This chapter looks at tax issues relating to franchising. Specifically, it focuses on the tax rules that commonly apply to franchising arrangements, the tax parameters under which franchising operations should be structured, the tax structuring options to consider and the anti-avoidance rules, which are increasingly focused on international tax structuring. In this respect the main rules to be considered are those concerning the tax treatment of trading transactions and intellectual property (IP), as these are at the heart of any franchising arrangement.
In looking at these tax rules, we consider corporate franchisors and franchisees – partly for the sake of brevity and partly because (as far as franchisors are concerned) these are the entities most commonly involved in franchising arrangements.
We also look in this chapter at the rules from a UK perspective. While many of the principles of international taxation can be applied generically in several jurisdictions, tax is by its very nature highly jurisdiction-specific. In looking at the UK rules we hope to highlight those principles while grounding them in a real-life legal framework. This approach will give the reader a broad understanding of the tax principles that apply to any situation while leaving him or her free to take more detailed local advice in any specific circumstance. It should be noted, however, that on 23 June 2016 the United Kingdom voted to leave the European Union (EU). The United Kingdom reached agreement with the EU regarding the terms of the United Kingdom's withdrawal from the EU during January 2020, departing the EU on 31 January 2020, and implementing legislation 2 was passed by the UK Parliament giving effect to this agreement (the Withdrawal Agreement). The Withdrawal Agreement, however, provided for a transitional or implementation period during which the United Kingdom would continue to be treated as part of the EU for most purposes, including the EU's single market and customs union, with a view to reaching agreement on a future trading partnership with the EU during this period, based on a non-binding political declaration agreed between the EU and the United Kingdom setting out the framework for their future relationship. This period ends on 31 December 2020 and, at the time of writing, the terms of any future trading relationship with the EU remain uncertain . In spite of this uncertainty, we have, where possible, set out how the withdrawal of the United Kingdom from the EU will affect certain areas discussed in this chapter, in particular access to EU treaties and those UK tax laws that are derived from EU law, such as value added tax (VAT).
Finally, franchisors and franchisees are businesses and as such are concerned with all the tax issues that any business would be. This is not a tax book and we have therefore focused only on those issues that are specific to franchising businesses, namely the tax issues arising from the assets and services that make up the franchising arrangements. While we have in parts mentioned other tax issues that may be relevant, we have only done so in passing.
In broad outline, this chapter will consider the following tax issues in order:
II THE GENERAL FRAMEWORK FOR THE TAXATION OF COMPANIES IN THE United Kingdom
To understand how corporate franchisors and franchisees are taxed in the United Kingdom requires a broad understanding of the UK corporation tax regime – in particular as it applies to IP-based trading entities. We therefore commence with a very broad overview of the relevant UK corporation tax rules before applying these to the franchising context.
The corporation tax regime in the United Kingdom operates to tax companies. A company is defined as any body corporate or unincorporated association but does not include a partnership, a local authority or local authority association. 3 The amount on which corporation tax is chargeable is the sum of income computed under the various charging provisions and chargeable gains computed in accordance with the rules in the Taxation of Chargeable Gains Act 1992 (TCGA).
A company is subject to corporation tax in the United Kingdom:
Companies that are not within the charge to corporation tax can still be subject to income tax on certain UK-sourced income (generally where tax is deducted at source).
Broadly speaking, a company is a resident of the United Kingdom if it is either:
Where a company is resident in both the United Kingdom and elsewhere (e.g., because it is incorporated in the United Kingdom but managed and controlled in another jurisdiction), it is necessary to consider whether there is a tiebreaker clause in the relevant double-taxation treaty. The multilateral instrument (MLI) that implemented Action 6 of the Action Plan on Base Erosion and Profit Shifting (BEPS) project introduced into affected double tax treaties a tie-breaker provision based on a mutual agreement between the relevant tax authorities instead of the previous provision based on the place of 'effective management'.
Subject to certain exemptions for preparatory or auxiliary activities, a company will have a permanent establishment in the United Kingdom if it has a fixed place of business in the United Kingdom through which its business is wholly or partly carried on, or its agent (other than an independent agent acting in the ordinary course of its business) has and habitually exercises in the United Kingdom authority to do business on its behalf. A fixed place of business includes a branch, office, factory, workshop, place of management or a building site. 9 The final report for Action 7 of the BEPS project (see Section V.iv) significantly expanded the Organisation for Economic Co-operation and Development (OECD) definition of permanent establishment to include situations in which the agent plays the principal role leading to the conclusion of contracts that are routinely concluded without modification, whether the contracts are in the name of the enterprise or for supplies of goods, rights, property or services by the enterprise. Although the United Kingdom has decided against amending its domestic definition of permanent establishment to reflect Action 7, the new OECD definition has been adopted in certain jurisdictions and thus has an impact on the overseas operations of UK companies.
i Profits chargeable to corporation tax
Corporation tax applies to profits of a company. The term profit is defined as income and chargeable gains except insofar as the context otherwise requires 10 and is as adjusted for tax purposes. In the case of a non-resident company with a permanent establishment in the United Kingdom, its chargeable profits will be profits from its trading income arising directly or indirectly through, or income from property or rights used or held by or for, the permanent establishment and chargeable gains subject to corporation tax. 11 However, there is an exemption from tax for most dividends or other distributions received from other companies (unless, generally speaking, the dividends or distributions are out of untaxed income).
Under the corporation tax regime, income is classified into different charging provisions, such as:
As profits include chargeable gains, corporation tax applies to chargeable gains rather than capital gains tax 12 (which applies for individuals). Chargeable gains are generally calculated in accordance with the capital gains tax rules. However, the intangible fixed assets regime covers gains from assets included within that regime instead of the chargeable gains rules.
Expenditure that is allowed for tax purposes to reduce profits is determined in accordance with specific charging provisions. So, any disbursement or expense of an income nature wholly and exclusively laid out or expended for the purposes of trade is deductible against profits of that trade for corporation tax purposes in the same manner as for income tax.
Additionally, there are specific rules outside the charging provisions that allow tax deductions against total profits; for example:
The rules on trading income generally take precedence over other charging provisions.
Trading profits
The taxable profits of a trade must be calculated in accordance with generally accepted accounting practice but are subject to any tax adjustments. 13 Therefore, the starting point for determining taxable trading profits is to use the profit before tax as disclosed in the accounts and adjust it for tax.
Some income and expenses may be excluded. For example, depreciation will not be allowed as a deduction for tax purposes, 14 although expenditure 'capitalised' in accounts may be deferred revenue expenditure that could be deducted when amortised under generally accepted accounting principles. For capital expenditure, capital allowances relief may be available. Also, capital receipts are not chargeable to tax as income and should, therefore, not be included in calculating the trading profits unless there is a specific rule to the contrary. 15
What is a 'trade'?
There is no statutory definition for 'trade' provided in the legislation and hence the term is interpreted in accordance with its ordinary meaning. The final report of the Royal Commission on the Taxation of Profits and Income in 1955 summarised the most important considerations in determining whether a taxpayer has engaged in trade (termed 'badges of trade'). The main factors to look at to indicate whether a transaction is trading in nature are as follows: 16
In Ransom (Inspector of Taxes) v. Higgs 17 Lord Reid observed that the term 'trade' is used to 'denote operations of a commercial character by which the trader provides to customers for reward some kind of goods or services'.
Relief for trading expenditure
Expenditure is deductible against trading profits for tax purposes if it is of an income nature and incurred wholly and exclusively for the purposes of trade. 18 If expenditure is incurred for more than one reason, one of which is a non-business reason, then, an identifiable part of the expense that can be attributed as being wholly and exclusively for the purposes of trade will not be disallowed.
ii Intangible fixed assets regime
The intangible fixed assets regime in Part 8 of the CTA 2009 provides a broad base for taxation of IP and relief in respect of IP expenditure. It is based on the accounting treatment, thereby generally eliminating the need to make capital and income distinctions. The regime generally takes priority for corporation tax purposes against other charging regimes. 19
It applies to intangible fixed assets that are:
It is therefore often referred to as the 'post-April 2002' regime for IP.
Broadly speaking, an intangible asset is regarded as created or acquired on or after 1 April 2002 to the extent that expenditure on its creation or acquisition was incurred on or after that date. 21
If part of the expenditure was incurred prior to and some on or after 1 April 2002, the asset is treated as being two separate assets with apportionment being on a just and reasonable basis. 22 Internally generated goodwill is treated as created before 1 April 2002 if the business was carried on before that date. 23
An intangible fixed asset is 'an intangible asset acquired or created by the company for use on a continuing basis in the course of the company's activities'. 24 The term intangible asset adopts the meaning used in UK generally accepted accounting principles (GAAP). 25
Since 2015, companies have had to adopt the UK GAAP contained in FRS 101 and 102, and since 2016 a small-company regime within FRS 102 applies, although certain 'micro' entities can account under a new simplified accounting standard, FRS 105. FRS 101 is effectively International Financial Reporting Standards (IFRS) with simplified disclosure. FRS 102 is a new regime based upon IFRS for small and medium-sized enterprises (SMEs). Under both FRS 102 and FRS 105, an intangible asset is an identifiable non-monetary asset without physical substance. Such an asset is identifiable when:
Under IFRS, 'intangible assets' are identifiable non-monetary assets without physical substance. Assets are identifiable if they are separable or arise from contractual or other legal rights (regardless of whether those rights are separable from the entity (paragraphs 8 and 12 of International Accounting Standard 38).
Intangible assets include any IP, which means:
The rules also apply to goodwill (which takes its accounting meaning). 26
The regime does not apply to an asset held:
Even though an asset may fall into the definition, there are exclusions such as assets for which plant and machinery capital allowances have previously been made, rights over tangible movable property, rights enjoyed by virtue of an estate, interest or right in or over land, etc.
Royalties and other credits
The post-April 2002 regime treats all royalties and disposal proceeds (credits) as income and treats most costs (debits) on the acquisition and development of intangible fixed assets as expenses on the same basis as for accounting purposes.
Credits can arise as follows:
Debits
Debits are brought into account for tax purposes in respect of expenditure on intangible fixed assets when recognised for accounting purposes. For example, debits can arise:
Alternatively, a company may elect to write down an intangible fixed asset for tax purposes at a fixed 4 per cent per annum instead of the accounting rate of amortisation. An irrevocable election must be made in writing to HM Revenue & Customs (HMRC) within two years of the end of the accounting period in which the asset is created or acquired. 37 The election will take effect with respect to all capitalised expenditure in respect of that asset.
For four years after 2015, it was not possible to obtain a debit for the cost of acquired goodwill or similar IP. However, the Finance Act 2019 reinstated relief for goodwill and customer-related IP acquired on or after 1 April 2019 as part of a business acquisition with eligible IP assets where the goodwill is neither a 'pre-FA 2019 relevant asset' nor acquired as part of a business incorporation.
Where transfers of intangible assets take place between related parties, the transfer is generally treated as taking place at market value, either under Section 845 of the CTA 2009 or under transfer pricing rules.
The manner in which debits and credits are brought into account will depend on the use to which the IP is put. Assets held for the purposes of a trade will give rise to trading credits or debits. Assets held for a property business are taxed as profits or losses of that business. Non-trading assets give rise to a separate head of non-trading profits. If there is a non-trading loss then the taxpayer is entitled to deduct the non-trading loss against total profits of the relevant accounting period, surrender it by group relief or carry it forward to relieve in future periods. 38
iii Pre-April 2002 regime
For IP that is not within the intangible fixed assets regime (see above), the old corporation tax rules continue to apply, which are in many cases equivalent to income tax rules. We refer to these rules as the 'pre-April 2002 regime'.
Under the pre-April 2002 regime for corporation tax, amounts are generally included in or deducted from income to the extent that such items are not capital in nature and amounts are within the chargeable gains rules to the extent that they are capital in nature. So it is crucial to determine whether a receipt or expense is income or capital in nature. The distinction must be interpreted in accordance with the ordinary meaning of the terms by having regard to case law.
A leading authority on this topic, Inland Revenue Commissioners v. John Lewis Properties plc 39 provides the following considerations to determine whether a receipt is income or capital in nature:
The following receipts have been held to be income:
The following receipts have been held to be capital:
Expenditure will be classified as capital if it is incurred with a view to bringing into existence an asset or advantage for the enduring benefit of the trade. 46 For example, a sum paid for the acquisition of a business was held to be capital in nature. 47 In Tucker v. Granada Motorway Services Limited, 48 the House of Lords determined that expenditure incurred for a variation of a lease was capital in nature even though it had no balance sheet value. Having regard to the case law, 49 HMRC offers the following guidance to indicate capital expenditure:
Other specific charging provisions
If a company receives income or gains from IP rights, which do not amount to profits of its trade, then there are a number of specific charging provisions that could catch such receipts.
