Payments from the franchisee to the franchisor generally include: - an initial franchise fee - franchise renewal fees - franchise service fees or royalties - advertising fees - training fees. Such payments can be deducted against income earned if it is in the production of income and not of a capital nature (Section 11(1)(a) of the Income Tax Act). Payments that are of a capital nature can not be deducted for income tax purposes, but it is important to keep good records of capital expenses, as it will become relevant in determining the capital gains tax implications of a resale of the franchise. Capital or Revenue? Payments that form part of the cost base for the franchise business, for example expenses related to the establishment of a business and initial training, are of a capital nature and can not be deducted as an expense against income. In the High Court case of Seeff Properties cc v CIR (60 SATC 407) , for example, the court held that a payment for early cancellation of a franchise agreement was expenditure of a capital nature since the payment related to the acquisition of an income-producing asset, rather than being part of the cost of performing the taxpayer's income earning operations. In CSARS v Kajadas Cosmetics (Pty) Ltd (64 SATC 200), the court held that an annual licence fee to acquire the exclusive distribution right of a product for a lengthy period over a vast area was a capital expense. Such payments are regarded as related to the establishment of a business and the court found that the exclusive distribution rights formed part of the company's income earning machine and as the licence fee was more closely related to the company's income earning machinery than to its income earning operations, it was of a capital nature. The importance of establishing the true nature of payments made to the franchisor is illustrated in Tax Court Case No 1738 (65 SATC 37), where it was found that the initial fee paid by franchisees were not of a capital nature. In terms of the franchise agreement in this case, the initial fee was "a one-time entry charge payable in return for the grant to the Franchisee of the right to use the Identifications and Know-how". The agreement also made it clear that the ownership of the Identifications and Know-how at all times belong to the franchisor and is not transferred to the franchisee. The gross income definition in the Income Tax Act specifically provides that any amounts received for the right to use a trade mark (par g) and for know-how (par gA) are included in taxable income. Recurring payments of royalties or levies for the use of intellectual property, head office expenses such as administration, advertising and technical support, are of a revenue nature and can be deducted against the annual income of the franchisee for income tax purposes. Such fees form part of the recipient's gross income and are therefore subject to income tax in the franchisor's hands. 
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The supreme court confirmed this principle in 2007 when it overturned a well-publicised High Court judgement against BP. (BP Southern Africa (Pty) Ltd v CSARS [69 SATC 79]) In this case the payments were made on a regular annual basis and BP SA did not acquire ownership of or any enduring right to the trademarks but merely paid for their use. BP SA's parent company remained the sole rightful owner of the licensed marks, and all rights and goodwill attaching or arising out of their use accrued to the benefit of the parent company. Upon termination of the license agreement, BP SA would no longer be entitled to use the name "BP" or any of the licensed property. The court held that the annual licence fees that BP paid its parent company were deductible under section 11(a) as a revenue expense, because it was incurred in the course of a trade, was related to the running of the business and produced no enduring benefit beyond the end of the year. It is therefore crucial to pay attention to the way in which payments are defined in the franchise agreement, as this will influence the tax treatment thereof. A franchise fee may represent expenses of both a capital and revenue nature and the distinction should be made clear in the way the agreements are worded. Section 11(f) Section 11(f) of the Income Tax Act provides that a premium or like payment for the use of patents, designs, trade marks, copyrights or similar assets in the course of a trade is deductible for income tax purposes if the payment is to a South African resident. In the case mentioned above, BP SA argued that if the licence fees were not deductible in terms of section 11(a), they would be deductible under section 11(f) even if they were capital in nature. The court did not comment on this argument, so it is still unclear whether section 11(f) deductions can include amounts of a capital nature. Section 11(gD) Section 11(gD) of the Income Tax Act allows for a deduction of the cost of a licence if it is purchased from the Government, a provincial administration or municipality and if it relates to gambling, telecommunications, or the production or distribution of petroleum. Section 23I Section 23I of the Income Tax Act is an anti-avoidance provision aimed at disallowing a deduction for royalties paid on intellectual property that was at some stage owned or developed by the person paying the royalties (or any of its connected persons), if the royalties received is not taxable in South Africa as well. Withholding tax Franchise fees (royalties) paid to non-resident franchisors are subject to withholding tax. It is the responsibility of the franchisee to calculate and pay the withholding tax over to SARS. The rate of the withholding tax depends on the relevant double taxation agreement between South Africa and the country in which the franchisor is a tax resident. Copyright © 2009 Esmari van de Vyver |
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