Tax implications of franchises
Written by Ray Coman
A franchise is a right to carry out certain commercial activities. Usually the franchisee pays the franchisor to be granted use of trademarks, branding, processes and knowledge. The franchise agreement allows for the transfer of these intangible assets. It is usually paid for through an initial lump sum followed by periodic, say, monthly fees.
The right to use the company’s name and branding is usually covered by an initial lump sum. The initial payment can also cover training and basic resources required to operate as a franchisee such as stock and merchandise. The ongoing service fee is typically either a set amount fixed in advance or a percentage of sales. Pitfalls in planning could result in the franchisee not obtaining as much tax relief as is available. Specifically, the valuation of components of a franchise contract should be interpreted so as to bring tax benefits as soon as possible.
A franchise will usually include intangible assets. Examples of an intangible assets include a customer base, design rights, patented ideas and trademarks.
The difference between what is paid for the franchise and the net assets is described as goodwill. Goodwill is also an intangible asset. Often it is not possible to separate out the exact value of goodwill where there is not a ready market for the other intangible assets. However, an attempted valuation of the different elements of the intangibles can bring tax benefits as explained below.
The upfront payment usually covers the cost of intangibles. An intangible asset is not deducted, in full, from profits in year one but added to the balance sheet and deducted over several accounting periods. This deduction is known as amortisation. Amortisation is only possible for companies and therefore franchises are not advisable for unincorporated businesses. The amortisation depends on the type of intangible asset.
The following intangibles, (described in S879A (2) of the CTA2009 as relevant assets) are amortised at 6.5%:
- Goodwill as explained above
- Customer base or potential customer base
- Unregistered trademarks.
Any license of the above relevant assets is also amortised at 6.5%. Therefore, goodwill, as part of a franchise will generally get tax relief slower than other components of the payment.
Intangible assets that do not fall into the above category are amortised over their useful economic life. Estimating the useful life of something intangible is highly subjective. Fortunately however, in a franchise agreement, the life of an asset is the license term of the contract. Amortisation period matches that of the contract. Straight line is the conventional method of write off.
Any part of the franchise cost which is not intangible can obtain immediate tax relief. This is expanded up on in the section on tax planning.
A realisation occurs when an intangible asset is disposed of. In a franchise, this will occur either when the franchise ends or, if sooner, when the franchisee ends the business or sells it on.
The tax treatment mirrors that of the capital allowance regime for tangible assets. The difference between amortised cost and proceeds is recognised as either a taxable credit or debit.
If the franchisee keeps the business going until expiry of the contract, the amortised value of the intangible will be nil and no further tax adjustment is required. By contrast, if the franchisee sells the business on and the value of the intangible assets has appreciated there could be a taxable credit to account for. For any element of goodwill, unless the business has been going for longer than 15 years, there will likely be some additional write off when the business is disposed of.
There is no mechanism by which an unincorporated business can deduct the cost of goodwill from profits. Therefore, it will likely to be beneficial to form a company prior to engagement in the franchise in order to obtain tax relief for the purchase of intangible assets.
The lump sum can be paid in instalments so that the deduction from profits chargeable to corporation tax more closely matches cash outflows.
Franchisees are most likely to build up revenue during their initial phase and to that extent an instalment arrangement also eases cash flow strain as the business starts up.
Simply because the initial outlay is paid for in a lump sum does not mean that every element of the lump sum will be intangible asset. Separate the lump sum into elements that can be immediately written off against profits.
Training to acquire a new skill will be capital, whereas training to maintain an existing skill is revenue in nature. In fact, this means that continued professional development can be deducted from profits chargeable to tax, whereas start up training would be amortised. To the extent it can be argued that training is development of a pre-existing expertise, that element of the outlay can be straightaway set against profits.
Any part of the lump sum that includes tangible assets will be taxed according to the capital allowance regime. In practice this usually means that the first £50,000 of computer or other equipment, or office furniture is tax deductible in year one.
Any lease which is part of the initial outlay will be taxed according to the lease agreement.
Stock is written off against profit when it is sold. At the year end stock is valued at the lower of cost and net realisable value. In practice, tax relief can be obtained on any stock which is worth less than it was acquired for.
Expendable items such as office supplies and merchandise are deducted from profits chargeable to corporation tax.
To separate elements of the lump sum for tax purposes, the franchise agreement should clearly identify the items to which each part of the payment relates.
Capital costs are on assets which tend to be used over several years. By contrast, revenue costs relate to a specific transaction. Sometimes a franchise requires a monthly or yearly fee in addition to an upfront payment. There is a convention that ongoing fees are revenue in nature. This means that franchise fees that are paid each month, or each year, can be deducted for profits chargeable to tax when those costs are incurred. Theoretically, the fees could relate to an intangible asset, but HMRC have indicated that it is acceptable to treat them as revenue.
If the franchise is VAT registered, VAT is often recoverable on all aspects of the lump sum, including those identified as intangible.
The franchise agreement should be specific about the length of the contract to enable a unambiguous method for writing off the cost of intangible assets.
Exit terms should be clearly stated so that the tax implications of realisation can be considered in advance.