However, as the intangible fixed asset regime also applies to royalties relating to pre-April 2002 IP, 55 the pre-April 2002 corporation tax regime for intangibles is in almost all circumstances limited to rules relating to capital disposals of such IP and certain specific circumstances, which are excluded from the regime. The general position would be that capital disposals of pre-April 2002 IP should be within the chargeable gains rules. There are, however, some specific rules that override this treatment. We now consider these specific rules.
Disposals of know-how
There are four specific tax rules that could apply to disposals of pre-April 2002 know-how:
In respect of the first rule, receipts from the disposal of know-how in the course of trade 56 are specifically treated as trading income – even if capital in nature – under Section 177 of the CTA 2009 unless brought into account under Section 462 of the CAA 2001. Where the trade is also disposed of, the receipt is treated as a capital payment for goodwill although this may be disapplied by election. 57 The ability to make such an election and the more general trading treatment under Section 177 of the CTA 2009 is disapplied where the transfer is between connected parties.
Profits arising in a year on the disposal of know-how otherwise than in the course of a trade, or for giving or fulfilling an undertaking in connection with such a disposal that restricts any person's activities (whether or not enforceable), are taxed under Sections 908–910 of the CTA 2009. A deduction is allowed for expenditure wholly and exclusively incurred in the acquisition or disposal of know-how (so long as it is only taken into account once). This tax charge does not apply where:
The term 'know-how' for the above tax charges is defined as any industrial information or techniques likely to assist in:
There is also a specific capital allowance regime for know-how (see Section VI). Where such capital allowances have been obtained and the know-how disposed of, then the disposal value on such know-how has to be brought into account under Section 462 of the CAA 2001, in which case it will reduce the capital allowances available in the period or, if the company is liable to a balancing charge, be treated as a receipt of the trade.
Disposals of patent rights
Tax is charged on any non-trading profits from the sale of the whole or part of any patent rights. 59 For non-residents, the tax is charged only on the sale of UK patent rights. The term patent rights means the right to do or authorise the doing of anything that, but for the right, would be an infringement of a patent. 60 Licences are treated as sales. The grantor of a licence is treated as making a part sale unless the licence is exclusive and for the remaining period of the rights, in which case it is treated as the sale of the whole of those rights.
The profit brought into charge is the difference between any capital sums comprised in the proceeds of sale less any deductible costs. 61 The deductible costs are the capital costs of the rights sold (less amounts met by certain other persons – e.g., public bodies) and incidental expenses incurred by the seller in connection with the sale of the patent rights. 62
Under spreading rules, the seller (if UK tax-resident) must spread the profits over six years for tax purposes unless he or she elects to tax it all in the year of receipt. 63 Non-residents selling UK patent rights will be taxed in the year of receipt unless they elect to spread the income over six years. 64 Any such election for income tax purposes must be made on or before the first anniversary of the self-assessment filing date for the year of receipt.
Where non-residents are charged to tax under these rules, the person paying the consideration may have to deduct tax at source.
Capital allowances are available for capital expenditure incurred to acquire patent rights for the purpose of a trade within the charge to UK tax 65 or for patent rights that give rise to UK taxable income. 66 Where there is a disposal of patents for which such allowances have been given, then the disposal value will need to be bought into account for capital allowances purposes (limited to the capital expenditure incurred on the patent). If this gives rise to a balancing charge, it would again be taxed as a receipt of the trade (or potentially non-trading income).
A company will be within the charge to corporation tax on its chargeable gains if it is resident in the United Kingdom, trading in the United Kingdom through a permanent establishment or, from 6 April 2020, carrying on a UK property business. If trading in the United Kingdom through a permanent establishment, corporation tax on chargeable gains will apply to any UK-situated assets used in or for the purposes of the permanent establishment. 67
The rules as to whether an IP asset is a UK asset or a non-UK asset are summarised below: 68
| Asset type | UK asset if: |
|---|---|
| Goodwill | Trade, business or profession carried on in the United Kingdom |
| Patents, trademarks and registered designs | Registered in the United Kingdom |
| Rights or licences to use a patent, trademark or registered design | Rights exercisable in the United Kingdom |
| Copyright, design right, franchises | Rights exercisable in the United Kingdom |
| Rights or licence to use the copyright, work or design in which the design right subsists | Rights exercisable in the United Kingdom |
Capital gains tax (and corporation tax on chargeable gains) applies on a disposal of an asset. 69 Disposals include part disposals 70 as well as situations where capital sums are derived from assets, 71 which includes capital sums received as consideration for use or exploitation of assets and capital sums received for forfeiture, surrender or refraining from exercise of rights. Similarly, the extinction or abrogation of a right or restriction over an asset by the person entitled to enforce it is considered a disposal of such a right or restriction. 72
A chargeable gain or loss is calculated as the proceeds received on disposal (consideration) less the base cost (cost of the asset, expenditure wholly and exclusively incurred for the purpose of enhancing the value of the asset, costs incidental to the acquisition and costs incidental to making the disposal). 73 For a corporate taxpayer, the base cost can be increased by indexation (i.e., the base cost is increased in line with the retail price index) from the date of acquisition until 31 December 2017 (the allowance being frozen from that date). The consideration will be deemed to be the market value (as distinct from the actual amount received) where the transaction is between connected parties or not at arm's length. 74 Gains are not chargeable to corporation tax on chargeable gains if they are subject to tax as income. 75
iv Reorganisations
To allow intra-group transactions to be effected in a tax-neutral manner, there are specific rules that allow assets to be transferred within a UK group without crystallising capital gains tax or a tax charge under the intangible fixed asset rules 76 subject to 'de-grouping charges' if the transferee leaves the group within six years of the date of the transfer. 77 A condition of such transfers is that the transferee is within the scope of corporation tax in respect of the asset after the transfer. 78 The Finance Act 2019 introduced changes to the de-grouping charge, which will no longer apply where a company that owns intangibles leaves a group as part of a share disposal that qualifies for the Substantial Shareholdings Exemption. In these cases, assets that would otherwise have been subject to the charge remain at their written-down value.
To prevent assets being taken out of the UK tax net by migrating companies offshore, there are also charges under capital gains and chargeable intangible asset rules should a company migrate its tax residence offshore, 79 albeit with potential to postpone any charge if the company remains a 75 per cent subsidiary of a UK company. 80 Following ECJ case law 81 and a request from the European Commission to change UK law, the Finance Act 2013 saw an amendment to the migration rules whereby a company can either pay the exit charge in instalments or can pay the tax 10 years after migration or, if earlier, on disposal of the assets.
For chargeable gains assets and for chargeable intangible assets, there are in certain circumstances rules that allow assets to be transferred to companies resident offshore in a tax-neutral manner provided in Section 140, Section 140A, Section 140C, Section 140E and Section 140F of the TCGA and equivalent rules Chapter 11 of Part 8 of the CTA 2009. For example, Section 140 applies to a UK company carrying on a trade outside the United Kingdom through a permanent establishment that transfers the trade for an issue of shares or shares and loan stock whereby it owns after the transaction at least 25 per cent of the transferee's ordinary share capital. Any gain is rolled over into the shares although may still be payable if any of the assets are transferred within six years. The rules in Section 140A to 140F of the TCGA cover situations set out in the EU Merger Directive and EU Tax Merger Directive 82 as well as the European Directive establishing the European Company and European Cooperative Society. These provisions will remain in force after the end of the transition period on 31 December 2020, but the remaining Member States will no longer treat the United Kingdom as a member of the EU, so these provisions will cease to be available to UK companies after the country leaves the EU. The rules on mergers are outside the scope of this chapter, but a franchisor seeking to migrate part of its trade offshore will need to consider whether it could fall within any of these particular rules. It might also consider transferring assets to a foreign permanent establishment, which could be exempt from tax under the exemption in Chapter 3A of the CTA 2009.
III Deduction of tax at source
There are a number of provisions that give rise to deduction of tax at source on IP royalties that could apply to franchising arrangements. Section 906 of the Income Tax Act 2007 (ITA) requires a person who pays a royalty or other sum for the use of IP that is within the charge to income tax or corporation tax to a person whose usual place of abode is outside the United Kingdom (or makes a periodic payment to certain persons who have acquired their rights from such a UK person) to withhold tax at the basic rate and to account for that tax to HMRC.
For this purpose, IP means:
There are exclusions for copyright payments relating to cinematographic films or video recordings, or their soundtracks.
If a payment does not fall within the provisions of Section 906, it may nevertheless give rise to an obligation to deduct tax at source under:
We consider these in more detail below.
i Qualifying annual payments
Qualifying annual payments are subject to deduction of tax under Sections 900 (payments by individuals) and 901 (other payers) ITA. Under Section 899 ITA, a qualifying annual payment must meet the following conditions:
An annual payment is one that is payable under a legal obligation and is capable of recurring over a period of more than 12 months. 83 The amounts must be income receipts, and not a capital receipt, so a capital amount paid in instalments would not constitute an annual payment. The amounts must also be 'pure income profit' in the hands of the recipient. Broadly speaking, pure income profit comes to the recipient without the recipient having to do anything in return. Therefore, payments for goods or services cannot be an annual payment. 84
An individual who makes a qualifying annual payment will only be required to deduct tax if the payment is made for genuine commercial reasons in connection with the individual's trade, profession or vocation. 85 There is no similar test for companies.
In the franchising context, this is unlikely to apply following the changes to the deduction of tax rules enacted in the Finance Act 2016. These changes effectively broadened the definition of royalty, simplifying the withholding tax treatment where payments are being made to a person whose usual place of abode is outside the United Kingdom. Therefore, payments to non-residents will be covered by Section 906 ITA and payments to UK companies will generally be excluded from the obligation to deduct tax (see Section III.iv). The qualifying annual payment withholding tax charge will therefore only apply where the franchisor is a UK unincorporated business.
ii Patent royalties
To the extent that a patent royalty is not a qualifying annual payment and is not covered by Section 904 (annual payments made in consideration of dividends or exempt consideration, which is unlikely to be applicable in the context of franchising), it may be subject to deduction of tax under Section 903 of the ITA. This section applies to a royalty or other sum in respect of the use of a patent, which arises in the United Kingdom and is charged to income tax or corporation tax. Again, following the 2016 changes, this will only apply where the franchisor is a UK unincorporated business.
iii Sales of UK patent rights
If a UK person buys rights in a patent from a non-resident seller that is liable for UK tax in respect of the sale under Section 587 of the ITTOIA 2005 or Section 912 of the CTA 2009, then the purchaser is obliged to deduct basic rate tax from the purchase price and account for this to HMRC. 86 For these purposes 'patent rights' means a right to do or authorise the doing of any thing that, but for the right, would be an infringement of a patent, and thus includes licences. For non-resident sellers the charges only apply to patents granted under UK law.
iv Excepted payments
The above requirements to deduct tax under Sections 901 (qualifying annual payments), 903 (patent royalties), 906 (IP royalties) and 910 (proceeds of sale of patent rights) do not apply where the payer is a company, local authority or partnership (with a corporate or local authority partner) if such a payer has a reasonable belief that the payment is an excepted payment and, in the case of deductions under Sections 901 and 903, the payer itself has no 'modified net income' (calculated under Section 1025 of the ITA) that would be subject to income tax.
Excepted payments include payments where the person beneficially entitled to the income is:
If the payer 'reasonably believes' that an exemption applies it may pay gross, but if that belief proves incorrect, the withholding obligation is re-imposed so the payer is at risk. There is no general mechanism for HMRC to certify that payments may be made gross under these rules.
v Source of royalty
The Finance Act 2016 also introduced rules to define the source of royalties or other sums paid in respect of IP where the payer is non-UK resident but the payment is made in connection partly with a trade carried on by a UK permanent establishment of the payer. Under these new rules, the entity will need to apportion on a just and reasonable basis the proportion of the payment that relates to the trade carried on through the UK permanent establishment.
vi Anti-treaty shopping rules
The 2016 changes also introduced anti-treaty shopping rules. 87 Under these rules, relief will not be available under a double-tax treaty where a payment to a connected person is made under a double-tax treaty tax avoidance arrangement (where obtaining treaty relief is contrary to the object and purpose of the treaty and is the main, or one of the main, purposes of the arrangements) and any tax so deducted is not creditable against corporation tax of a recipient company.
vii EU Interest and Royalties Directive
Council Directive (EC) No. 2003/49 (the Interest and Royalties Directive) introduced a common system of taxation applicable to interest and royalty payments made between associated companies of Member States. These provisions have force in the United Kingdom (ITTOIA, Sections 757–767 and Section 914 of the ITA) and provide an exemption from income tax on royalties where:
Both companies must be 25 per cent associates, that is, one company holds at least 25 per cent of the capital or voting rights in the other or there must be a parent company of both companies that holds such a share in each.
