Australia: Franchising Matters

HIGH COURT UPHOLDS WIN FOR FRANCHISORS

In edition 3 of Franchise Matters, we examined the decision of the Full Court of the Federal Court in Poulet Frai Pty Ltd v The Silver Fox Company Pty Ltd (otherwise known as "Lenards case"). We now update you on what appears to be the final chapter to this case.

In September 1998, the Silver Fox Company ("Franchisee") purchased a Lenards Chicken franchise in South Australia. Over the following 2 years, the franchise repeatedly failed to achieve the specified minimum gross revenue targets. In July 2000, Poulet Frai ("Franchisor") terminated the Franchise Agreement.

The Franchisee sued the Franchisor and Master Franchisee on the basis of misleading and deceptive conduct in breach of section 52 of the Trade Practices Act. The trial judge found that the Franchisor and Master Franchisee had misrepresented

(1) the potential sales and profitability of the franchise; and

(2) the desirability of the location for the Lenard's Chicken shop.

The Franchisor and Master Franchisee appealed to the Full Federal Court, which overturned the trial judge's decision. The Full Federal Court held that the financial information provided to the Franchisee was a guide only. Additionally, the suggestion that the Franchisee relied on the financial information was completely opposite to the Franchisee's written acknowledgments that it had made its own investigations.

Not to be defeated, the Franchisee recently sought leave to appeal to the High Court of Australia. However, the High Court has refused to grant the Franchisee leave to appeal, and upheld the Full Federal Court's finding that the Franchisor and Master Franchisee had NOT engaged in misleading and deceptive conduct.

The High Court's reinforcement of the Full Federal Court's decision signals a positive for Franchisors. While it does not mean that Franchisors can be careless in the representations and disclosures they make to potential franchisees, it does highlight that it is the franchisee's own responsibility to get advice and satisfy itself as to the potential profitability and suitability of the particular franchise system. The Lenards case also reinforces the usefulness of disclaimers and 'entire agreement' clauses in franchise agreements. Lastly, it also reminds Franchisors of the importance of ensuring that their franchisee signs a Representations Certificates located in the franchise agreement.

This following case highlights the circumstances in which a court will enforce restraint of trade provisions, preventing former franchisees from operating a competing business once the franchise relationship has ended. Raine & Horne Pty Ltd v Adacol Pty Ltd (2006) NSWSC 36 Raine & Horne Pty Ltd ("Raine & Horne") granted Adacol Pty Ltd ("defendant") a franchise, pursuant to a Franchise Agreement to conduct a real estate business from 2 separate premises. The Franchise Agreement was due to end on the 3 August 2007. During 2005 a representative from the competitor Ray White approached the defendant and asked the defendant to become a Ray White franchise.

In December 2005, the defendants informed Raine & Horne that they were leaving the franchise and had since entered into a Franchise Agreement with Ray White and, in effect, terminated the Franchise Agreement with Raine & Horne. The defendants were operating from the same premises, however changed the décor according to Ray White colours. Raine & Horne sought an injunction to prevent the defendant from operating a competing business.

Clause 29.1 of the Franchise Agreement stipulated that for a period of 12 months after the termination, the defendant could not "conduct or be in any way employed or interested in a real estate agency business which carries on business substantially within a radius of five kilometres from the premises". The court was faced with having to balance public policy issues against protecting the legitimate interests of the Franchisor.

In enforcing the restraint, the court said that "restraints of trade may be valid where they are reasonably necessary to protect some identified legitimate interest of the party seeking to enforce the restraint, and where they do no more than is reasonably necessary to achieve that". The restraint of trade clause did not prevent the defendant from carrying on its business, it simply prevented the defendant from establishing a business within a particular locale. For this reason, the court felt it reasonable to enforce the restraint of trade provision.

1. What tax is payable when a franchisor grants a franchise or a franchisee sells the franchise?

Most amounts received by a franchisor relating to the grant or operation of a franchise (such as franchise fees, training fees, renewals etc) should be assessable income and taxable as ordinary income. Expenses which relate to the granting or operation of a franchise (such as legal or advertising costs) and are part of the ordinary business for the franchisor should be deductible outright.

Whilst many franchises are often granted as greenfield sites, a franchise could also be granted in conjunction with the sale of an existing franchisor owned business or existing franchise, which will include goodwill. Goodwill is a capital asset and any gain made on the sale would be a capital gain for the selling party, whether franchisor or existing franchisee. The selling party may be able to reduce the gain if certain capital gains tax ("CGT") concessions or exemptions may be available.

2. How is Intellectual Property ("IP") treated for tax purposes?

The franchisor or related entity is likely to own intellectual property ("IP") which it licenses to the franchisees in receipt of licence/royalty fees. These fees, whether payable upfront or over time, should be assessable as ordinary income.

Costs involved in developing IP may be claimable as an outright deduction if part of ordinary business activities for the franchisor.

Alternatively, the franchisor can claim depreciation deductions for the cost of certain IP (specifically, a patent, registered design, copyright or in-house software), or otherwise, the costs may form part of the cost base for the IP (such as trade mark) for CGT purposes which will reduce a potential capital gain on the disposal of the IP.

3. GST issues

Assuming that the franchisor is registered for GST, it would also be required to charge GST on taxable supplies it makes to the franchisee. The supply of the franchise and any services performed pursuant to the franchise agreement (such as training for the franchisee etc) should be taxable supplies and therefore GST would be required to be remitted by the franchisor. In relation to ongoing licence/royalty fees, it is common for recipient created tax invoice ("RCTI") arrangements to be entered into, whereby the franchisee issues RCTIs, reducing the administrative burden on the franchisor.

One of the issues that is often overlooked, particularly where there have been long negotiations or a protracted sign up process, is the requirement to pay stamp duty. Failure to pay stamp duty, when required by law, may render a Franchise Agreement, Lease/Licence Agreement or Sale of Business Agreement unenforceable in a Court.

Stamp duty is a State based tax levied by the various State Governments on certain transaction documents.

The transaction documents that are liable for stamp duty and the amount or rates of stamp duty payable vary from State to State. Some examples of the types of documents which can be subject to stamp duty include:

• Franchise Agreements
• IP Licence Agreements
• Transfer of Business Agreements
• Leases/Licence Agreements
• Guarantees and Indemnities
• Mortgages and Trusts

Generally, the location of the franchise business or business premises will determine which State's Stamp Duty laws apply. However, if the business is located within more than one State then the transactions documents may need to be assessed for Stamp Duty in a number of States. Most of these types of stamp duty has been abolished in Victoria.

Most States and Territories have a time limit in which stamp duty must be paid on a transaction document and, if not paid, then penalties apply.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.