Interested in the franchise sector? Then you should study the tax court’s 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 Sars’s 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 B’s 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.
Every aspect of the contract between the taxpayer and its customers was dictated by the franchise agreement
The provision was originally intended to cater for situations that arise 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 finalised the colour required. The courts have since made it clear that the section may also apply to other sectors, and the question in B’s case was whether it applied to the contract between the franchisee and the franchiser.
According to Sars, several preconditions must exist for the section to apply. These include that 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 franchiser, 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 franchiser for each restaurant it operates and is "required" to "upgrade and/or refurbish" the restaurants at intervals "determined by the franchiser".
Sars said there were effectively two contracts in operation: one between B and the franchiser; 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 does, contains no requirement to upgrade. Thus, section 24C did not apply.
Furthermore, argued Sars, the upgrade expenditure is not certain but depends on the franchiser.
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 taxpayer’s 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 franchiser".
Inextricably linked
The points raised by Sars were novel, and neither side could find any decisions on the application of section 24C to a franchise agreement such as that in B’s case.
The court found 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 taxpayer’s generating of its income". The two "are not legally independent and separate" but inextricably linked, said the judge. She held that B’s income was earned under the same contract as that which required the taxpayer’s future expenditure.
And while the franchiser might get to choose "the colour of the tiles", there was an unconditional obligation by B to perform.
In the end, B’s 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 scrutinised in light of the court’s finding — and the thinking of Sars.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.