Payment gross is permitted where the payer reasonably believes the exemption applies, but (as for the excepted payments rules) the payer is at risk if that belief is incorrect. As a practical matter, if the payee is an EU company, the payer's risk can be eliminated as the payee company could make a claim under the applicable double-tax treaty that should result in HMRC issuing a payment direction to the payer to apply a reduced or zero rate of withholding (see further below).
Under the terms of the UK–EU Withdrawal Agreement, the United Kingdom ceases to be a Member State of the EU and UK companies receiving payments from associated companies in EU Member States will no longer benefit under the Interest and Royalties Directive. However, UK companies can still rely on Sections 757–767 ITTOIA and Section 914 ITA to eliminate withholding tax on payments of royalties to associated companies in EU Member States. Any change to this arrangement will require a further change to UK domestic law.
viii Double-tax treaties
Royalties paid by a UK resident to a resident of a country with which the United Kingdom has a double-tax treaty (DTT) may be exempt from withholding taxes as a result of the operation of a royalty article of that DTT. Even if the royalty article does not extinguish the withholding tax liability it will normally impose a restriction on the amount that can be deducted. There are, broadly speaking, three main types of tax treaty upon which most are based; these are the OECD Model Tax Convention, the UN Model Tax Convention (usually adopted by developing nations) and the US Model Tax Convention.
In respect of royalties, Article 12 of the OECD Model Tax Convention provides as follows:
A non-resident licensor must, unless Section 911 of the ITA applies (see below), make an application to its own domestic tax authorities claiming relief under the relevant article of the DTT and demonstrating that it fulfils the requirements of that article. Following the BEPS, 82 countries (including the United Kingdom) signed an MLI to amend their DTTs. These changes tackled a number of key action points arising from the BEPS project, one of which is 'treaty shopping, namely putting a company in a jurisdiction to take advantage of its DTT network. Where both parties to a DTT have signed and implemented the MLI, that DTT will now include a 'principal purpose test', which effectively denies treaty benefits where it is 'reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction'. Even without the principal purpose test, if the recipient is a 'conduit' vehicle, it may struggle to satisfy the beneficial ownership requirement following the case of Indofood International Finance Ltd v. JPMorgan Chase Bank NA. 88 This UK case (the principle in which is being applied generally by many tax authorities – although cf. the Canadian cases of Prevost 89 and Velcro 90 ) suggests that the meaning of beneficial ownership in tax treaties is more limited than the legal test and will not apply where a conduit vehicle has back-to-back arrangements to pay on receipts of interest or royalties.
Once satisfied the treaty conditions apply, the non-resident's tax authority will certify to HMRC that the licensor is entitled to relief under the relevant DTT and HMRC will then direct the payer to make future payments at the rate specified under the relevant DTT.
Under Section 911 ITA, a UK company that makes a payment of royalties otherwise subject to deduction of tax may, if it thinks fit, calculate the sum of income tax to be deducted by reference to the rate applicable in the relevant tax treaty (if lower than the UK rate) and make the payment on that basis (that is, without receiving a payment direction from HMRC following a treaty claim). However, the company must reasonably believe that, at the time the payment is made, the payee is entitled to relief in respect of the payment under a relevant tax treaty. As before, the payer is at risk if the payee is not entitled to a reduced rate of withholding under the treaty. However, the payee can make a claim under the treaty that will result in the payer receiving a direction to pay at a reduced rate from HMRC and hence, if there is any doubt, mitigate risk.
ix Offshore receipts
Originally proposed as an extension to royalty withholding tax, new rules enacted by Section 15 of and Schedule 3 to the Finance Act 2019 impose an income tax charge on gross receipts received by a non-UK entity where that entity owns IP used to generate sales revenue in the United Kingdom. Although not technically a withholding tax, the tax (which came into effect on 6 April 2019) is collected through self-assessment from the non-UK resident, but members of the same 'control group' (see below) are jointly and severally liable. The rules have been designed to target multinational groups that hold intangible property in low-tax offshore jurisdictions and use that IP to generate revenue from UK customers or provide sales in the UK. They target groups that realise income from UK sales in low-tax offshore jurisdictions that do not have a full tax treaty with the UK.
There are three exemptions from the income tax charge: where the foreign tax is at least half of the UK tax, where there is business undertaken in the non-UK territory and where the UK sales do not exceed £10 million in the year.
These rules are targeted at multinational groups, but franchisees should be aware that the joint and several liability provisions are widely drawn (Section 608O ITTOIA). If the tax remains unpaid for six months after the payable date, the UK tax authorities can collect that tax from a person in the same control group as the non-UK resident entity at any time in the tax year to which the payment applies. Section 608S ITTOIA provides that two persons will be in the same control group if they are consolidated for accounting purposes, one of them has a 51 per cent investment in the other, or a third person has a 51 per cent investment in each of them.
x Issues relating to royalty payments in the franchising context
A major component in any franchising agreement will be a payment of royalties for use of the brand and other IP licensed to the franchisee. As stated above, a franchisee paying a royalty for use of IP may have to deduct tax at source. The manner in which a deduction will be required will depend on the type of IP and the residence of the payee. In the context of a franchising arrangement, payments are likely to be made to a corporate franchisor that will either be UK tax-resident or non-resident. Payments to UK tax-resident corporate franchisors by UK franchisees should not give rise to any withholding tax issues.
If the payment is to a non-UK tax-resident company by a UK-based franchisee, withholding tax applies to all royalties and other payments in respect of IP. Assuming that the recipient is not trading in the United Kingdom through a permanent establishment, royalties will give rise to an obligation to deduct tax unless the UK rules are overridden by a tax treaty or, assuming there is no specific change of law post-Brexit and there is a sufficient connection, the Interest and Royalties Directive (as implemented into UK law in ITTOIA and ITA).
In any event, the franchisor will be carrying out significant activities under the franchising agreement, including exercising control functions and providing support and assistance services on a recurring basis. The manner in which the franchisor carries out these functions may give rise to a permanent establishment of the franchisor in the United Kingdom. In this event, the payments may be treated as received by such a permanent establishment and therefore as excepted payments.
As the franchisee's obligation to deduct tax at source is heavily dependent on the franchisor's tax status (e.g., whether it has a taxable permanent establishment in the United Kingdom), the franchisee must investigate the treatment of the payments it makes in this respect to ensure that it correctly deducts and accounts for any tax. If the franchisee fails to deduct tax at source, it will still have to account for the tax to HMRC together with interest and penalties. It may, depending on the terms of the agreement, be able to deduct the amount it has failed to deduct at source from future payments, but this is likely to be possible only where there has been a genuine error of fact. 91 Additionally, the franchisee may under the terms of the franchising agreement have a 'gross-up obligation' for any tax deducted on payments. While an agreement to pay royalties without deducting tax under Section 906 is void under Section 909 of the ITA, this is unlikely to apply to a gross-up provision as such a provision will increase the amount payable and therefore also increase the tax deducted at source – so it is not an agreement to pay without deduction of tax.
In practice, even where UK law dictates that there should be a deduction of tax at source for the royalty element of any fees, an appropriate DTT may well apply to give rise to zero or a reduced rate of withholding tax. Under Section 911 the payer need not deduct tax so long as it reasonably believes that at the time the payment is made the payee is entitled to relief under an applicable DTT. The franchisee should therefore seek to ensure that the franchisor (or if different, the relevant entity licensing the IP rights) benefits from relief under the applicable treaty. This may include ascertaining its country of residence, ensuring it is taxable in that country under relevant rules (e.g., not receiving the income in a branch in a third country that is exempt from tax in the country of residence), ensuring that the royalties are 'beneficially' owned by the recipient for treaty purposes and that the franchisor does not have a permanent establishment in the United Kingdom or, if it does, that the royalties are not effectively connected with such a permanent establishment, as well as ascertaining whether anti-avoidance rules, such as Section 917A ITA, apply. As well as investigating the franchisor's ability to obtain treaty relief, the franchisee may seek to obtain warranty protection in this respect under the franchising agreement.
IV TAX PRINCIPLES FOR FRANCHISORS
i Tax treatment of receipts
Although UK franchisors will be taxable on all fees received or receivable, the nature of such taxation will depend on the type of fee. A UK franchisor will therefore need to know how its fees are to be treated for tax purposes.
In this respect a typical franchise agreement will comprise fees payable for the following:
The fees are likely to comprise both an initial fee and regular ongoing payments. In practice, the fees are often not separated out in the above constituent elements in the documentation but are simply an 'initial fee' and ongoing 'service fees' plus additional amounts for reimbursement of expenditure and contributions to advertising.
As we have seen, a UK franchisor will, broadly speaking, be paying corporation tax on all its profits albeit under different charging provisions. UK franchisors will generally be carrying on a trade in the United Kingdom and their profits will be subject to corporation tax as trading profits.
For UK franchisors whose IP was created or acquired on or after 1 April 2002, the profits and losses relating to any intangible assets will be calculated under the intangible fixed asset regime whether the receipt is capital in nature or not, but such profits and losses will in any event be taxed as part of the franchisor's trading profits to the extent that the relevant IP assets are held for the purposes of a trade carried on by the transferor, 92 which will almost certainly be the case. Therefore, the franchisor should be subject to corporation tax on the profits in its accounts subject to any standard tax adjustments (e.g., for disallowable expenditure or transfer pricing). If the transaction involves a 'realisation' of a chargeable intangible asset, then it is possible that a tax charge under the chargeable intangible assets regime could qualify for rollover relief if reinvested in new IP. 93 However, realisation for the purposes of these rules means a transaction resulting, in accordance with generally accepted accounting practice, in the asset ceasing to be on the company's balance sheet or in a reduction in the accounting value of the asset (or would do if it had a balance sheet value). 94 On this basis it is unlikely in the vast majority of franchising arrangements that a realisation would occur for the purposes of these rules in respect of its activities carried out in the course of its general franchising business.
UK franchisors, whose IP does not fall within the intangible fixed assets regime, may need to analyse transactions in more detail to determine the manner of taxation. For many franchisors, HMRC are likely to accept that all fees simply constitute part of the franchisor's trading profits for corporation tax purposes so in practice, in the vast majority of cases, the tax treatment will be the same as for those in the intangible fixed assets regime. Franchisors may, however, seek to separate the fees into their component parts and tax them accordingly. If HMRC or a taxpayer wish to segregate the income between trading and other elements, the allocation would need to be a reasonable apportionment and justifiable. 95 If the relevant IP assets are segregated from the trade (e.g., held in a different company from the employees responsible for providing services), then a more detailed analysis of the components of any charge will be necessary.
Should the consideration be split into its component elements these could be taxed as follows.
Initial fee
If payable to a trading company rather than an IP holding company, this is likely to constitute a trading receipt. Arguably there may be a capital sum for a part disposal of goodwill or a capital sum derived from an asset and taxable under Section 22(c) or (d) or Section 29(5) of the TCGA. Where the franchise relates to a new jurisdiction, it will be difficult to say that there has been any disposal of a capital asset; HMRC's view is that there is not generally any reduction in the franchisor's goodwill as a result of entering into any new franchise agreements – on the contrary its goodwill is usually enhanced. 96 Additionally, under normal principles it would generally be difficult to say for a franchisor that the fees it generates are capital in nature. Therefore, the payment is most likely to be liable to corporation tax on income as a trading profit rather than a capital receipt. HMRC in its guidance cites Jeffrey v. Rolls-Royce 97 as authority for treating the initial fee as a trading receipt in normal circumstances. Specifically, it highlights that in this case (concerning disposals of know-how that were treated as income) the circumstances have similarities to many franchising cases, in particular:
It is irrelevant that the payment is in instalments. 99
However, if it can be shown that there has been a part disposal of existing goodwill, then this could be taxed within the capital gains rules – for example where the franchisor disposes of existing trading sites to a franchisee. To the extent that there has been a disposal of goodwill subject to capital gains tax (or corporation tax on chargeable gains), then any gain could be subject to rollover relief if the franchisor reinvests the gain in chargeable intangible assets 12 months before or within three years after the disposal. 100 Similarly, if there has been a realisation of goodwill or other IP within the intangible fixed asset regime, the gain can be rolled over into a new chargeable intangible asset. 101
Know-how
A disposal of know-how may be taxed as income under Section 908 of the CTA 2009 or as part of the trading profits of the company under Section 177(2) of the CTA 2009 (disposal of know-how where trade continues). This will not, however, be the case where the know-how has qualified for capital allowances and is brought into account under Section 462 of the CAA 2001, or it is taxed on disposal of a trade as part of the goodwill of the trade under Section 178 of the CTA 2009 or the disposal is a sale between connected persons.
