CONCEPT OF FRANCHISE SERVICES AND LEVY OF SERVICE TAX

[Dr. Sanjiv Agarwal]

Service Tax has been imposed on Franchisee Services with effect from 1st July, 2003 vide Notification No. 7/2003-ST dated 20th June, 2003. The gross amount charged to a franchisee by the franchiser for franchise service shall be chargeable to service tax.

Franchising happens when someone develops a proven business concept and transfers the trademark and business know-how to an entrepreneur termed franchisee. The franchisee usually gets the rights for a specific time period and in a specific geographic area for a one-time franchise fee and royalty. 

Concept of Franchising

The premise of franchising (joint collaboration) lies in combining the built-in customization passed to customers by traditional retail and the huge buying power and thereby low prices forwarded to customers by large modern retail.

These strengths can form the basis of strong corporate partnerships which can come to happen through franchising. It endeavors to create a powerful ecosystem to form partnerships on the foundation of mutual trust between corporate and small businesses, each contributing in different spheres combined with ample dose of innovation.

Globally, franchising is the greatest contributor in organizing and uplifting small businesses through business partnerships. In U.S. alone there are over nine lakh franchised outlets with sales exceeding US $ 2 billion. This huge gap indicates that there is unlimited potential for small business ownership to grow in India through franchising.

In the US, almost a third of the retail sales come from franchised business as 50 per cent of retail is franchised there. In a country like Australia, there is documented evidence that having converted to franchises, corporate stores get a sales kick of 20-30%. This essentially proves the franchisees dedicated and sincere involvement with the business and franchising as the superior business modus operandi. 

Franchising is a way of doing business which inIndiais about 20 years old and globally around 50 years old. Franchisees range from McDonalds to Pizza Hut, Mr. Beans to Sagar Ratna, schools to hospitals, sports and management schools. Franchising today applies to any economic idea encompassing various products and services, manufacture, processing, distribution, sales and services etc. According to Ian Cockburn, web editor at Pipers-Global (UK), it is a business arrangement of business which allows for the reputation, (goodwill) innovation, technical know-how and expertise of the innovator (franchisor) to be combined with the energy, industry and investment of another party (franchisee) to conduct the business of providing and selling of goods and services. 

Franchisees are increasingly becoming popular and gaining ground. Franchisees are generally the people who have been previously employed and see a franchise opportunity as a relaxed way of working and making money. It is a better option with lesser risks in a proven business. Franchisees are people who are prepared to invest in themselves, their skills and freedom to work and enjoy the rewards which their hard work will bring. 

Franchising is a contractual bond between a franchisor who has developed a brand and a business format through usually long experience of selling a product or a service and the franchisee who usually provides the capital and the entrepreneurship at the retail outlet level. As the route for business expansion and branding, franchising offers an excellent business model, particularly for service organisations waiting to expand their network and reach to the consumer. Examples could be NIIT, Aptech, Pizza Hut, Nike, Adidas, Cafe Day, Woodlands, VLCC centres, etc. 

The terms, ‘contract or agreement’ will be governed by the Indian Contract Act 1872. Accordingly, the words ‘contracts’ or ‘agreements’ have not been defined in the statutory provisions of the service tax. The services shall be taxable only when backed by a maintenance contract or agreement. Generally, a person may enter into an agreement or contract for a specific period say, for one year or two years or any other period. It may be oral or in writing but as per Indian Contract Act, 1872, a contract should be enforceable by law. Generally, trade agreements/contracts are in writing only as against oral understanding on promise. 

According to Indian Contracts Act, 1872, following definitions can be referred –

(a)   Every promise and every set of promises, forming the consideration for each other is an agreement.

(b)   An agreement not enforceable by law is said to be void.

(c)   An agreement enforceable by law is a contract.

Oxford’s dictionary defines ‘agreement’ to mean an arrangement, a promise or a contract made with. In the same dictionary, ‘contract’ has been defined to mean to make a legal agreement with.

Section 10 deals with what agreements are contracts. All agreements are contracts if they are made by the free consent of parties competent to contract, for a lawful consideration and with a lawful object, and are not hereby expressly declared to be void. If the services are carried out without a contract or agreement, such services shall not be taxable. 

It should be noted that unless all the ingredients mentioned at (i) to (iv) of the said definition of franchise are satisfied, the agreement can not be called as franchise agreement. 

For example, the mere fact that a principal manufacturer has allowed production of goods bearing his brand name by another person under “License Production Agreement”, does not make the agreement a Franchise Agreement. A franchise agreement also includes the franchisee being obliged to follow the concept of business operation, managerial expertise, market techniques etc. of the franchiser and is under an obligation not engage in selling, producing or providing similar goods or services, identified with any other person. Therefore, in the absence of such ingredient, a mere licensed production cannot be called as a franchise agreement and accordingly the license fees paid for such license production cannot be charged service tax. This has been clarified by CBEC vide Circular No. 59/8/2003–ST dated 20-6-2003.  This circular has since become ineffective in view of changed definition of franchise by the Finance Act 2005 and subsequent clarification issued by CBEC vide Circular No. B.1/6/2005-TRU dated 27-7-2005 

The scope of taxable services has been extended by the Finance Act, 2005 by removing the conditions stipulated in the meaning of ‘franchise’ itself. Thus, franchise services now include all agreements by which franchisor grants representational rights to franchisee to sell or manufacture goods or provide services which are identified with the franchisor. There being no stipulation of any condition, all franchise agreements will be covered under the scope of taxable services. If a service is subject to exclusion under intellectual property right services or business auxiliary services, it may be hit by franchise service. Thus, all transactions relating to representational rights will be taxed. Such representational rights may or may not be a trade mark, service mark, trade name, logo or any other symbol, whether registered or not. IPR rights are covered under IPR services but those not covered under IPR services will get included under franchise services. 

To make the coverage of franchise service more comprehensive, effective from
16-6-2005, amendments have been made to define “franchise” as an agreement by which the franchisor grants representational rights to franchisee to sell or manufacture goods or provide service or undertake any process identified with the franchisor, by any symbol such as a trade mark, service mark, trade name or logo. No other condition is required to be fulfilled for levy of service tax. 

In view of the amended definition, License Production Agreements where principal allows production of goods bearing his brand name by another person would be covered under the purview of service tax under this category. Similarly, if rights are granted for rendering services identified with the principal on his behalf, such services by the principal to the service recipient would be taxable. (Vide CBEC Circular No. B1/6/2005-TRU dated 27-7-2005). 

In Delhi Public School Society v. Commissioner of Service Tax (2007) 6 STT 5 (CESTAT, New Delhi), where assessee was an educational institution formed with an objective of progressive schemes to impart liberal and sound education, based on the agreement, it was held that assessee was rendering the service which was in the nature of franchise service and as such pre-deposit was waived partly only.

 

 

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