In franchising, a franchisor will provide a franchisee with access to a tried and trusted (and branded) system for running a business together with training, centralised marketing and other ancillary services. The main income streams for a franchisor should be clearly set out in the franchise agreement and will include one or more of the following:
- Initial fee
- On-going royalty payments
- Marketing levy
- Mark up on the products.
If it is not, a franchisor will find that it is not entitled to these payments. Each is treated differently for tax purposes. In this blog we will first look at each of these payments and then discuss how they are treated for taxation.
Franchise Fees And Tax
Initial Fees
The initial fee includes a payment for use of the franchisor’s brand and start-up costs to help the franchisee set up in business. Such costs often include training costs, stock and equipment, site selection (if property is required) and fixtures and fittings. This fee should not contain a profit element, which will largely come from the on-going royalty payments made by a franchisee.
The initial fee will vary depending on a number of factors, including the strength of the brand, earning potential, training to be offered and the size of the potential business. Clearly a hotel or restaurant will require much greater investment than a personal services franchise teaching maths to children. Hence there is considerable variation both within and across the range of initial fee.
It is not uncommon for a franchisor to offer a franchisee some assistance with regards to the payment of the initial fee, for instance by agreeing to accept payments by instalment during the early part of the term.
On-going Royalty Payments
Once the business is up and running, franchisees make on-going payments to the franchisor, which is often expressed as a fixed percentage of turnover and/or from the cost of the goods supplied for sale.
The average on-going (royalty) fee is 11.7% of the franchisee’s turnover and is paid on a monthly basis. In some cases this can be a fixed amount. Where a franchisor also charges a mark-up on the products to be sold in the franchisee’s business, the royalty fee should be discounted to take that into account.
Marketing Levy
A marketing levy, which averages at around 2% of turnover, is also collected from franchisees and will be used by a franchisor in its national marketing initiatives. The agreement should provide that the marketing fund be kept in a separate account and for it to be subject to audit.
Is A Franchise Fee Tax Deductible?
The taxation treatment of the initial fee will vary between the franchisee and the franchisor. The franchisor will be taxed on the initial fee as income but will be able to offset the costs incurred in the provision of training, equipment, fixtures and fittings and so on.
The franchisee will be treated as having acquired a combination of an intangible asset, tangible assets and potentially some revenue items. This split will depend on the terms of the agreement and the facts of the case. Where it can be demonstrated that part of the initial fee relates to training or other revenue items then a deduction is allowed for that expense.
The costs related to acquiring equipment and fixtures may qualify for tax relief but this is spread over a number of years depending on the type of equipment acquired, although currently expenditure on equipment can be deducted in full up to a certain limit each year.
The intangible assets acquired will include, amongst others, the right to use the brand name and some know how, and the costs for acquiring these will be allowed over the term of the franchise agreement or potentially a longer period.
The tax treatment of the on-going fees will be similar for the franchisor and franchisee, as they will be taxed or allowed in the period in which they are incurred.
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