Show-how
Fees for training the franchisee's staff and ongoing training will normally be part of the trading receipts of the franchisor.
Advertising payments
Where franchisees contribute to central advertising costs incurred by the franchisor, the receipts will typically be revenue receipts taxable as trading profits with a corresponding deduction allowed for the advertising spend. One would expect the income and expenditure to be matched for accounting purposes and generally one would expect advertising expenditure to be an income expense such that there is no net tax payable (unless the franchisor is receiving more than it is spending). To the extent that the expenditure has not been paid, any provision in the accounts will need to be sufficiently accurate to allow a deduction. 102
Capital payments in respect of patent rights
Where patent rights are transferred, any receipt could give rise to a taxable receipt under Section 912 of the CTA 2009, spread over six years unless tax is elected to be paid earlier.
Royalties
As stated, except for franchisors that may hold the IP separately from the rest of the trade, all receipts are likely to constitute taxable trading profits. Therefore, characterising the receipts as royalties is unlikely to have a practical effect for corporation tax purposes.
Premises
Certain franchisors will seek to provide a franchisee with suitably fitted out and branded premises. The tax treatment of any fees for doing this will depend on the nature of these arrangements.
ii International issues
We now look at the options available for a UK taxpayer when carrying on an international trade. If the franchisor is carrying out its full franchising business, including providing services and licensing all IP from one entity in the United Kingdom, it will be receiving the above mixed supply of services and payments for use of IP. Assuming that the franchisor's activities are not undertaken through a permanent establishment in a different jurisdiction, the fees should all be taxable under the UK corporation tax rules either as trading income, profits from IP or potentially, for the initial fee, chargeable gains (if the franchisor's IP is pre-April 2002 IP).
There used to be a distinction between foreign source income and UK source income. This distinction, broadly speaking, disappeared for corporation tax purposes when the tax rules were rewritten into CTA 2009 and CTA 2010. Therefore, all trading income is dealt with under the same provisions of CTA 2009, as is all IP income. There is now no longer a general distinction between UK and foreign source income except that double-tax relief is available on foreign-sourced income.
Double-tax relief in the United Kingdom takes two forms: treaty relief and unilateral relief. Treaty relief is relief granted under an applicable double-tax treaty. Section 2 of the Taxation (International and Other Provisions) Act 2010 (TIOPA) provides for double-tax arrangements in respect of a territory outside the United Kingdom with a view to affording relief from double taxation to have effect by means of an Order in Council. The taxes covered by such arrangements include income tax, corporation tax, capital gains tax and taxes imposed outside the United Kingdom of a similar character to these taxes. As well as invoking the 'royalties' provision of any applicable tax treaty, a number of other provisions may be applicable to a franchisor, such as (in the case of the OECD Model Treaty):
Unilateral relief (i.e., double-tax relief given in the absence of any protection under a double-tax treaty) is provided under Section 9 of the TIOPA in respect of income 'arising' and gains 'accruing' in the territory for which tax relief is sought. Unilateral relief is provided in respect of tax on income or capital gains that corresponds to income tax, capital gains tax or corporation tax and includes state, provincial or local income taxes or taxes levied by a municipality or any other local body. 103
Double-tax relief can be problematic in the following respects:
A UK resident may receive income consisting of royalties or 'know-how' payments from a foreign resident. While in particular cases there may be special circumstances that will require to be taken into account, in general such income should be dealt with as follows.a) Payments made by a person resident in a foreign country to a person carrying on a trade in the UK as consideration for the use of, or for the privilege of using, in the foreign country any copyright, patent, design, secret process or formula, trademark or other like property may be treated for the purpose of credit (whether under double-taxation agreements or by way of unilateral relief) as income arising outside the UK, except to the extent that they represent consideration for services (other than merely incidental services) rendered in this country by the recipient to the payer. b) Traders resident in the UK are not entitled to claim credit for any tax which is levied in the foreign country in respect of payments for services which are rendered in the UK and are not merely incidental services. In any such case the net amount of the payment (after deduction of any foreign tax borne by them on the payments) is included in the computation of profits for UK tax purposes.The prohibition on credit for foreign tax charged on payments for services rendered in the UK may be overruled by the terms of those double-taxation agreements which have a royalties Article which includes technical services in the definition of royalties (see INTM153130) or a separate technical fees Article (see INTM153140) and those agreements deem the source of such payments to be in the country of which the payer is a resident. In such cases, even though the services are rendered in the UK, credit is due for the foreign tax charged on these payments.If the owner of a right such as a patent, trademark or copyright is not engaged in any trade to which the right relates but derives income by exploiting that right, the source of the income may be regarded for the purpose of credit as located in the country where the right is enforceable.
V FRANCHISOR STRUCTURING
Over the past 40 years, as businesses have become increasingly mobile and international, and particularly since the digitalisation of the economy, multinational operations have increasingly used tax planning as a tool to maximise their after-tax returns. There has been a game of cat and mouse between multinational operations and the revenue authorities as more sophisticated structures have grown up to minimise taxes, tax authorities have introduced rules to block such structures and well-advised businesses have introduced even more sophisticated tax structures and mitigation strategies to overcome such rules.
Today, with a difficult worldwide economic situation and the tight budgetary conditions facing many Western economies, politicians, press and public are increasingly scrutinising the tax affairs of multinational companies. This is particularly the case in the sectors of the economy that rely heavily on intangible assets such as brands that are highly mobile and that can, if located in low-tax jurisdictions with minimal substance requirements, have a dramatic downward effect on a group's effective corporate tax rate.
This increasing scrutiny is leading to increased crackdowns on international tax avoidance behaviour and tax arbitrage, with measures such as the BEPS project, which is being run by the OECD and G20 (see Section V.iv). At the same time, however, many governments are seeking to reduce corporate tax rates and provide corporate tax incentives to attract inward investment. In an area such as franchising, where profits substantially derive from IP, there were traditionally significant opportunities to locate IP in a low-tax jurisdiction to minimise taxes. However, the effect that an overly aggressive tax structure may have on reputation is becoming a key business concern, particularly for consumer-facing businesses.
This section gives a general overview of the tax strategies a franchisor may consider in looking to reduce its effective tax rate and outlines the anti-avoidance rules that have been introduced to limit overly aggressive planning.
A common form of tax planning for franchisors was to take their IP and operations offshore from the United Kingdom to a jurisdiction with a lower tax rate. By doing this they would hope that income could be rolled up in a lower-taxed jurisdiction thus avoiding or at least deferring UK tax.
For tax purposes, a relevant IP holding entity (IP Co) ideally should not be subject to:
Therefore, tax planning would involve considering which entity would be effective in reducing profits tax and withholding tax, thereby assisting to lower the effective rate.
This entity could either be:
As tax havens do not have decent tax treaty networks, withholding taxes may dictate having an entity with a low level of taxation in the structure (and therefore access to a tax treaty network). Examples of relevant jurisdictions that may meet these criteria are the United Kingdom, Luxembourg, Belgium, the Netherlands, Cyprus and Ireland. The availability of certain tax advantages in these jurisdictions could, depending on the circumstances, give rise to a competitive effective tax rate. Such advantages to be considered may include:
An increasingly important factor to bear in mind when looking at the location of any vehicle is that the vehicle is likely to require 'substance' to obtain the relevant tax benefits. It is therefore almost always better to locate companies in jurisdictions where there are people with the requisite skills and experience to manage the business carried on by such a company. This requirement for substance has been particularly enhanced following the BEPS project (e.g., the new transfer pricing regime for intangibles).
If IP is held in a taxable structure, tax planning will concentrate around minimising the tax rate (e.g., using special tax regimes applicable in that jurisdiction), maximising reliefs (e.g., amortisation of acquisition cost, R&D reliefs and finance costs) and avoiding withholding taxes.
For an IP Co to be tax-efficient, the licensees would be residents of jurisdictions that do not apply withholding tax on payments to the IP holding vehicle or that have suitable double-tax treaties to reduce or eliminate any withholding tax.
One further way to reduce withholding taxes used to be by using another entity (royalty company) through which the royalties would flow. By flowing the royalties through a royalty company (1) with a suitable tax treaty with the licensee's jurisdiction (eliminating or reducing withholding taxes on royalties); and (2) incorporated in a country that does not levy withholding tax on royalty payments (or has a suitable tax treaty with the jurisdiction in which the IP Co is located), withholding taxes on the royalties could be mitigated (subject to anti-avoidance rules).
However, various tax treaty provisions prevent 'treaty shopping'. Again, the BEPS project has made planning through 'conduit' and similar structures more difficult, as it has resulted in the inclusion in tax treaties of various provisions that prevent treaty abuse. Additionally, anti-avoidance rules may apply to deny treaty benefits or the tax authorities may not view the royalty company as being entitled to the royalties for treaty purposes. 107
If a UK entity were to set up a structure with an offshore subsidiary IP Co or royalty company, the following hurdles would need to be overcome to achieve its aims:
In addition, all relevant anti-avoidance measures and the offshore receipt rules (see Section III.ix) would need to be considered in detail and overcome. In summary, it is increasingly difficult for a UK business to transfer its IP out of the UK to minimise the business's effective tax rate.
i Tax charges on transferring IP to an offshore licensing entity
A taxable gain may be crystallised when a franchisor disposes of the relevant assets to an offshore company. In seeking to transfer IP to an offshore entity, the franchisor will have to consider the assets to be transferred carefully.
If we consider the nature of the assets to be transferred, each will have a slightly different treatment when seeking to either transfer the asset or simply register new classes of such IP in an offshore jurisdiction. In this respect it should be borne in mind that different IP has different characteristics. Goodwill can be very local to a business or it can be worldwide; patent rights, however, cannot be enforced outside the jurisdiction of registration but may confer priority registration rights overseas. A franchisor looking to transfer IP offshore will therefore have to analyse carefully each asset from both a legal and an economic perspective to determine whether any value is being transferred to the offshore entity and whether such a transfer is therefore taxable (either because the offshore acquirer pays a market price or is deemed to do so under transfer pricing or similar rules).
Specifically, different assets will be taxed as follows:
Where a company has a solid UK business but is looking to expand internationally through franchising arrangements, it may seek to split its IP between that which relates to the United Kingdom and that which relates to jurisdictions outside the United Kingdom. It may then seek to transfer the non-UK IP to a tax-friendly jurisdiction and argue that the non-UK IP has no or little value at the time of such a transfer. Whether or not this is justifiable is a question of valuation, which will depend on the extent to which the franchisor has already carried on any trade abroad or has any pre-existing enforcement rights in the relevant offshore jurisdictions, including priority registration rights. This will vary between different classes of IP. However, the 'substance' requirements (see Section V.v) will make this difficult to achieve unless real commercial activities are also located in that jurisdiction.
Should there be any taxable profit or gain on the transfer, the franchisor will look to see whether it has any tax assets (such as losses) that it can utilise against a gain. Companies looking to migrate their assets offshore may also consider the reorganisation rules outlined above to determine if they could do so without crystallising a tax charge. It should be borne in mind, however, that many of those rules require a bona fide (and not a tax avoidance) intention to fall within the relevant provisions. 108 Alternatively, a franchisor may consider licensing the IP in a manner that does not give rise to a disposal of the asset but that gives rise to tax on the licence fees over a number of years. Whether a licence amounts to a disposal depends on its terms and whether the receipt falls into income or capital as set out above. An exclusive licence for a long period is likely to constitute a disposal whereas a non-exclusive licence for a short period is not.
ii Controlled foreign company rules
Under the United Kingdom's CFC rules contained in Part 9A of the TIOPA 2010, if a company resident outside the United Kingdom is controlled by persons resident in the United Kingdom, then the profits of the non-resident company (together with any creditable local tax) can be apportioned to UK tax-resident corporate shareholders and charged to UK tax.
Control by UK persons includes cases where a company is controlled by two shareholders each holding 40 per cent or more of the controlling rights and one of which is resident in the United Kingdom. The rules are designed to target transactions that artificially divert profits from the United Kingdom.
