The Hon’ble Bombay High Court (HC), in its landmark judgment dated 11 August 2016[1] in the case of Subway Systems India Private Ltd (Subway or Petitioner) held that the State of Maharashtra could not levy Value Added Tax (VAT) on royalty and franchise fees received from franchisees under franchise agreements.

Subway received a tax demand from the Maharashtra VAT authorities on grounds that franchise fees and royalty received by the Petitioner was consideration for transfer of the right to use its trademark to the franchisees. The demand was based on grounds that (a) the Hon’ble Bombay High Court in the Tata Sons judgment had held that VAT was applicable on brand sharing arrangements; and (b) the Maharashtra Government had specifically notified ‘Franchise’ as goods of intangible or incorporeal nature, subject to VAT under the Maharashtra VAT Act, 2002 (MVAT Act).

Subway, in a writ petition before the HC, challenged the constitutional validity of levy of VAT on franchise fees and royalty received as consideration from franchisees under franchise agreements.

The matter was heard over multiple hearings wherein host of landmark rulings were examined by the HC in this context, including Supreme Court judgments in the 20th Century Finance Corporation case[2] and the BSNL case[3], the Andhra Pradesh High Court ruling in the Rashtriya Ispat Nigam case[4], the HC ruling in the Duke & Sons case[5] and the Kerala High Court ruling in the Malabar Gold case[6].

Facts of the Case

The Petitioner, a part of an international restaurant chain, operates and franchises sandwich shops in India. The Petitioner was granted a non-exclusive sub-license by Subway International B.V. (SIBV), a Dutch limited liability corporation to establish, operate and franchise others to operate ‘SUBWAY’ branded restaurants in India. Typically, the Petitioner enters into franchise agreements with third parties, under which it provides specified services such as use of trademark, associated confidential information and goodwill such as policies, forms, recipes, trade secrets, etc. Under the franchise agreements, the Petitioner receives consideration in the form of (i) a one-time franchisee fee; and (ii) a periodic royalty fee. Subway has been paying service tax regularly on the aforesaid consideration. In March 2015, Petitioner received a notice from VAT authorities demanding tax and penalty on the aforesaid consideration received from franchisees.

Issue before HC

The question before the HC was whether the Petitioner was liable to pay VAT or service tax on franchise fees and royalty received under the franchise agreements with third parties.

Key arguments of the Petitioner

  • The franchise arrangement was a composite contract for providing various services and the permissive use of ‘Subway’ service mark was one element of such service;
  • The franchise agreement was not a sale transaction but a package of various services including  mere permission to use intangible rights in a restrictive manner;
  • Subway’s composite agreement could not be split in light of Constitutional provisions under clause 366(29A)(d), when there was no intention of contracting parties for separate agreements neither was there any distinctly discernible sale element;
  • The contracts could not be artificially split to enable the sale element, neither could the whole agreement be taxed as sale since it is well settled law that service tax and sales tax are mutually exclusive and States cannot entrench upon powers exclusively available to the Centre under the Union List; and
  • Alternatively, even if the transaction amounted to sale, the situs of such deemed sale would be Delhi and not Maharashtra since Subway is based in Delhi and has no place of business in Maharashtra.

HC’s Ruling

  • The HC examined the clauses of the franchise agreements and made following key observations:
  1. The Franchisee was entitled to display the name ‘Subway’ only for limited period, on expiry of which, all rights of the franchisee would be terminated;
  2. The Franchisee could not sub-franchise the mere permission it obtains under the franchise agreements;
  3. There was no territorial restriction or competition restriction of any kind placed on Subway; and
  4. Subway was entitled to enter into multiple franchise agreements simultaneously and it could even operate its own outlet.
  • Basis the aforesaid, the HC observed that the Subway franchise agreement was a classic example of permissive use of goods since the franchisee has limited rights to display ‘Subway’ marks and its trade dress and such rights and permissions ceased to exist at the end of stipulated time. The franchisees were bound by set terms under the franchise agreement and any breach of the same would also result in termination of the franchise agreement.
  • The HC also accepted the submission that if situs of intangible goods was to be examined, it would be Delhi based on the principle that “the owner of an intangible asset would be the closest approximation of the situs of his intangible asset”.
  • However, the HC specifically stated that every franchise agreement need not necessarily fall outside the purview of MVAT Act and facts of each agreement have to be examined to determine whether it constitutes “transfer of right to use” or merely a “permissive use” of intangible rights.
  • In essence, the HC unequivocally held that a franchise agreement which grants permissive use of intangible rights to its franchisees will qualify as service and will not attract VAT. 

Comment 

This landmark judgment has laid down principles to differentiate between a “permissive use” which is classifiable as a service and “transfer of right to use” which is classifiable as a deemed sale. This judgment will provide much needed relief not only to Subway but also to other similar arrangements which are currently facing double taxation under service tax as well as VAT.

Since this judgment is well reasoned, it provides significant business opportunity to review existing arrangements involving use of intangible rights for avoiding double taxation.