAR FEES
The taxation of amounts received by a franchisor will depend on the nature of the receipt, generally as outlined in the franchise agreement. A franchisor may receive franchise fees, either as a lump sum, on a periodic basis or both. It may also be entitled to receive amounts as management fees, rents, and royalties or for the sale of goods. Virtually all these sources of revenue are taxed as income on an accrual basis, as earned, whether received or receivable. Generally, lump sum payments received by a franchisor are fully taxable where the franchisor is in the business of selling franchises. In some (rare) cases, the sale of a franchise might be considered as a capital transaction and taxable as a capital gain (at 50%) or as something known as eligible capital expenditure (at 50% subject to certain other considerations). This more favorable treatment might be available when an existing business sells it first franchise, similar to the sale of a business.
As well, all amounts received, even if for goods to be delivered or services to be rendered are taxable upon receipt. A reasonable reserve for amounts relating to goods or services to be delivered or rendered after the year-end may be claimed.
Payments made by a franchisee under an agreement may take a number of different forms. These can include the purchase of goods, management fees, advertising and other promotional expenses, rents and royalties. If these types of payments are not otherwise disguised fees for the purchase of the franchise rights, then they should all be deductible by the franchisee in the course of carrying on business. As with the franchisor, all such expenditures are reported on an accrual basis, when incurred.
Payments on account of the acquisition of the franchise by the franchisee, whether as a lump sum or by way of periodic payments, are treated differently for tax purposes. In the case of those franchise arrangements with a limited and ascertainable life, the expenditure is considered depreciable capital property (class 14). CCA (tax depreciation) may be claimed against income in the year. The maximum CCA that may be claimed is generally the prorata straight-line amortization of the franchise term. This calculation is done on a per diem basis. As an example, if a two-year franchise right was acquired on December 1, by a company with a December year end, CCA would be calculated as 31 (days) divided by 730 (365 times 2) times the cost of the franchise rights.
In the case of the costs associated with franchise rights with an indefinite life, the expenditure is considered to be an eligible capital expenditure (“ECE”). In many respects, an ECE is treated similar to the class 14 treatment of a definite life franchise, except that only one half of the expenditure is added to the ECE “pool” and the balance in the pool may be amortized at the rate of 7% on a declining balance basis. Whether a franchise right is of a limited life or not is not always as straightforward as one might think. The nature of renewal and termination provisions may have some determining influence on this issue.
Note that whether treated as depreciable capital property or as an ECE, the franchisee may only amortize the costs associated with the acquisition of the franchise, notwithstanding that in almost all cases, the amounts are fully taxable as income to the franchisor.
Although non-resident issues may be relevant for either the franchisor or the franchisee, our limited comments are directed to a resident franchisee paying amounts to a non-resident franchisor. Perhaps the two principal tax issues for a non-resident franchisor are withholding taxes on payments to the non-resident and choosing the most appropriate structure for carrying on business in Canada.
The Canadian Income Tax Act requires a 25% withholding tax on payments of certain amounts to non-residents. This may include a management or administration fee, and rents, royalties or other similar payments. Generally this withholding rate is reduced in most tax treaties. For example, the Canada-U.S. treaty only requires a 10% or 15% withholding on most amounts. The responsibility for withholding rests with the payor (franchisee). If appropriate amounts are not withheld or remitted, the franchisee will be held responsible.
The non-resident franchisor may conduct business in Canada directly through a branch and would be subject to Canadian income tax on income “earned” in Canada. The branch should not be subject to withholding tax on payments received from the franchisee. The Canadian franchisee should apply to have its withholding obligations waived under these circumstances.
The non-resident franchisor operating as a branch will be subject to income tax at the top
corporate tax rate. There are many issues in dealing with the determination of branch profits. In addition, it will be subject to branch tax of 25% on net withdrawals from the branch.
An alternative arrangement would have the non-resident conduct its business in Canada through a Canadian corporation. The franchisee may pay the various fees to a resident corporation without any withholding tax. The Canadian corporation will need to ensure transfer pricing on goods and services between it and its foreign parent meet an arm’s length standard in order to avoid adverse tax adjustments.
As indicated, the space provided does not permit a more detailed review of tax issues associated with franchising. The treatment of franchise and other similar fees, as well as most of the issues raised earlier must be carefully considered when embarking on a new franchise arrangement, so that no unintended result occurs. Among other things, when the franchise agreement is prepared, close attention should be given to the tax consequences to both sides of the franchise equation.
© 2003, Aki Chencinski