GST on Franchise Agreements

While tax authorities allege that the franchise agreements are taxable under GST at 18%, taxpayers allege that such transactions are exempt from GST.

A franchise agreement is a legally binding agreement by which the franchiser allows the use of certain intellectual propriety rights to the franchisee in return for consideration. These agreements are very commonly used to scale business models for example: expanding on a restaurant chain is generally done by franchising out the intellectual property of the brand by the franchisor to another party (franchisee) who then will set up the same business model and use the property of the franchisor in return for royalty payments.

There have been multiple disputes surrounding the taxation of such agreements. While tax authorities allege that the agreements are taxable under Goods and Service Tax (GST) at 18%, taxpayers allege that such transactions are exempt from GST tax.
 
Structure of Franchise Agreements:

While the GST Acts have not defined “franchise”, the definition from the Finance Act, 1994 can be borrowed. The Act allows that franchise refers to, “means an agreement by which the franchisee is granted representational right to sell or manufacture goods or to provide service or undertake any process identified with franchisor, whether or not a trade mark, service mark, trade name or logo or any such symbol, as the case may be, is involved.”

Further, franchisor means, “any person who enters in to franchise with a franchisee and includes any associates of franchisor or a person designated by franchisor to enter into franchise on his behalf and the term "franchisee" shall be construed accordingly.”

Hence, franchising is a mode by which one party is allowing the use of its branch, business model, name, and other intellectual property to another party in return for consideration- generally known as royalty payments. Franchising is also different from licensing as licensing is usually a model used for transfer of intellectual property rights for goods, while franchising is usually used to expand service related business models.

When franchise agreements are entered into, the parties transfer the right to use intellectual property rights in return for certain payments such as franchise fees, and royalty payments. There has been debate on whether these payments should be taxable under GST. Generally, the GST will be taxable based on what kind of service is being provided by the franchisee and whether those are taxable under the Act itself. The Authority for Advance Ruling has provided some clarity on the applicability of the GST rules.
 
Rulings on Franchise Agreements:

Over the last year, the Authority for Advance Rulings have clarified the application of certain GST rules for such agreements.

1. Do parties in a franchise agreement require registration under GST?
As per section 22 and section 6 of CGST, anyone having an aggregate turnover of 20 lakhs and who provides a taxable supply of goods or services, then they are liable for GST registration. As per section 24 of the CGST Act, the following require compulsory registration with GST:
  • Persons making any inter-State taxable supply;
  • Casual taxable persons making taxable supply;
  • Persons who are required to pay tax under reverse charge;
  • Person who are required to pay tax under sub-section (5) of section 9;
  • Non-resident taxable persons making taxable supply;
  • Persons who are required to deduct tax under section 51, whether or not separately registered under this Act; etc.
  • And other supplies as laid down in section 24.
In the case of In re: Pratator (AAR Gujarat), it was held by the AAR that parties that qualify in the above rules are liable for GST registration.

In this case, the parties had entered into a franchise agreement under which they the franchisee was to build out required infrastructure and sell goods on behalf of the franchisor, using the brand and other intellectual property of the franchisor. The AAR held that any franchisor that was acting on behalf of the franchisee would always qualify for compulsory registration. In this case, since the franchisee is selling goods and services on behalf of the franchisor, they have to be registered under GST since they provide taxable services as an agent of the franchisor.

2. How are franchisee fees and royalty payments classified under GST? And does a franchise agreement mean that there is a transfer of business units?
In a franchise agreement there are generally two kinds of payments being made: franchisee fees and royalty fees. The franchisee fees may be a lump sum payment made by the franhisee at the time of entering into the contract, while the royalty payments may be recurring monthly fees.

In the case of M/S. Tea Post Private Ltd., the Authority clarified the GST treatment for such payments. The applicants in this case were arguing that the payment of franchisee fees and royalty would be covered under Service Code Trariff, Heading 9973 (Leasing or rental services with or without operator) of the Notification No.11/2017-Central Tax (Rate) dated 28.06.2017 which would attract GST @12%. The applicant also argued that franchisee fee is covered under heading 997336 as well.

The Authority looked into both heads of classification and found that 9973 was for Licensing services for the right to use intellectual property and similar products; and heading 997336  was for Licensing services for the right to use trademarks and franchises. The Authority created a distinction between franchising and licensing mainly on the following grounds:

  • Under licensing, the licensor does not exercise autonomous control over the activities of the licensee with regard to the licensed product. The franchisor on the other hand continues to exercise control over the business of the franchisee in terms of quality of service provided, marketing & selling strategies, etc.
  • Licensing generally does not require technical support as part of the licensing services, while a franchisor will generally provide adequate support to the franchisee for carrying out the business activities.
  • Franchising is mostly related to service products such as restaurant chains, service Centres; while licensing is mainly for products and goods related supplies.

Hence, the agreements entered into by parties must be analyzed along the above lines to determine whether it is a franchise agreement or a licensing agreement in substance. Both headings in 9973 and 9936 are in reference to licensing services entered into under a licensing agreement. If it is found that the services are entered into under a franchisee agreement then these are classified under Heading 9983-Other professional, technical and business services, as per the Serial No. 21 of the Notification No.11/2017- Central Tax (Rate) dated 28.06.2017. Further, they found that as per the Annexure: Scheme of Classification of Services, the Franchisee Fee and Royalty covers under Service Code (Tariff) No. 998396 as “Trademarks and franchises.”

This implies that franchisee fees and royalty payments under a franchise agreement fall under Chapter Heading 9983 as “Other professional, technical and business services” and Service Code (Tariff) - 998396-Trademarks and franchises, attracting GST @ 18%. 

Secondly, the applicants tried to argue that since the franchise agreement required the transfer of assets for setting up the business, hence it was a situation of transfer of business assets, and not taxable supply of goods under GST. Transfer of business assets refers to situation of transfer of an ongoing concern as a whole. Even independent transfer of a business means the transfer of a a distinct business vertical and not the same vertical of which a certain portion has been transferred to other entity. Such transfers are exempt from GST.

However, franchising is akin to opening a new branch of an existing business from where the franchisee will carry out the commercial activities. Hence, supplies made by a franchisor to a franchisee under an existing franchise agreement would be taxable as supply of goods or services under section 7 of the CGST Act. Franchisors can also avail input tax credit on such the supply of such infrastructure/equipment as it qualifies as a taxable supply.