If you’ve been thinking of expanding your franchise network beyond U.S. borders, you are well aware of the many business, financial and legal hurdles you must address. But you will also need to consider taxes other countries may impose on your business. This article focuses on withholding taxes a foreign country may impose on various streams of income the foreign franchisee will pay to the U.S. franchisor (U.S. Franchisor) pursuant to the franchise arrangement.
One of the simplest ways to expand your franchise network internationally is to enter into a franchise agreement with a franchisee located in a foreign country. Many terms of the franchise agreement will be similar to that of a standard U.S. franchise agreement. Among other things, it will specify a territory and provide for payments for use of intellectual property, rental of equipment, sale of property, training and the like. A master franchise agreement, which is a form often used in international transactions, may also provide for many or most of these same types of payments.
Royalties, Rents, Service Fees & Interest
Some or all of the payments the U.S. Franchisor receives may be subject to withholding tax imposed by the foreign country, including royalties, rents, service fees and interest. If we assume, for example, that under the terms of the franchise agreement the foreign country franchisee (FC Franchisee) were to pay a $100 royalty to the U.S. Franchisor, and the foreign country imposes a 20 percent withholding tax on royalties, the U.S. Franchisor would receive only $80 of the $100 royalty payment, with the remaining $20 withheld by the FC Franchisee and paid to the foreign country.
In certain circumstances the U.S. Franchisor may realize U.S. income tax savings that would offset part or all of the $20 in lost revenue. In any event, to protect the U.S. Franchisor, the franchise agreement should include a term requiring the FC Franchisee to be responsible for all taxes imposed by the foreign country on any payment to the U.S. Franchisor. This contract term is often referred to as a gross-up provision because the payment is to be grossed up to cover any foreign country taxes. In our example, the purpose of the gross-up provision is to ensure the U.S. Franchisor will receive the full $100 royalty payment.
Shifting the Burden
Shifting the burden of the foreign country withholding tax to the FC Franchisee, however, makes the franchise arrangement much less beneficial to the FC Franchisee. In our example, the FC Franchisee will end up paying a total of $125 ($100 to the U.S. Franchisor and $25 in withholding tax). The full $125 will be subject to the withholding tax and 20 percent of $125 is $25. If the FC Franchisee paid $120, 20 percent of that (that is, $24) would go to the withholding tax and the U.S. Franchisor would receive only $96, not $100 as intended. The FC Franchisee may realize income tax savings as a result of the payment of the extra $25; however, that would offset only part of this additional $25 cost. So that neither the U.S. Franchisor nor the FC Franchisee is severely harmed by the foreign country withholding tax, the goal should be to eliminate as much of that tax as possible. For example, there may be tax saving opportunities available to parties who structure a franchise arrangement to take advantage of tax treaty relief provisions.
The United States has entered into tax treaties with more than 50 countries. One of the purposes of a tax treaty is to reduce or eliminate withholding taxes. Understanding the types of payments that are exempted from withholding tax under a tax treaty (or under the foreign country’s tax laws) and structuring a franchise arrangement accordingly can lead to significant tax savings. For instance, depending on the FC Franchisee’s country, withholding tax savings often can be realized if the U.S. Franchisor sells (rather than leases) equipment to the FC Franchisee or if the U.S. Franchisor performs services in the United States rather than in the FC Franchisee’s country.
In addition to withholding taxes, other countries may impose sales-and-use or value-added taxes on payments for goods and services or rental payments made by a FC Franchisee. These taxes also need to be considered.
So, when contemplating expansion of your franchise network to another country:
- Consider including a gross-up provision to shift the burden of any foreign taxes to the franchisee.
- Obtain advice on minimizing foreign country and U.S. taxes.