Are royalty payments tax-deductible?


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royalty payments

Management services fees, commonly described as royalties, have always been seen as an expense incurred in the operation of a business. As such, they constitute a legitimate tax-deductible item in franchisees’ income tax returns, right? ‘Wrong!’ says SARS, and a recent court ruling seems to back them up.


Background Information

What happened is this: up to now, it was generally accepted that royalty payments paid for the use of rights are tax-deductible. After all, they are an expense, which forms part of the day-to-day running costs of the taxpayer. A bit like the rental paid for business premises. A decision handed down in the unreported tax case ITC 11454 changed all that. In its submission, SARS argued that royalty payments are being paid for the creation and maintenance of an asset that is essential in the conduct of the business and are therefore of a capital nature. Agreeing that royalties cannot be compared with, for example, costs incurred for the renting of premises, the ruling sided with SARS.

Not surprisingly, this judgement caused great anxiety in franchise circles. On the face of it, if it is upheld on appeal it could mean that franchisees who have been deducting royalty payments from their taxable income in the past are at risk of facing substantial claims from SARS made up of back taxes, penalties and interest. Moreover, they would be required to pay tax on royalties in future.
In an attempt to create certainty, FASA arranged for tax expert Daniel Erasmus to address members on the issue. In some ways, Daniel’s presentation heightened franchisors’ concerns, but it also became clear that all is not lost provided the franchise fraternity sits up, takes notice and then acts in unison.

The Dark Cloud

Daniel opened his presentation with a bang: best available estimates suggest that so-called royalty payments made by South Africa’s franchisees to their franchisors amount to R6,46bn per annum. Up to now, these payments were seen to be legitimate business expenses and treated as such by franchisees in their tax returns. Should SARS be successful in attacking this view and subsequently decide to re-examine tax returns for, say, the past five years, South Africa’s typical franchisee would face the following claim:

R275 000,00 in unpaid back taxes

R550 000,00 (200%) in penalties

R360 000,00 in interest

adding up to a grand total of R1,185 000,00 in tax arrears, payable on demand. Should it come to this, SARS may show largesse by offering franchisees an option to pay the amount off over time. This, however, would increase the sum because interest would be added until full payment has been received.

A Ray of Hope

Moving on, Daniel stated that firstly, SARS would have to establish that royalties paid by franchisees to their franchisors are of a capital nature. Should they manage to do this, they would still have a hard time proving that the taxpayer acted in bad faith when treating royalties as revenue-related expenses. After all, this view had never been challenged before.

This is important because if SARS cannot prove that the taxpayer deliberately misrepresented income, it cannot impose penalties and interest and unpaid back taxes. (Although this assumption is not backed up by tax legislation, it is in line with SARSÔÇÖ own internal guidelines and usually accepted as valid defence.)

This does not stop SARS from examining tax returns for the past five years, disallowing the deductions and issuing revised assessments. So, even if franchisees escape paying penalties and interest for royalties paid, they would still be liable for payment of unpaid back taxes. In the example used above, this would amount to R275 000,00.

Then there is the future to think of. The payment of royalties falling due in future from after-tax earnings could render a good number of franchised outlets unprofitable. It is important, therefore, that the franchise sector responds to this challenge decisively and in a pro-active manner.

Daniel explained how the process is likely to unfold. He stressed that SARS is not a law unto themselves; they are obliged to respect taxpayers’ rights, which are considerable. It is important for taxpayers to know their rights ‘ those that affect the current issue are set out in Daniel’s presentation and the complete text can be accessed by visiting the web site www.taxtalk.co.za

Our Comment

We believe that franchisees of bona fide franchise chains have less to worry about than might appear to be the case. For one thing, the judgement refers to mining rights; as we shall point out just know, this is a passive right, far removed from the reality of a franchisor’s obligation towards its franchisees. In the opening sentence to this paragraph, we used the expression ‘bona fide franchise chains’ advisedly. There is every reason to believe that networks that do not operate in accordance with proper business format franchise principles might indeed be caught in the net.

What we are referring to is the appropriate interpretation of the term ‘royalty’. For many years, experts have held that when talking about ongoing franchise fees payable by a franchisee to a franchisor who conducts a bona fide business format franchise, the term ‘management services fee’ should be used rather than the term ‘royalty’. Numerous volumes of expert literature published by FASA since 1988 containing contributions by M Mendelsohn, K Illetschko and others, as well as FASA’s own Code of Ethics and Business Practices, first published in 1979, back this up.

In our view, provided that:

  • the franchisor can substantiate that it carries out its obligations under a business format franchise arrangement
  • the franchise agreement is worded properly and can withstand the test of ‘substance over form’

franchisees are entitled to claim at least a substantial portion of their ongoing franchise fees as tax-deductible expense.

To ensure, as far as is humanly possible, that SARS accepts this point of view, the franchise agreement should clearly set out what the ongoing franchise fee is paid for. It is paid in return for ongoing support services the franchisor provides to its franchisees; inevitably, it will contain a royalty element to cover the use of the trademark, but this will constitute only a small part. The principle of ‘substance over form’ demands that for such a contention to withstand a challenge by SARS, it is not good enough for the franchisor to say that he provides franchisee support, this must be on record as being an ongoing practice. Ongoing support typically includes marketing and training, which are actual expenses and therefore should be tax deductible.

Once it has been established that this is indeed the case, it must be incorporated, firstly, in all future franchise agreements, secondly, existing agreements should be amended to reflect this. As Daniel noted: existing agreements can be lawfully altered as long as both parties agree to it and it is not done to distort facts.

Disclaimer – although we believe that the opinions expressed above are sound, they should not be perceived as constituting legal or tax advice. Every franchisor would be well advised to consult with a competent tax attorney and have the resulting findings incorporated in the franchise agreement.

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