THERE are more than 1,100 franchises registered with the Ministry of Domestic Trade and Consumer Affairs. In 2022, the total sales value exceeded RM14 billion, and by 2025, it is expected to exceed RM26 billion. Significant franchise payments are made to both local and foreign franchisors.
Franchise defined
The Franchise Act 2012 defines a franchise as whereby the franchisor grants the right to operate a franchise system determined by the franchisor and allows the franchisee to use a trademark, trade secret, confidential information, or intellectual property owned by the franchisor, and the right to administer continuous control over the franchisee’s business operations in accordance with the franchise system. In return, the franchisee is required to pay a fee to the franchisor.
Current understanding
There is confusion among taxpayers on the treatment of the payments they make to the franchisors. There is a general belief that all franchise payments are not tax deductible based on the Shaklee case decision which concluded that the franchise fee paid in that situation was for an exclusive licence or right to operate the business and therefore the payment is to acquire a capital asset and not in the production of income.
Although this is a decision by the High Court, it is time to re-examine this decision on the basis that the franchisees acquire more than an exclusive licence which represents only one component of the payment. The other components are usually for the use of the trademark, making available the know-how (secret information of an industrial and commercial nature arising from previous experiences) from the franchisor to the franchisee, providing continuous technical assistance and guidance, procurement services etc.
There is a special gazette order issued in 2012 that specifically allows a tax deduction for franchise fees paid for a local franchise brand registered under the Trademarks Act 1976, to a local franchisor (70% owned by Malaysians) registered under the Franchise Act 1998, provided that the franchise fee is paid prior to the commencement of the franchisee’s business.
What should be the tax treatment?
The franchise arrangement represents a mixed contract that consists of providing the use of intellectual property (trademarks, brand name, know-how), actively providing technical assistance and services, and an exclusive licence to operate the franchise.
Usually, there are two types of payments made under the franchise agreement: Initial payment and continuous payment.
Internationally, it is recognised in countries such as the UK, Canada and the US that the initial payment made before the business commences is a payment towards the initial cost of setting up the business, or as a cost of acquiring an intangible, and therefore it is regarded as a capital expenditure. Subsequent ongoing fees or payments periodically are recognised in many Commonwealth countries as deductible expenditure.
Where should we be heading?
The initial payment to foreign franchisors is not likely to be allowed deduction on the grounds that it represents payment for acquiring an exclusive right or licence to commence the business.
However, the recurring payments for the use of the trademark, know-how, and technical services should be tax deductible as the franchisee cannot generate income without such assistance.
Withholding tax implication
It is incorrect to deduct royalty withholding tax on the total franchise fee payments made to the non-resident franchisor. The withholding tax should only be confined to the royalty component which will be the payment for the use of the intellectual property such as trademarks and know-how.
Technical assistance and day-to-day support should only be subject to withholding tax if the services are provided in Malaysia. Despite the non-deductibility of initial franchise fee, withholding is still applicable on the initial fees.
There is misunderstanding among taxpayers that if the withholding tax is paid, the tax deduction is given automatically. This is incorrect. You need to determine the withholding tax position and tax deductibility separately.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
