A couple of years ago, I gave advice to someone acquiring a franchise from a U.S.-based franchisor, and the deal went wrong because the parties hadn’t dealt with the issue of withholdings tax.
When I advise franchisees, I dole it out in two phases.
Phase One involves reading the documentation in its entirety, commenting on it and advising the client about what is normal for that kind of agreement, what is not, and what is “off the wall.” I provide some guidance on what can be negotiated and what normally can’t. And I can usually predict what the costs will be for the advice, because I’ve done it before.
If the client wants to hire me to help negotiate the agreement beyond the advice provided, I move to Phase Two, and there are various levels of contact I might have with the franchisor or its lawyer in these “negotiations.”
The client mentioned above didn’t see the need for Phase Two, or perhaps she couldn’t afford more than the cost of my initial advice. She went off to negotiate a few things in the agreement herself and subsequently signed it, without nailing down one of the most important bits of advice I gave her: Deal with withholdings tax.
You’ve got to make sure you and the franchisor (or more accurately, your accountant and the franchisor’s accountant) have provided for Canadian withholdings tax of 10 per cent that’s applied on the payment of all royalties crossing the border into the United States. “Royalties” are the continuing payment a franchisee makes for utilizing the franchisor’s business system and trademarks. Except for adverting fund payments, it’s often the only regular payment made to a franchisor by a franchisee after the payment of the initial franchise fee to acquire the rights in the first place.
Royalties may be between 5 per cent and 10 per cent of a franchisee’s “gross sales” (that is, the total sales made by a franchisee in the businesses, net of GST, PST, HST and refunds) and they are payable monthly or weekly, depending on the agreement. Royalties can also be expressed as a fixed amount rather than a percentage of sales.
Although established U.S.-based franchisors know all about withholdings tax, other U.S. and foreign franchisors who haven’t previously ventured outside their own countries may not think about it, or understand it, and I can assure you that if this is not provided for at the outset, it could mean the ruin of the franchisee, like it did for my client. She and her franchisor didn’t understand withholdings tax. Her franchisor expected a monthly royalty to be paid with no deductions, but she had to pay 15 per cent of her royalties to Canada Revenue Agency, plus pay the franchisor all of what he expected. The franchisor didn’t realize he could get a tax credit in the United States for what the Canadian franchisee had paid
Here’s how it works, in very general terms.
When a U.S.-based franchisor enters into a franchise agreement with a Canadian, “withholding tax” is payable on all royalties payable to that franchisor. The withholding occurs “at source,” meaning it’s the Canadian franchisee that has the duty to remit it and pay it directly to the Canada Revenue Agency. Different rates of withholding tax apply depending on the character of the payment. Income Tax Regulations requires a base amount of withholding to be 10 per cent on any fees, remuneration, or payments for services rendered in Canada by a non-resident, and this includes royalties. But this amount can vary depending on the characterization of the payment.
But many U.S.-based franchisors expect all of their royalties without any deductions for tax. “Tax deductions are the franchisee’s responsibility,” they’ll say. “If the franchisee has to pay tax at their end, that’s their problem, not ours.”
But this means the franchisee has to pay 15 per cent more than what it bargained for. It could ruin the business.
Well, the answer is there’s a set off. The U.S. franchisor will get a tax credit for the payment of withholdings tax made by the Canadian, so normally it’s neutral. Once withholding tax is remitted by the Canadian franchisee, the balance of the royalty payment is made to the U.S. franchisor, which claims the gross amount of the payment on its income-tax return in the year of receipt. The amount of withholding tax is also claimed as “foreign tax credits” (or FTC's) on the franchisor’s return and FTC's typically reduce the overall income tax payable by the U.S. franchisor to the IRS by the exact amount that was withheld and remitted by the Canadian franchisee to Canada Revenue Agency.
In other words, it’s a wash.
My client’s problem was that the franchisor didn’t know it could claim a tax credit and didn’t seem to want to know how easy it was to deal with it.
So remember, when you’re dealing with a U.S. or other foreign franchisor, make sure you can deduct withholdings tax from royalties so that the franchisor gets the write-off for what you’ve paid.
Special to the Globe and Mail
Vancouver franchise lawyer Tony Wilson is the author of Buying A Franchise In Canada – Understanding and Negotiating Your Franchise Agreement and he is ranked as a leading Canadian franchise lawyer by LEXPERT. He is head of the Franchise Law Group at Boughton Law Corp. in Vancouver and acts for both franchisors and franchisees across Canada, many of whom are in the food services and hospitality industry. He is a registered Trademark Agent, an Adjunct Professor at Simon Fraser University and he also writes for Bartalk and Canadian Lawyer magazines.