The rules relating to CFCs are highly technical and detailed (and therefore beyond the scope of this chapter). However, there are a number of helpful exemptions that eliminate this charge. The main entity-level exemptions to a CFC apportionment are:
Anti-avoidance rules attach to prevent the exemptions applying in abusive situations.
Even if the CFC is not exempt under the above rules, its profits are only apportioned to relevant UK shareholders and subject to tax under the CFC rules to the extent that those profits fall within one of the 'gateways'. CFC gateways include:
Of most relevance for franchising activities will be the first two of these gateways. If a company's profits meet a number of tests as to non-attribution to the United Kingdom, it will not fall within this first gateway. One of these tests is an IP condition that is similar to the above IP test in the excluded territories exemption.
The intention behind these exemptions and gateways is to stop the CFC rules catching commercially driven structures. However, because of the complexity of these rules they may catch what might seem to be commercial structures and therefore need to be considered in all cases where companies are owned directly or indirectly by UK companies.
iii Diverted profits tax
This tax applies where:
Where the rules apply, a tax charge at 25 per cent applies to the amount of profits that would otherwise have been taxed in the United Kingdom. In the case of the avoided permanent establishment, the DPT rules also charge to tax any royalties that would have been deemed to be payable had there been a UK permanent establishment. The rules do not apply:
iv Anti-avoidance
It is clear that there would, in the absence of rules to the contrary, be significant scope for tax planning as the nature of IP assets means that they are easy to move across borders.
The historic approach to judicial intervention in tax avoidance cases can be seen in IRC v. Duke of Westminster, 109 when Lord Tomlin said: 'Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be.' This approach gave rise to a literal interpretation of tax legislation, allowing structures to be easily devised that circumvented the relevant legislation. However, modern jurisprudence, following a line of cases, including Ramsay (WT) Ltd v. IRC, 110 Furniss v. Dawson 111 and Barclays Mercantile Business Finance v. Mawson, 112 has taken a more purposive interpretation of tax legislation. As Lord Nicholls says in Barclays Mercantile Business Finance v. Mawson:
The essence of the new approach was to give the statutory provision a purposive construction to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description.
The courts are therefore no longer prepared to take a blinkered look at each transaction but will consider a tax avoidance scheme as a whole. An example of the current approach in overcoming a tax avoidance scheme can be seen in Astall & Another v. HM Revenue & Customs. 113 An example of the limits of such an approach, where it was not possible to interpret the purpose of the legislation, can be seen in the case of Mayes v. HMRC. 114
Any tax planning and structuring in respect of franchising arrangements and IP licensing structures should therefore always consider whether what is planned falls within the relevant legislation after taking a purposive interpretation of that legislation.
Further specific anti-avoidance rules have been developed to catch the more obvious schemes that have been devised. In any given situation, all relevant specific anti-avoidance rules, sometimes known as targeted anti-avoidance rules (TAARs), will need to be considered. As this is not a tax textbook, we will not consider all possible TAARs in this chapter. There are also rules whereby certain types of tax avoidance schemes have to be notified to HMRC. 115
Additionally, the United Kingdom has a general anti-abuse rule (GAAR) that could apply to any given transaction and would need to be considered seriously by anybody seeking to implement any tax planning. The details of the GAAR are set out in Part 5 Finance Act 2013. The GAAR applies to counteract tax advantages arising from tax arrangements that are abusive. 116
'Tax arrangements' for the purposes of the GAAR are arrangements of which it would be reasonable to conclude, having regard to all the circumstances, that the obtaining of a tax advantage was the main purpose or one of the main purposes. Such arrangements are abusive if they are arrangements the entering into or carrying out of which cannot reasonably be regarded as a reasonable course of action in relation to the relevant tax provisions having regard to all the circumstances, including whether:
Examples of things that might indicate that tax arrangements are abusive include profits being significantly less than economic profits, deductions significantly greater than economic costs or claims for tax credits relating to taxes that are unlikely to be paid. In contrast, compliance with HMRC practice is indicative that arrangements are not abusive.
A number of taxpayer safeguards are built into the GAAR, including:
The legislation is also supported by detailed guidance rules issued by HMRC. In respect of international tax planning the guidance notes state: 121
B5.1 There is a network of treaties between States setting out rules that govern the taxation of investment and business activities involving more than one State. These treaties (which are typically based on an OECD Model Treaty) are usually referred to as 'double-tax treaties', and their purpose is to avoid subjecting such investments or activities to tax in more than one State and to prevent tax evasion. The United Kingdom has entered into over 100 such treaties, and they are given effect in domestic tax law.B5.2 Many of the established rules of international taxation are set out in double-taxation treaties. These cover, for example, the attribution of profits to branches or between group companies of multinational enterprises, and the allocation of taxing rights to the different States where such enterprises operate. The fact that arrangements benefit from these rules does not mean that the arrangements amount to abuse, and so the GAAR cannot be applied to them. Accordingly, many cases of the sort which have generated a great deal of media and Parliamentary debate in the months leading up to the enactment of the GAAR cannot be dealt with by the GAARB5.3 However, where there are abusive arrangements which try to exploit particular provisions in a double-tax treaty, or the way in which such provisions interact with other provisions of UK tax law, then the GAAR can be applied to counteract the abusive arrangements.
The BEPS project has also changed the global approach to international tax planning and the MLI (see Section III.viii) has significantly reduced the scope for treaty shopping. 122
In addition, the EU adopted the Anti-Tax Avoidance Directive (ATAD), which has been in force since 1 January 2019. The ATAD imposes a minimum standard for a number of the matters set out in this chapter, to be applicable at EU level, including exit taxation (i.e., tax on assets transferred across borders); an EU-wide GAAR; and minimum standards of CFC rules. Furthermore, the EU is looking to impose a common corporate tax base under which corporate tax is calculated in each Member State on the same set of rules; followed by a common consolidated corporate tax base under which tax will be payable on an EU-wide basis and then apportioned to relevant Member States. The United Kingdom is unlikely to be subject to these rules following its departure from the EU.
v Company residence
As stated, where an entity is established in any jurisdiction to hold IP rights or carry out any other function, it is likely to require the requisite substance commensurate with its functions. Such substance requirements may arise as a result of a number of factors:
HMRC will apply these tests to determine whether an entity established offshore is actually resident in the United Kingdom. It is usually best practice to ensure that an entity is appropriately managed in its home jurisdiction to ensure that it meets any required substance tests locally and to ensure that it is not resident in the United Kingdom (or another taxable jurisdiction).
As stated above, a company that is not incorporated in the United Kingdom could be treated as resident in the United Kingdom under UK domestic law if it is centrally managed and controlled in the United Kingdom. The meaning of central management and control is not defined in UK statute and has instead been determined according to UK case law principles. Broadly, the central management and control test is a question of fact that looks at where the highest level of control (i.e., the overall strategic management structure, as opposed to the day-to-day management) of an overseas company is physically conducted. As stated in UK case law, 123 the question depends on where the 'real business is carried on' and this is 'where the central management and control actually abides'. It is also stated that 'it is the actual place of management, not that place in which it ought to be managed, which fixes the residence of a company'. 124 If this is in the United Kingdom, the company is UK tax-resident (in the absence of any tax treaty provision to the contrary). Cases have attached importance to the place where the company's board of directors meet, although this is not necessarily conclusive. HMRC sets out detailed guidance in its manuals as to the meaning of central management and control, including a reproduction of the Statement of Practice, 125 which sets out its view of the factors relevant to determining residence under the common law test.
In some cases, central management and control may be exercised by a single individual. This may happen when a chairman or managing director exercises powers formally conferred by the company's articles and the other board members are little more than ciphers, or by reason of a dominant shareholding or for some other reason. In those cases, the residence of the company is where the controlling individual exercises those powers.
In general, the place of directors' meetings is significant only insofar as those meetings constitute the medium through which central management and control is exercised. In the case of Wood and another v. Holden 126 the Court of Appeal held that an overseas incorporated company, managed by an overseas trust company, which received advice from professional advisers in the United Kingdom, could not be considered to be UK-resident for tax purposes purely because the trust company acted on the recommendations of the professional advisers. This case showed that there must be clear evidence that the central management and control of a non-UK incorporated company is carried out by its directors, and that the authority of the directors has not been usurped by anybody (such as UK-based directors or advisers) in the United Kingdom.
Where a treaty tiebreaker applies, residence is where the company is 'effectively managed', although, following implementation of the MLI, this is likely to change in many treaties to the jurisdiction agreed by the relevant tax authorities under a mutual agreement procedure. It is usually very difficult to see how the place of the 'central management and control' of a company's business for the purposes of determining its residence under UK domestic law will not be the same as the location of its 'place of effective management' for the purposes of the double-tax treaty. A useful case, which considered in detail a company's residence, was that of Laerstate BV v. HM Revenue & Customs. 127
As well as residence issues, a company will be keen not to have taxable permanent establishments in a jurisdiction outside its place of residence. As well as ensuring that the company does not have an overseas office or other fixed place of business, it should not have dependent agents concluding or substantially negotiating contracts on its behalf outside its jurisdiction of residence. Ideally the company should also not have any employees outside such a jurisdiction.
As a practical matter, companies should follow clear guidelines to ensure their decision-making processes do not inadvertently mean they are resident in a different jurisdiction from that intended – or for that matter trade through a permanent establishment in such a jurisdiction. Examples of matters that could be contained in such guidelines might include:
vi Tax issues arising from corporate structuring
As well as the above issues that arise from tax-driven structuring, many tax issues for franchisors can arise from more commercially driven corporate structuring. For example, franchisors may seek equity participation in their franchisees for economic benefits but also to provide the franchisors with a degree of corporate control. The tax implications of such joint-venture arrangements will depend on the precise circumstances but may involve:
VI FRANCHISEE TAX POSITION
While franchisors will generally be companies (and we have therefore concentrated on the corporation tax rules for companies), franchisees may be much smaller businesses and could be run as companies, partnerships or unincorporated small traders. It is beyond the scope of this book to discuss the general tax environment for all such traders. We set out below, however, the tax treatment of the likely payments by corporate franchisees under franchising arrangements. This is generally the reverse of the franchisor treatment. Specifically, a franchisee will want to know:
For the franchisee, a greater degree of analysis will generally be required as the nature of the payments will vary more dramatically.
i Initial fee
The crucial question for the franchisee will be whether the initial fee (or fees) payable by it are income or capital in nature. As the fees will be incurred wholly and exclusively for the franchisee's trade, then if income in nature the fees should be deductible as part of the franchisee's trading profits. If capital in nature, the fees would not be so deductible. The tax treatment will depend on the nature of the fee and the circumstances of the franchisee. Specifically, for corporate franchisees:
HMRC states in its published guidance 134 that:
Whether an apportionment between capital and revenue expenditure is appropriate depends on the facts. The facts may show that no part of the initial lump sum fees can be attributed to services of a revenue nature provided by the franchiser because such services are separately charged for in the annual fees.In practice, franchisees may put forward an apportionment without reference to the franchisor. An apportionment of this type may be difficult to justify in relation to the services provided. For instance, some franchisors are unwilling to negotiate special terms with individual franchisees and the same lump sum is payable irrespective of the actual services required from the franchisor; for example, the number of staff needing training may be irrelevant.If the agreement terms are such that no part of the initial fee is specifically attributed to revenue items, then the claim for apportionment may need to be critically examined.
ii Capital allowances
A deduction for capital expenditure is available under the capital allowances regime to reduce profits for corporation tax (under the pre-April 2002 regime) and for income tax purposes. Generally, expenditure must be classified as capital and must be incurred on specified assets. Specific rules provide for expenditure on R&D, know-how and patents to be relieved.
The quantum of capital allowance that can be claimed by a taxpayer is provided at a specified rate for each tax year and depends on the type of capital asset and the type of entity incurring the expenditure.
Acquisition of know-how
Where a taxpayer incurs expenditure for the purpose of acquiring know-how from an unconnected person, a capital allowance deduction may be available if the know-how is used in a trade. 135
Know-how is defined as 'any industrial information or techniques likely to assist in manufacturing or processing goods or material; working a source of mineral deposits; or carrying out any agricultural, forestry or fishing operations'. 136
HMRC takes the view that this definition does not extend to commercial know-how (such as market research, customer lists and sales techniques) because this is not 'industrial information or techniques likely to assist in the manufacture of goods or materials'. 137 As such, know-how allowances are unlikely to be of relevance in many franchising situations.
