Sunday, November 8, 2009

OPTIONS WHEN ONE PAYMENT IS TAXABLE TWICE

       Many of you may think that today's topic, as suggested by the headline, is a little nonsensical. After all, one payment should never be deemed as taxable income to two separate entities at the same time, should it? Only when it occurs to your organisation will you realise that it is not a joke at all.
       If you are not familiar with the franchise agreement framework, you will need to understand the relationship as well as the roles of the franchisor and the franchisee. In brief, an owner of intellectual property rights, a franchisor, will grant a licence to use trademark or trade name, whether registered or unregistered, as well as technique for the production or for the operation of the franchised business, to a franchisee for a certain period of time in exchange for the franchise fees. The franchise fee structure is often divided into an initial franchise fee that is charged at a fixed amount; and a variable fee that is tied to the gross sales revenue of the franchised business.
       What is the reason behind this fee structure? The combination between the initial fee and the variable fee is not really groundless, as it is structured to help the franchisee not to incur too large a financial burden at the beginning stage when the business has not yet generated much revenue. In many circumstances, the trademark or service mark is also brand new to consumers in the local market.
       To allow the franchised business to grow together with the brand, the initial franchise fee tends to be fixed at a low rate, which means that the franchisor will first contribute intellectual property rights. Certainly, the franchisor, in return, expects higher profits via the variable franchise fee from the growth of the business. This is a typical sharing scheme whereby the franchisor will contribute intellectual property rights and the franchisee will invest the costs and efforts in the local market.
       The key that most franchisors expect from franchisees is the effort in marketing and promotional activities in the permitted jurisdiction (e.g. Thailand). If the franchisee does not do marketing activities actively or does not put in sufficient effort, the franchisor can hardly expect good sales volume. In the absence of good sales volume, the variable franchise fee would be marginal.
       Thus, it is not a surprise to see the franchisor require the franchisee to incur an amount of marketing expenses in each year, e.g. advertisements on TV, radio, newspapers and magazines. Although the franchisee has the liberty to engage any agencies and freely negotiate advertising fees with agencies or the media, as the intellectual property rights are the property of the franchisor, it is normal that the franchisor will maintain a "control" on such advertisements to ensure that the franchisee will not do anything that may harm the brand image.
       At this stage, the franchisor does not directly enjoy any monetary value from the betterment of trademark or trade names at the moment that the franchisee incurs such marketing expenditures. Only when the sales volume goes up will the franchisor receive the higher amount of the variable fee from the franchisee. Thus, no matter how much money the franchisee spends on advertising, if the sales volume is going nowhere, the franchisor won't make money.
       In the tax arena, the fees paid by a Thai franchisee to an offshore franchisor, whether a fixed amount or a variable percentage, are always subject to 15% withholding tax. Also, upon payment of the fees, the franchisee will have to remit VAT which is currently imposed at the rate of 7%, to the tax authorities. While this tax liability sounds usual, the Large Taxpayers Office has challenged several franchisees on the grounds that the marketing expenses paid by them to advertising agencies (e.g. advertising agencies, TV, newspapers, media, etc) must be deemed as disguised franchise fees that have to be includable in the tax base.
       As the marketing expenses help to publicise the trademark or trade name of the franchisor, and the franchisee is obligated to spend certain amounts in each year and under strict supervision of the franchisor, it can be deemed that the franchisor immediately obtains the monetary benefits in the form of higher value for its brand. Hence, marketing expenses the franchisee paid to agencies are also deemed as royalties subject to withholding tax and VAT.
       Now things start to get really interesting from a tax perspective. In two weeks we'll follow up with an explanation of the caveats related to this issue.

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