Double whammy for franchises

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Anjlika Chopra is Director, Deloitte Touche Tohmatsu India Pvt Ltd
Anjlika Chopra is Director, Deloitte Touche Tohmatsu India Pvt Ltd

Franchising is a prevalent business model whereby the brand owner (or franchisor) provides representational rights to the buyer (or franchisee) for a consideration. This consideration is usually bifurcated into a one-time upfront franchise fee and royalty (calculated periodically on the basis of sales). The brand usage is restricted to an agreed timeframe, at the discretion of the franchisor. We have several familiar examples of this business model ranging from restaurants, schools and hospitals to fitness centres and commercial training and coaching centres.

However, little does a consumer realise that the price of any commodity or service includes two tax components — service tax and value added tax. Legislatively, these levies operate at levels — Central and State. Double taxation appears to originate from differences in the understanding of the various authorities involved.

A typical franchise arrangement is not restricted to the transfer of a brand or intellectual property alone. Rather, it is an entire bunch of guidelines and processes to be followed — ranging from specifications for the ingredients to the detailed operations manual, location of the site, marketing strategy, training, and others — in order to ensure that the franchisee conforms to the quality norms and specifications of the franchisor.

From a service tax perspective, under a franchise arrangement the franchisee is granted a representational right to sell or manufacture goods, or provide services, or undertake any process identified with the franchisor, whether or not a trademark, service mark, trade name or logo or any such symbol is involved.

Thus, the scope has been very wide, to bring within the service tax net any service involving transfer of representational right. With the ‘negative list’ approach, the service tax boundaries appear even more stretched.

The 46th amendment to the Constitution introduced Clause 29A in Article 366, to levy VAT on the transfer of the right to use any goods for any purpose (whether or not for a specified period) for cash, deferred payment or other valuable consideration.

Consequently, the States assumed the powers to levy VAT on such deemed sales transactions and, correspondingly, amended the respective State legislations to incorporate entries for intangible goods such as copyright, patent and goodwill.

Subsequently a series of franchise transactions involving temporary or permanent transfer of trademark and/or brand name were held liable for VAT.

The moot question now is whether a franchise transaction should be subjected to service tax, VAT, or both. While the dominant intention of the contract theory is a major parameter, its applicability is losing ground due to conflicting decisions by various courts. Even after the Apex Court categorically held that State authorities cannot levy VAT on the service element of the sales transactions, lawmakers and assessees continue to struggle with the ambiguous taxation mechanism.

Where does this leave us? The franchisors insist that what is being transferred are wholesome services (with the brand and trademark being merely an incidental part of the entire package). However, if recent trends in the industry are anything to go by, VAT authorities have turned around the core intent of the franchise arrangements. Thus, lawmakers urgently need to revisit the Constitution and clear the air on the issue of double taxation. Perhaps the solution lies in the Goods and Services Tax, or GST?

There are conflicting rules on whether a franchise is subject is to sales tax, VAT, or both. The negative list has not helped either.

(This article was published in the Business Line print edition dated August 20, 2012)
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