The rate of allowance depends on the tax year in which the relief is sought. Where relief is sought, the allowance is:
Broadly speaking, AQE is capital expenditure on know-how that is incurred for the purposes of the trade and TDV is the net proceeds of sale (which consists of capital sums).
Acquisition of patent rights
A capital allowance deduction is available for capital expenditure incurred to acquire patent rights for the purpose of a trade within the charge to UK tax 140 (or for patent rights that give rise to UK taxable income). 141
Patent rights are defined as rights to do or authorise the doing of anything that would, but for that right, be an infringement of a patent. 142
There is a separate pool of expenditure for each trade and a pool for non-trading expenditure. The writing down allowance available is 25 per cent of the excess of the AQE over total disposal receipts 143 each tax year with similar rules for balancing charges or allowances as know-how. Where the patent rights are not used for a trade, any allowance is given against patent income only.
iii Ongoing fees
Ongoing payments will almost always constitute deductible expenses for the purposes of calculating the franchisee's trading profits as they should be income in nature and wholly and exclusively incurred for the purposes of the trade. The key question for such expenses will be whether they are subject to deduction of tax at source – which may also be a question for some capital expenditure included in the initial fee (e.g., if patents have been acquired). Whether or not this is an issue for the franchisee will depend on whether or not the agreement includes a gross-up clause, pursuant to which the fees are increased such that the franchisor stays in the same after-tax position.
As well as the above issues that are specific to the agreement, franchisees will have to contend with all the same tax issues as many other small businesses would have to contend with. For example, it would have to consider:
VII TRANSFER PRICING
Where transactions take place between related, associated or connected companies, there is an incentive for profits to be 'moved' from a company with a relatively high tax rate to another company with a relatively low tax rate. This could be achieved, for example, in the context of a trademark licence, by an inflated royalty being charged by a licensor in a low-tax jurisdiction to a licensee resident in a high-tax jurisdiction (thus stripping taxable profits out of the high-tax jurisdiction).
The transfer pricing regime seeks to prevent this type of practice by requiring an arm's-length price to be paid (in the above case, an arm's-length royalty to be paid by the licensee). This is a general rule, which is similar to the specific rules, which impose market value prices on transactions between connected persons (e.g., for capital gains tax, TCGA 1992, Section 17 and for chargeable intangible assets, CTA 2009, Section 845).
Many countries have a transfer pricing regime and, although the precise mechanics vary from country to country, many are based on the OECD's transfer pricing guidelines, which were most recently updated in 2017 to bring them into line with the BEPS action points. The United Kingdom's transfer pricing rules are in TIOPA 2010, Part 4. Broadly speaking, the provisions seek to adjust the tax return of a person who obtains a potential UK tax advantage from its non-arm's length dealing with another person. The tax return is adjusted as though the transaction had been at arm's length. SMEs may be exempt from transfer pricing rules under Section 166 TIOPA unless the transaction is with a party in a non-qualifying territory (broadly speaking, a tax haven), although HMRC may by notice, in the case of medium-sized enterprises (and where the UK Patent Box applies, small enterprises), disapply the exemption. The definition of an SME follows the general EU definition. 144
The regime applies where provision has been made or imposed between two 'affected persons' by a transaction or series of transactions, the participation condition is met, and the actual provision differs from what would have been the actual provision between independent enterprises dealing on arm's-length terms (the 'arm's-length provision'). The UK rules apply even where the transactions are between two UK parties.
To meet the participation condition, one person must control the other or they must be under the control of the same person. 'Control' means voting control or control by virtue of powers conferred by the articles of association or other document regulating the powers of a company whereby the company's affairs are conducted in accordance with the wishes of the controller. 145 In the context of a partnership, control means the right to a share of more than one half of its assets or income. The definition is extended in certain circumstances (e.g., to include rights held by connected persons, rights that will be acquired in the future or persons who own 40 per cent or more of the controlling shares in a company where there is another such 40 per cent or more shareholder).
Where the provisions apply, penalties may be assessed to the extent of tax lost because of fraud or negligent conduct. However, HMRC indicates that where the taxpayer makes an honest and reasonable attempt to comply with the legislation, HMRC will not impose a penalty. 146
In practice, determining the arm's-length value, particularly one that is acceptable to the revenue authorities of two countries, is a difficult exercise. This is particularly the case for intangible assets such as IP, which are often unique to the company or group concerned.
The OECD Transfer Pricing Guidelines 147 describe valuation methods that are generally acceptable to tax authorities around the globe and that have been accepted by HMRC. These are divided into traditional transaction methods and transactional profit methods.
i Traditional transaction methods
Comparable uncontrolled price
The comparable uncontrolled price (CUP) method simply compares the price charged between the connected parties (the 'controlled transaction') with the price in a comparable uncontrolled transaction (i.e., a comparable transaction between unconnected third parties – an 'uncontrolled transaction'). The price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction if the two are comparable. The two transactions should be comparable if:
While the CUP method is the most reliable method for transfer pricing, identifying good, reliable comparable uncontrolled transactions can be difficult in practice, as was demonstrated in the case of DSG Retail Ltd and others v. HMRC. 148
Resale minus (resale price)
This method is most useful where a company purchases goods for distribution from a connected party (the minus effectively corresponds to a commission and represents the amount out of which the reseller would seek to cover its expenses and, in the light of its functions (taking into account assets used and risks assumed), make an appropriate profit).
Cost plus
This method is most useful for services or where semi-finished goods are transferred between related parties (e.g., a manufacturing company selling to a distribution affiliate), or where joint facility agreements have been concluded. It is in effect the opposite of resale minus, looking at costs incurred and stating that an independent third party would expect to make a fixed profit in addition to such costs. The starting point is therefore the costs incurred by the supplier of the goods or services. A percentage is then added to this to give the supplier a profit appropriate to the functions carried out and the market conditions. The profit element is determined by looking at comparable uncontrolled transactions carried out by the supplier with independent third parties (an 'internal comparable'). If the supplier does not enter into comparable uncontrolled transactions, the mark-up that would have been earned in comparable transactions by an independent enterprise (an 'external comparable') should be considered. As cost-plus generally gives rise to a low fixed profit, it is more suitable to low-risk, low-value functions and is likely to be challenged where the functions or risk involved should give rise to a variable and potentially high level of profits. A risk and functional analysis of what the supplier actually provides is therefore key as to the application of this (and all transfer pricing methodologies). In looking at comparables, it is therefore important to demonstrate similar risk allocations in comparable circumstances. Cost plus can also be used for R&D services, provided that the functional analysis and allocation of risk justify this methodology and any realistically available options or alternative structures in pricing the transaction. In this sense it is sometimes necessary to consider not just who contractually takes the entrepreneurial risk but who would take the entrepreneurial risk were the parties independent.
ii Transactional profit methods
There are two further methods supported by the OECD guidelines that do not look so much at each transaction undertaken by a party but at what level of profit should be allocated to the party. These two methods are the profit split method and the transactional net margin method.
Profit split
This method seeks to determine the division of profits that independent enterprises would have expected to realise from the relevant transactions. It is a 'two-sided' method as it looks at both (or all the) parties to the transaction. The other methods are 'one-sided' in that they only test the appropriate return for a single party without considering the effect on the return of the other party. The method is useful for complex trading relationships where it can be difficult to evaluate transactions separately. The most recent OECD Guidelines make clear that application of a profit split methodology should split the profits on an economically valid basis, which approximates the division of profits that would have been anticipated and reflected in an agreement made at arm's length. This part of the OECD Guidelines was updated as a result of the BEPS project to provide more guidance and examples on when this might be the most appropriate method to use and how it should be applied.
Transactional net margin method
The transactional net margin method looks at the net profit relative to a particular base (e.g., costs, sales, assets) that a taxpayer realises from a controlled transaction. In this sense it is similar to cost plus or resale minus. So in this sense internal comparable should be considered in the first instance followed by external comparables. The OECD Guidelines emphasise finding comparable transactions based on functional analysis.
Applying transfer pricing principles to transactions involving intangible assets, including disposals of such assets and royalty payments, is a particularly difficult area because of the uniqueness of most IP and therefore the lack of comparables. There is a specific chapter of the OECD Guidelines dedicated to intangible property. Similarly, there are special chapters dedicated to intra-group services, cost contribution arrangements and business restructurings – all of which may need to be considered in the context of franchising arrangements. The chapter relating to intangible assets was rewritten as part of the BEPS project. 149 This provides new guidance on defining intangibles, identifying transactions involving intangibles and for determining arm's-length terms for transactions involving intangibles. In a key change resulting from this project, it has been highlighted that IP income should accrue to entities that perform value-creating functions relating to the development, enhancement, maintenance, protection and exploitation of the intangible asset (known as the 'DEMPE functions'). The net effect of this is that it will be more difficult for multinational enterprises to argue that a company in a low-tax jurisdiction that simply funds IP development (e.g., R&D or marketing expenses) can accrue the income from the resulting IP, as it will not have sufficient substance in terms of people functions.
Whichever valuation method is chosen, evidence will be needed to justify the value given. Documentation should be kept to prove the relevant relationship, nature, terms and prices of the relevant transactions, the valuation method used (particularly how the arm's-length price was determined, including any functional analysis or comparable study). The basis for any computational adjustment required to reach an arm's-length value should be retained, and the terms of relevant commercial arrangements with both third-party and affiliated customers. Such documentation should be kept for at least six years from the end of the chargeable period to which it relates.
The extent of documentation should be such 'as is reasonable given the nature, size and complexity (or otherwise) of their business or of the relevant transaction (or series of transactions) but which adequately demonstrates that their transfer pricing meets the arm's-length standard'. 150
It should also be borne in mind that where transfer pricing is relevant to any transaction, a taxpayer may apply pursuant to Section 223 of the TIOPA for an advance pricing agreement to seek clarity on the terms of a transaction for transfer pricing purposes. Such agreements can be unilateral (i.e., only agreements with HMRC) or bilateral (i.e., where the agreement relates to a cross-border transaction seeking agreement with HMRC and the tax authority in the other jurisdiction).
VIII VALUE ADDED TAX
Broadly speaking, VAT is an indirect tax, chargeable on consumer expenditure. In the EU, it is based on the EU VAT Directive. 151 VAT is implemented under the VAT Directive and various other EU regulations thereunder as well as local implementing laws in each jurisdiction. In the United Kingdom, the main implementing law is the Value Added Tax Act 1994 (VATA).
Under the UK rules, VAT applies to any supply where:
There are at present separate import VAT charges where goods are 'imported' into the United Kingdom from outside the EU and, from 1 January 2021, goods moving to Great Britain from outside the United Kingdom (including from any EU Member State) will also be treated as imports, rather than as an intra-EU 'acquisition' (business-to-business (B2B)) or 'distance sale' (business-to-consumer (B2C)) of goods under current VAT rules. 153
VAT is collected and payable by the supplier or by the person making the importation or (when applicable) acquisition. The ultimate 'cost' of VAT is intended to be borne at the end of the supply chain by the end user or consumer (who cannot recover the VAT cost), but the tax is collected at different stages in the supply chain.
A VAT-registered person must charge VAT (output tax) on its VATable supplies and can recover the VAT it pays (input tax) on supplies received by it to the extent that this can be attributed to its onward taxable (i.e., VATable or zero-rated) supplies. At intervals, when a return is made to HMRC, the VAT-registered person adds up all the input tax and all the output tax and deducts the input tax from the output tax; and if there is a positive balance, it pays to the UK tax authority, HMRC, (generally on a monthly or quarterly basis) the difference between its output and input tax (or it receives a repayment where input tax exceeds output tax).
Input tax is generally only recoverable to the extent it is attributable to taxable supplies. Therefore, where a VAT-registered person makes both taxable and non-taxable (i.e., exempt, non-business, or certain other outside the scope of VAT) supplies, only a proportion of his or her input tax will be recoverable.
Businesses that make taxable and exempt supplies are generally referred to as 'partially exempt traders', typical examples of which are banks and insurance companies. The recovery of input tax attributable to 'outside the scope' supplies varies. However, recovery is not blocked in the case of exports of services that would be taxable if made in the United Kingdom.
VAT records must be kept by VAT-registered persons for up to six years and a VAT invoice must normally be issued to support a customer's VAT recovery, showing the number of the invoice and the date, the date of supply, the supplier's name, address and VAT registration number, and the customer's name and address. In addition, the type of supply (e.g., sale or hire) must be shown, with a description sufficient to identify the goods or services supplied, the quantity and amount payable (excluding VAT), the rate of any cash discount offered and the rate and amount of VAT charged.
