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CARMEL RICKARD
INTERESTED in the franchise sector? Then you should study the tax courts newest
decision that illustrates how the revenue collecting authorities are thinking about
franchise contracts that include an obligation to make regular upgrades of business
premises.
B, an unnamed taxpayer operating a chain of franchise eateries, appealed against
SARSs additional assessments for 2011 to 2014. B claimed certain allowances for
future expenditure on refurbishing and upgrading the restaurants under Section 24C
of the Income Tax Act, but SARS refused the claims, disputing Bs interpretation of
the section and whether it even applied.
This section allows a taxpayer who receives funds in a particular year as part of a
contract, to have some of these funds ring-fenced or deducted by SARS by way of a
reserve to finance future expenditure.
The provision was originally intended to cater for the situation that arises in the
building industry, for example, when a builder is paid for tiles in one tax year but only
buys them the following tax year after the client has finalized the colour required. The
courts have since made it clear that the section may also apply to other sectors, and
the question in Bs case was whether it applied to the contract between the
franchisee and the franchisor?
According to SARS, several preconditions must exist for the section to apply. Among
these, the funds and the obligation to spend the money must arise from the same
contract; and the expenditure of the reserved funds must be a certainty.
In the contract between B and the franchisor, B had to undertake that its main object
and sole business would be operating the various restaurants. B pays a monthly
franchise and service fee to the franchisor for each restaurant it operates and is
required to upgrade and/or refurbish the restaurants at intervals determined by
the franchisor.
SARS said there were effectively two contracts in operation, one between B and the
franchisor, the other between B and its customers, who purchase meals. The first
contract, which includes the requirement to upgrade, brings in no funds. The second,
which brings in the funds, contains no requirement to upgrade. Thus, s 24C did not
apply.
Furthermore, argued SARS, the upgrade expenditure is not certain but dependens on
the franchisor.
B, in response, said it could not sell meals to customers absent the franchise
agreement. In this sense there was a single contract, and a single source of the
taxpayers income. And under that contract, the obligation to upgrade was not
optional: it simply (placed) absolute control over the approval of all plans and
specifications in the hands of the franchisor.
The points raised by SARS were novel, and neither side could find any decisions on
the application of s 24C to a franchise agreement such as that in Bs case.
The court found that the obligation to sell meals was a central condition, contained in
the body of the same contract requiring B to incur future expenditure. Every aspect of
the contract between the taxpayer and its customers was dictated by the franchise
agreement: it intrudes into every aspect of the taxpayers generating of its income.
The two are not legally independent and separate but are inextricably linked, said
the judge. She held that Bs income was earned under the same contract as that which
required the taxpayers future expenditure. And while the franchisor might get to
choose the colour of the tiles, there was an unconditional obligation by B to
perform.
In the end, Bs appeal succeeded and the additional estimates by SARS were set aside.
But it was a close call, illustrating the need for franchise contracts requiring regular
upgrades to be carefully scrutinized in the light of the courts finding and the
thinking of SARS.