The taxation of marketing fees earned by franchisors in terms of franchise agreements
The growing franchise industry in South Africa is a major contributor to the South African economy. There are various tax implications that arise in relation to franchise arrangements and it is important to consider the tax treatment of the various types income received and expenditure incurred by both franchisors and franchisees. There may be differing tax treatment attached to the various categories of expenditure and income catered for in a franchise agreement (e.g. initial fees, franchise renewal fees, royalties, marketing fees, cancellation fees, etc). The tax implications of these types of payments need to be borne in mind, taking into account the specific terms of the franchise agreement, noting that each case may turn on its own facts and circumstances.
In many franchise operations, the franchisor undertakes to manage a marketing or advertising fund and the franchisee is then required to make a contribution to the fund. The fund is then used to fund marketing and advertising campaigns in promotion of the franchise chain as a whole or a particular branch. In certain instances, the fees may also be used to reimburse the franchisor for the costs of administering the marketing or advertising fund.
Franchisees may seek to argue that the marketing fees as outlined above are in the nature of a trust fund (such amounts being held on behalf of the franchisees) and should be treated as such. Such marketing fees should generally constitute a deductible expense in the hands of the franchisee. Practically, the franchisee would typically be concerned about the discretion of the franchisor in determining how the marketing funds should be used. If the marketing fund is a trust fund, a franchisee would in theory have a right to object to such funds being used for a purpose that the franchisee does not approve of. If the fund is an asset of the franchisor, the franchisor has the discretion to use the funds as it deems appropriate for marketing purposes of the brand, subject to its obligations in terms of the consumer protection legislation.
Legal and tax implications aside however, the marketing fund is not in the nature of a trust fund (akin to an attorney’s trust fund, for example) and the franchisees’ contributions become the income of the franchisor once these amounts are paid into the marketing fund account of the franchisor. So, in terms of South Africa’s consumer protection legislation, whilst these amounts may be required to be paid into a separate marketing fund account and the franchisor is contractually obliged to report and account to the franchisees for the manner in which the marketing fund is used, the marketing fund is not a trust fund and it should not be argued that these amounts are in fact the franchisees’ monies held on behalf of the franchisees.
Whilst the franchisor may be obliged under an agreement with the franchisees to spend the marketing fees received by the franchisor on marketing and promoting the franchise business and its brand, such fees will nevertheless be deemed to have been received by and accruing to the franchisor. Such amounts would accordingly constitute ‘gross income’ in its hands and will be taxable in the franchisor’s hands. The franchisor should be entitled to a tax deduction of any expenditure incurred by it on marketing or promoting the franchise, assuming all the tests of deduction of expenditure are met.