There are no specific VAT laws for franchising in the United Kingdom, or in the EU VAT Directive, so general VAT principles apply to franchising arrangements. UK VAT laws have continued to be aligned with EU VAT laws during the Brexit transitional period ending 31 December 2020. However after this period, Great Britain (and the United Kingdom in respect of services) is not part of the EU's customs union and VAT system, so it could then unilaterally introduce specific UK VAT laws for franchising arrangements. It is also proposed that exceptional rules would apply in respect of movements of goods between Northern Ireland and EU Member States pursuant to the terms of a Protocol on Ireland/Northern Ireland, agreed in principle between the United Kingdom and the EU as part of settling the Withdrawal Agreement, and whose priority is to avoid a hard border between Ireland and Northern Ireland. According to HMRC, this means that Northern Ireland will remain aligned with the EU's VAT rules for goods moving between the EU and Northern Ireland, and otherwise Northern Ireland will remain part of the UK VAT system, so UK VAT rules related to transactions in services will apply across the whole of the United Kingdom. HMRC will also continue to be responsible for the operation of VAT and collection of revenues in Northern Ireland, whereas import VAT will be due on goods that enter Northern Ireland from Great Britain. The result is a special, dual VAT regime in Northern Ireland and a new process would apply for identifying Northern Ireland traders using a special VAT identification prefix for EU VAT purposes and enabling them to reclaim EU VAT through existing processes. However, at the time of writing, significant issues remain outstanding on the implementation and application of the Protocol, including with regard to respecting Northern Ireland's place in the United Kingdom's customs territory and internal market, and supporting the smooth flow of trade. Therefore, agreement is still required on the practical solutions necessary for traders such as supermarkets and franchises in relation to the Protocol and on how to establish which goods are at a genuine and substantial risk of entering the EU market.
i Taxable person
VAT applies to supplies made by a taxable person. Therefore, a person who is a taxable person must charge VAT on taxable supplies made by him or her at the appropriate rate and a person who is not a taxable person must not charge VAT in respect of any supply.
A 'taxable person' is essentially a person (including a company or a partnership) who makes taxable supplies in the United Kingdom in the course or furtherance of a business carried on by him or her and the aggregate value of the supplies that have been made by him or her in the previous 12 months or less, or are expected to be made in the forthcoming 12 months (or in the next 30 days alone), exceeds the prevailing registration limit (this is currently £85,000 in the United Kingdom). This threshold has, however, been removed with effect from 1 December 2012 for all non-UK traders without a UK establishment who make taxable supplies for VAT purposes of any value in the United Kingdom (such as supplies relating to UK land or supplies of stock stored in the UK). Businesses may also register voluntarily for VAT (thus becoming taxable persons).
ii Supply of goods and services
A 'supply of goods' means the supply of the whole property in goods but the transfer of an undivided share in property or of the possession of goods is a supply of services (unless possession is transferred under a sale agreement or in certain other circumstances (e.g., hire purchase agreements). Additionally, certain other supplies are specifically treated as supplies of goods (e.g., supplies of power or certain supplies of land). 154
A 'supply of services' is very widely defined as anything that is not a supply of goods but is done for a consideration (including, if so done, the granting, assignment or surrender of any right). 155 Granting IP rights will generally be supplies of services for VAT purposes.
iii Time of supply
Broadly, for goods, the time of supply is when they are removed or otherwise made available. If the goods are removed before it is known whether they are to be supplied, the time of supply is when the supply becomes certain or, if sooner, 12 months after removal. 156
The 'time of supply of services' is when the services are performed. 157 An exception to this general rule is where there is a continuous supply of services, in which case the time of supply is the earlier of when the payment is received by the supplier and when the supplier issues the invoice. 158 In the case of royalties, the time of supply is the earlier of when the royalties are received or a VAT invoice is issued. 159
For both goods and services, it is possible to accelerate the time of supply by the issue of a VAT invoice or receipt of payment (e.g., deposit or prepayment on account). 160 Further special time-of-supply rules apply in respect of reverse charge services received by UK businesses from outside the United Kingdom 161 and, until 31 December 2020, in respect of intra-EU acquisitions of goods to the United Kingdom (post-January 2021, this should be limited to Northern Ireland).
iv Taxable supply
A taxable supply is a supply of goods or services made in the United Kingdom other than an exempt supply. 162 There are three rates of UK VAT on taxable supplies, 20 per cent, 5 per cent (on a limited class of supplies) and nil (on zero-rated supplies). Supplies of certain services or types of stock may be exempt or subject to a reduced (for example, zero) rate of VAT, but this will depend on the nature of the services or goods in question and whether they form part of a mixed or composite supply with other goods or services.
An exempt supply in the United Kingdom is a supply specified in Schedule 9 of the VATA. Exempt supplies include financial and insurance services, but supplies of IP are not generally exempt. Zero-rated supplies are set out in Schedule 8 of the VATA and include, subject to detailed conditions, food, children's clothing, and medicines prescribed by pharmacists.
There are two other categories of supply, which are important for VAT purposes: 'outside-the-scope' supplies and other supplies treated as not involving a supply of goods or services with the result that VAT is not chargeable. Examples of such supplies include non-business supplies, the supply of certain international services (e.g., a transfer of IP to a customer outside the United Kingdom) and a transfer of a business as a going concern (TOGC). UK TOGC rules can cover IP supplies or licensing, or both. The expression 'going concern' generally refers to a business that is still in existence, live or operating and has all parts and features necessary to keep it in operation, as distinct from being only an inert aggregation of assets. A business scaled down because of financial difficulties or in anticipation of a sale, or even in liquidation, receivership or bankruptcy, can still be a going concern.
TOGC rules are not implemented in a harmonised way across Europe, and different local considerations will apply. In the United Kingdom, TOGC treatment for transfers of franchise businesses can be available provided several conditions are met, including that the same kind of business is transferred from a franchisor to a franchisee and that the new franchisee intends to carry on the same kind of business, without a significant break in trading after the transfer, and the transfer will not be followed by other immediately consecutive transfers of the business (e.g., to another new franchisee). Where only part of a business is sold, it must be capable of separate operation. HMRC internal guidance 163 notes the importance of establishing whether a franchisor has actually operated the business being transferred. If so, it is capable of being a TOGC. Otherwise, merely granting a franchise is not a TOGC, as such a grant is not the same kind of business as making supplies of goods and services under a franchise agreement. TOGC for VAT purposes may also be available in circumstances where a franchisee gives up a franchise and the franchisor 'installs' another franchisee in the premises. In those circumstances, one would have to examine whether the new franchisee was buying the premises, stock or fixtures and fittings from the old franchisee and that what was being transferred was the possession of a business as a going concern that could be carried on by the new franchisee on a lasting basis. The fact that the permission of the franchisor may be necessary for the assets to be sold should not prevent the transaction from being a TOGC. In addition, where the transferor is a taxable person (i.e., UK VAT registered), the transferee must be a taxable person (VAT registered) already or immediately become one as the result of the transfer (with the VAT registration usually being in place by and with effect from completion).
Where land is transferred as part of a TOGC, there are certain extra conditions that may have to be met for the transfer of the land or lease, etc. to be given TOGC (non-VAT) treatment. One such condition is that the transferee may have to make an election (called an 'option to tax') and notify HMRC of this decision to elect before completion (or an earlier payment) to waive any VAT exemption relating to a transfer of the property in question, and also notify the transferor that this option will not be revoked under certain anti-avoidance rules.
v Place of supply
The complex 'place-of-supply' rules determine in which country, if any, a supply of goods or services should be taxed. The result is that UK VAT is only chargeable where the place of supply under these rules, as implemented domestically, is the United Kingdom. UK VAT is not chargeable if the place of supply is outside the United Kingdom, even if made by a taxable person. If the place of supply is another Member State of the EU, that Member State has the jurisdiction to charge its local equivalent of VAT on the supply. If the place of supply is outside the EU, no Member State has the jurisdiction to charge VAT on the supply although VAT or sales tax may be chargeable outside the EU.
There are detailed rules for both goods and services and the rules vary depending on whether supplies are to 'taxable persons' (broadly speaking, businesses) or not. In the context of franchising we would assume that most supplies by franchisor to franchisee are B2B supplies of services.
Supply of services
The place of supply of services ultimately depends on various factors, such as the nature of the services, whether or not the recipient is a taxable person, and where the service is carried out. Nonetheless, subject to future legislative changes in the United Kingdom taking effect after 1 January 2021, in summary, the present position is that the general place-of-supply rule for services is as follows:
So, in a franchising context, B2B supplies of services by a franchisor to a relevant business person are generally treated as supplied in the country in which the recipient belongs. For this purpose, a relevant business person is a person registered for VAT in the United Kingdom, Isle of Man or EU or any person who independently carries out in any place any economic activity and where in any case the services are received other than wholly for private purposes.
It should be noted that the general rules stated above are subject to many exceptions. 164 For example, for broadcasting, telecommunications and electronically (BTE) supplied services, the supply is treated as made where the recipient belongs, irrespective of whether the recipient is in business or not, with the supplier liable to account for BTE supplies to non-business recipients, and VAT-registered business recipients being liable to account using a reverse charge procedure. The VAT Mini One-Stop Shop (MOSS) scheme, an electronic registration and payment system, was introduced across the EU to facilitate suppliers' VAT administration for their BTE supplies to non-business recipients or consumers in the EU where the supplier was not established. However, as a result of the United Kingdom's exit from the EU, from January 2021, the UK MOSS system will no longer be available for use by UK suppliers making cross-border BTE supplies to EU-based consumers, and a local UK VAT registration will be required of any non-UK suppliers to account for UK VAT on their BTE supplies. For IP royalty income, either the general B2B rule applies for UK VAT place-of-supply purposes (so VAT is chargeable where the business customer belongs) or, where applicable, a special rule listed in VATA 1994, Schedule 4A, Paragraph 16 applies for UK outbound IP (and other professional) supplies to non-business consumers outside the EU (which is expected to be amended to include non-business consumers in EU Member States (see below)), so that such supplies to both EU and non-EU private customers under UK VAT laws from 1 January 2021 will not be subject to UK VAT. For certain supplies, such as the hire of goods, the United Kingdom currently applies a use and enjoyment rule override against the general rules. The use and enjoyment rules are intended to make sure taxation takes place where services are consumed if services are either consumed within the UK but would otherwise escape VAT or they would be subject to UK VAT when consumed outside the EU. Effective use and enjoyment takes place where a recipient actually consumes services irrespective of the contractual arrangements, payment or beneficial interest. In these circumstances, the place of supply of the relevant service is where their effective use and enjoyment takes place. Where this is the United Kingdom, the services are subject to UK VAT and the parties would need to consider who is responsible for accounting for the VAT depending on the relevant rule or supply and VAT status of the recipient. The use and enjoyment rule as adopted in the United Kingdom (e.g., for the hire of goods in the United Kingdom) is expected to apply in respect of EU lessees as it does for non-EU lessees from 1 January 2021, so that UK VAT may be chargeable on the hire of goods in the United Kingdom by EU-based residents. The EU's own use and enjoyment rules will also have more relevance for the United Kingdom, with it becoming a non-EU jurisdiction for all intents and purposes from 1 January 2021.
In addition to these special rules and exceptions, a crucial question to determine the place of supply in respect of services is normally where the supplier or recipient 'belongs'. For a relevant business person, it is broadly the place where that person has its business establishment or some other 'fixed establishment' or (in the United Kingdom at least), if it has more than one business establishment, the establishment that is most directly concerned with the supply of services in question. How these provisions should be interpreted, as well as the meaning of terms such as 'fixed establishment', has been subject to a substantial body of UK and EU case law. Non-business persons are treated as belonging in the country of such a person's usual place of residence. 165
Supplies and imports of goods
The starting point under United Kingdom domestic law is Section 7 VATA, which sets out a priority for the place of supply of goods. If a supply does not involve the removal of the goods to or from the United Kingdom, they shall be treated as supplied in the United Kingdom if they are in the United Kingdom. There is then a complicated hierarchy of rules that follow this to determine the place of supply. If, for example, the supply involves their importation by the supplier and onward supply in Great Britain, UK VAT will be due. Similarly, if goods are to be installed or assembled in the UK, UK VAT will be due. Supplies of goods to EU registered businesses are currently UK VAT zero-rated as dispatches provided the goods are removed from the United Kingdom within three months of the supply. However, intra-UK–EU trade in goods from January 2021 will be subject to VAT rules on imports and exports and customs supervision and UK businesses may require local fiscal representation to provide trade (including providing services) within the EU. EU distance selling rules for UK VAT purposes will no longer be relevant.
Accordingly, from January 2021, shipments from the EU to Great Britain will become imports, and UK import VAT will become chargeable together with applicable duties or tariffs (except where HMRC's new import model applies). As noted, separate arrangements will apply in respect of goods moving from Great Britain to Northern Ireland, but the details of these arrangements are still under discussion with the EU. In addition, from 1 January 2021, supplies involving the export of goods outside the United Kingdom, including to EU Member States, can be VAT zero-rated.
Given the time of writing, we have outlined below some further detail on the proposed UK reforms for trade in goods, as well as the EU's future reforms derived from its Action Plan on VAT (see below) 166 and subsequent proposals (irrespective of Brexit). These rules for goods are, however, more complicated than the rules for services and we only outline them here on the assumption that the heart of a typical franchising arrangement is the licensing of IP and the supporting services. Nevertheless, there can be associated agreements for the supply and cross-border movement of goods, so the complex VAT rules on goods would then have to be considered carefully, particularly in light of Brexit for franchisors trading within Europe. For UK franchise arrangements involving movements of goods to Europe, customs valuation rules could become more significant, given that under current EU and UK customs rules (which are likely to be retained initially from 1 January 2021), royalties and licence fees in respect of IP rights incorporated in imported goods and payable to a seller are to be included in the customs value for import VAT and customs duty purposes. This applies, broadly, where such fees both relate to the imported goods (i.e., embodied in the goods) and are paid as a condition of the sale (even if they are not stipulated in the price paid or payable). In-scope arrangements could include the manufacture or sale for export of imported goods (incorporating, for example, patents, designs, models and manufacturing know-how and trademarks) or the use or resale of imported goods (in particular, copyright, and manufacturing processes inseparably embodied in the imported goods). For example, if the imported goods incorporate a trademark under which the goods are marketed and for which the licence fee is paid, this should be considered to be related to the imported goods, particularly if the licensee is not free to obtain such goods from other unrelated suppliers. Helpfully, EU guidance indicates that a franchising licence agreement that involves payment of a royalty or licence fee in return for the supply of services such as the training of the licensee's staff in the manufacture of the licensed product or in the use of machinery or plant, and technical assistance in the areas of management, administration, marketing, accounting, etc. should not be included in the customs value for the relevant goods. However, all the circumstances and contractual arrangements surrounding the sale (and the import of the goods and payments to third parties) may need to be examined, including possible links between sale and licensing agreements and other relevant information.
Further changes
In light of Brexit, HMRC has published a new proposed Great Britain (GB) Border Operating Model and a new import model will apply from 1 January 2021, whereby UK import VAT and duties will no longer be due at the GB border in respect of a consignment of goods valued at less than £135 (excluding, for example, excise goods). Instead, UK VAT will be charged on the goods to be imported as if they were already supplied in the United Kingdom, with such VAT accountable to HMRC on the UK VAT return. This means that businesses (whether or not in the United Kingdom) selling these low-value consignments of goods to be imported into Great Britain will be required to register for UK VAT and charge and collect any VAT due at the point of sale. In circumstances where businesses sell these low-value consignments to consumers through an online marketplace, the online marketplace will be required to register for UK VAT and to account for the VAT due on its VAT return. UK VAT registered businesses importing goods in a consignment valued at less than £135 will be required to account for VAT on their VAT return under the reverse charge method.
For consignments of goods exceeding £135, normal UK import VAT and customs duties and tariffs will apply. To assist businesses' cash flow, the United Kingdom will be introducing postponed VAT accounting from January 2021 for UK VAT registered businesses that act as the importer, so that UK import VAT may be declared and reclaimed on the same UK VAT return, without actually having to be paid to HMRC. However, HMRC is also insisting that the owner of the goods at the time of import must act as the importer of record for the goods when bringing them to the UK, as only the owner will be allowed to use postponed VAT accounting and reclaim the UK import VAT via the VAT return. There are a very few exceptions to this (e.g., using a qualifying undisclosed agent to import the goods instead). HMRC is therefore advising businesses to ensure that there is clarity in supplier trading terms on the owner of goods at the time of their import, on the responsibility for customs checks, tariffs, duties and border formalities, and on who will be financially responsible in the event of any issues.
Irrespective of Brexit, further changes proposed by the EU will affect all suppliers trading in goods within the EU and should be noted. These include reforms that will take effect in EU Member States from 1 July 2021, whereby a new low €10,000 threshold will replace all existing distance selling rules for intra-EU supplies of goods B2C and when this threshold is exceeded VAT will be due and accountable on the goods sales in the EU country of delivery. Online marketplaces facilitating sales will be treated as deemed suppliers for EU VAT purposes in certain circumstances and liable to account for any such VAT that is due. To mitigate the need for multiple EU VAT registrations for online suppliers, a new electronic One Stop Shop (OSS) VAT registration (simplification) service will be introduced. Similar to the UK's new import model, EU VAT will also become due at the point of sale (rather than at import) from non-EU sellers or online marketplaces in respect of sales of low-value goods to be imported (i.e., valued at less than €150), and a new electronic Import One Stop Shop will be developed to assist importers with their import VAT accounting obligations. These changes form part of the EU's VAT e-commerce package reforms, which themselves form part of a wider set of EU VAT proposals to implement a 'definitive' EU VAT system from July 2022. These latter proposals would end the EU's current practice of allowing an EU supplier to zero-rate intra-EU B2B sales and the EU purchaser to self-assess and account for (acquisition) VAT on intra-EU purchases, and instead would create a single destination-based VAT system for all cross-border transactions, under which supplies would be taxed in the destination Member State or where the transport of the goods ends, at the VAT rate applicable in that Member State, together with an OSS for all B2B EU traders to deal with their VAT accounting. Eventually this VAT treatment may be extended to all imported, cross-border services, the proposals for which will be implemented at a later date. Since the Action Plan on VAT, the European Commission has also adopted a Tax Action Plan that includes modernising EU VAT rules and tackling VAT fraud. The EU's 2022 reforms are not yet finally determined and the relevance of these proposals to UK businesses (as non-EU businesses) will depend on the United Kingdom's relationship with the EU following Brexit (e.g., whether they could be required to appoint an EU-based intermediary to use the OSS).
vi Importation of services from other countries
It has been noted above that where a supplier belonging outside the United Kingdom makes a supply to a taxable person in the United Kingdom and that supply is treated under the above rules as taking place in the United Kingdom, the 'reverse charge' rules apply. Under the reverse charge, the recipient of the services (rather than the supplier of the services) is required to account for VAT at the rate applicable in the Member State in which he or she belongs to the relevant tax authority. The rules also allow the recipient an input tax deduction in respect of purchases related to taxable outputs. The effect of the reverse charge in the United Kingdom, therefore, is to treat services brought in from outside the United Kingdom in the same way as services that are actually supplied in the United Kingdom if the recipient of the services is VAT registered but with the recipient applying the relevant VAT formalities. The reverse charge procedure may also be used on certain imports to Great Britain from 1 January 2021 and for certain domestic supplies (e.g., B2B wholesale telecommunications supplies in the United Kingdom).
Generally, reverse charges have no effect on recipients who are not taxable persons.
After 1 January 2021, VAT rules for (general rule) services (including IP) should largely remain unchanged. For example, the UK's reverse charge is applied by a UK VAT registered business that buys services from abroad and not just the EU, so this rule should not be impacted by Brexit. Similarly, for supplies of B2B services to EU business customers, the place of supply will remain the EU country where the business customer is based (invoices should still display the customer's EU VAT number as this is the best evidence of the customer's business status).
vii Effect of the above rules on franchising arrangements
The net effect of the above rules on franchising arrangements is that generally:
For example, under (a) above, in a franchising context, where a UK franchisor charges royalties under a standard franchise agreement to a UK franchisee (i.e., the royalties represent the franchisor's licensing of the franchisor's IP), this would be a B2B supply of IP or services for UK VAT purposes (assuming this licence were not part of a qualifying TOGC transfer of the franchise) and this supply would be inside the scope of UK VAT where supplied between two UK-established businesses. UK VAT would be chargeable, accountable by the franchisor. In the case of inbound IP supplies from a non-UK franchisor to a UK franchisee or licensee, then, as under (c) above, UK VAT would not be charged by the overseas franchisor, but it would instead be accountable by the UK VAT registered franchisee or licensee under the United Kingdom's reverse-charge mechanism, although, as this is a reporting or simplification mechanism, there should be no net VAT payable by the UK franchisee on the supply (i.e., then the supply should be cash-flow or VAT neutral for the franchisee or licensee) unless it was a partially or wholly exempt business that cannot fully recover UK VAT. Internal licensing of IP between sister franchisor entities would be subject to UK VAT on the same principles, assuming the entities were not part of a formal UK VAT group (which would need to be specially registered as such) to disregard such supplies. UK VAT grouping rules presently require group members to have a UK fixed establishment.
There have been some UK VAT cases involving franchising arrangements. One such case is Kumon Educational Company Limited v. HMRC, 168 which looked at rewards provided to a franchisee by the franchisor. It was held that these rewards were not for a separate VATable supply but were linked to the franchise fee and in effect amounted to a contingent discount. The franchise fee could therefore be reduced for VAT purposes and VAT previously accounted for repaid.
In Reeds School of Motoring (Sheffield) Ltd v. C & E Comrs, 169 driving tuition supplied to pupils was held to be made by the (franchisee) instructors as principals and not by the motoring school, the latter's role being to provide a supporting organisation by which the instructors were provided with the means to give tuition, such as the tuition cars. It was held that the tight control maintained by the school over the instructors was a common feature of franchise agreements, where the franchisor does not carry on the business in question (say for example, one of a chain of restaurants), but instead licenses another (for reward) to do so under a name and method of operation that are, or are intended to be, distinctive and well known. This control was held not to be determinative of the type of relationship between the parties, and it was concluded that the business in question was that of the franchisee while the franchise agreement was in force.
Tumble Tots UK Ltd v. Revenue and Customs Comrs 170 involved a franchisor of a chain of play centres for children. To take part in a play session, the child would need to be a member of the National Tumble Tots Club. An annual fee was payable, and this was the subject of the appeal. In return for the annual fee, a member received various benefits including a T-shirt and various newsletters and booklets. HMRC argued that there was one main supply of membership (standard rated), entitling the children to take part in activity sessions at Tumble Tots premises. All other supplies were considered to be incidental to this main supply. Tumble Tots argued that the main supplies were the zero-rated supplies of printed material and children's clothing (T-shirt), so overall it was making a zero-rated supply. The tribunal concluded that the membership was the main benefit, and all other supplies were incidental apart from the T-shirt that had some monetary benefit and importance to the child. However, HMRC appealed 171 to the High Court, which ruled that the aim of the payment made by the customer was to secure attendance at the classes. Other benefits such as the T-shirt were incidental to this main supply. The entire payment made by the customer was therefore subject to VAT.
In the joined cases of Air France-KLM and Hop!-Brit Air SAS v. Ministère des Finances et des Comptes publics, 172 (KLM), Hop!-Brit Air SAS (Hop) provided air passenger transport services under a franchise agreement with Air-France-KLM, with Air-France being responsible for marketing and ticket management on the franchised routes. In the context of the franchise agreement, Air-France received the ticket price direct from passengers and paid this on to Hop in relation to each transported passenger. Where there were 'no-shows' or tickets had expired, Air-France paid Hop compensation at an annual flat rate calculated at 2 per cent of the annual turnover (including VAT) received from the routes operated as a franchise. Hop did not account for VAT on these sums and the French authority issued assessments for VAT on these amounts. The question for the Court of Justice of the European Union (CJEU) was whether or not a non-refundable payment for unused tickets was a taxable supply. The taxpayer argued that payments in such circumstances should be treated as compensation and therefore outside the scope of VAT. However, the CJEU held that, looked at objectively, the payments were subject to VAT as they represented consideration for a right to benefit from the airline's obligations under a transport contract, even if they were not actually used by no-show passengers. It also held that the sums paid by Air France-KLM to Hop could not be regarded as compensation for harm suffered. Instead, the sums corresponded to the value attributed by the parties to the unused tickets issued for a transport service and were therefore subject to VAT.
HMRC has recently revised its VAT policy to treat most early termination and compensation payments payable from a customer to a supplier as further consideration for the supplier's supplies under the original contract, which is subject to applicable UK VAT. 173
