Key Business Issues For U.S. Franchisors Expanding Into Canada
March 2009 Franchising World
Canada has long been the first choice for international expansion for many U.S. franchisors, given cultural similarities and geographic proximity between the two countries. Nonetheless, U.S. franchisors considering expansion in Canada must take into account significant cultural, linguistic, demographic, judicial and statutory differences, as well as several commercial considerations, in rendering U.S. standard form franchise documentation in conformity with Canadian laws, customs and regional differences.
By Frank Zaid and Andraya Frith
Governing Law U.S. franchisors and their professional advisors regularly insist on the law of their home jurisdiction as being the governing law in a Canadian franchise agreement. Despite the perceived advantages of this practice, it is difficult to introduce expert evidence in a Canadian court to establish the principles of a foreign governing law and to enforce a foreign judgment in Canada if a U.S. forum is mandated for the determination of disputes and remedies.
Moreover, even though most common law jurisdictions in Canada will probably recognize a U.S. governing law clause, U.S. franchise laws, anti-trust laws, common law principles and other applicable statutes are generally more onerous for a franchisor than are the equivalent, applicable Canadian laws, principles and statutes.
Further, franchisors frequently seek injunctive relief against franchisees, particularly if there is a default under the franchise agreement or following termination of the relationship, to restrain a franchisee from breaching restrictive covenants respecting trademarks, trade secrets and non-competition. It is highly unlikely that a U.S. court would grant injunctive relief concerning the conduct of a franchisee in Canada, and even more unlikely that a Canadian court would recognize and enforce such relief.
Also, seeking injunctive relief this way would be more time consuming than if an injunction were sought directly in a Canadian court. A franchisor who ignored the exclusive (foreign) jurisdiction provision and applied directly to a Canadian court for an injunction would leave itself open to a franchisee seeking a stay of the action on the basis that the franchisor must bring its action in the United States. This approach would result in delay and increased uncertainty.
In the province of Québec (a civil law jurisdiction), a Québec court will not enforce a foreign judgment before first affording the defendant an opportunity to raise any defence that would have been available to it in the initial action. In other words, if a foreign franchisor brought and won an action in its home jurisdiction, it could be faced with the expense and uncertainty of litigating the same issues again.
Because of these uncertainties and potentially undesirable results, U.S. franchisors should ensure that their franchise agreements are governed by the laws of the province in which the franchised business is located and that this province be used for the choice of jurisdiction provision. Franchise legislation currently in force in Alberta, Ontario and Prince Edward Island provides that any provision in a franchise agreement attempting to restrict the application of the law of that province or the jurisdiction, venue or forum outside of that province is void with respect to a claim otherwise enforceable under the legislation in that province.
Alternative Dispute Resolution
While commercial arbitration is a common method of alternative dispute resolution in the United States, arbitration procedures and rules are not as well defined in Canada. Furthermore, Canadian arbitration associations are not as developed, particularly on a national basis, as organizations such as the American Arbitration Association. As a result, it is still not common practice for a Canadian franchise agreement to provide for arbitration as an alternative dispute resolution method.
Arbitration in Canada does not have significant advantages over the normal judicial process in resolving franchise disputes. However, if the parties seek resolution of their disputes by arbitration, the specific rules of arbitration need to be specified in the franchise agreement or in a separate arbitration agreement. To achieve a final determination at arbitration without public disclosure, the agreement must clearly state that the arbitration award is final and binding, confidential and not subject to appeal.
Investment Canada Act
One of the provisions of the Investment Canada Act deems that an option or a right of first refusal to acquire a Canadian business is considered to be an actual acquisition, unless it is agreed by the parties that the option or right is not considered to have been exercised until it actually is. Accordingly, a foreign-based franchisor with an option or right of first refusal to acquire a franchisee’s business (for example, on termination or expiration of the franchise agreement or resale of the franchise) must ensure that the agreement contains the requisite statutory deeming language. Otherwise, the foreign-based franchisor may be required to provide immediate notice to the Investment Canada Act when the franchise agreement is executed.
Both initial franchise fees and royalties paid by Canadian franchisees to U.S. franchisors will be subject to withholding tax under the Canadian Income Tax Act unless the U.S. franchisor "carries on business" in Canada through a "permanent establishment." The franchisee is personally liable to the Canada Revenue Agency for withholding tax remittance. While the Income Tax Act specifies a withholding tax rate of 25 percent, the Canada-U.S. Income Tax Convention reduces this rate to 10 percent if the franchisor is a U.S. resident and does not have a permanent establishment in Canada. In these circumstances, it is recommended that Canadian franchise agreements contain a provision requiring the franchisee to withhold and remit withholding tax to the CRA.
Amounts that would generally be considered reimbursement or payment for services rendered, such as training fees or on-site opening assistance, may be segregated from the initial franchise fee by agreement of the franchisor and franchisee and should not be subject to the withholding tax requirement. Payments for supplies and inventories are also not subject to withholding tax, provided their amounts bear a reasonable relationship to the fair market value of the goods purchased. While Canadian withholding tax is not recoverable by a foreign-based franchisor, depending upon the taxable position of the franchisor, the amounts withheld may be available as foreign tax credits against taxes otherwise owing and payable by the U.S. franchisor to the Internal Revenue Service.
To ensure that the franchisee fulfills the withholding tax requirements, a specific provision should be included in the payment section of the franchise agreement requiring the franchisee to pay these taxes to the appropriate tax authorities and to provide the franchisor with copies of receipts from the tax authorities. The franchisee should also be required to take all reasonable steps to assist the franchisor in obtaining any tax credits arising from such withholding taxes that are available in the franchisor’s home country.
In Canada, non-competition covenants are invalid unless they are reasonable, both as between the parties and with regard to the public interest. To be deemed reasonable, such a covenant must protect a proprietary interest of the party in whose favor it is given (such as the goodwill of the business). Also, it must not be broader in geographical area, time period or scope of activities covered than is necessary to protect such an interest. Otherwise, a franchisor who attempts to enforce any such unreasonably broad restrictive covenant may find itself without any protection. What is necessary in each situation will depend upon the particular franchise system, the circumstances, and the restrictions required to maintain the interests of the parties and, at the same time, preserve the public interest.
A Canadian court will not rewrite, write down or otherwise modify or edit restrictive covenants so that they become reasonable and enforceable. Generally, Canadian courts will not sever the objectionable portion of a non-competition covenant and allow the rest of the covenant to stand unless the severed and remaining parts are independent of each other (i.e., the offending part may be deleted without adding or altering any words and without affecting the meaning of the remaining parts.) Covenants should be drafted conservatively and to facilitate severance in case a part of the covenant is found to be objectionable.
Further, the scope of the restricted activity must be defined with certainty. A court will likely deem an ambiguous or uncertain covenant to be ineffective and unenforceable. The restricted activity must be defined in normal commercial terms so that the certainty of the covenant’s scope will be preserved. Canadian courts have held that restricted activities defined as "any competing activity" or "similar to the business conducted by the franchisor" are uncertain and therefore not enforceable.
Suggested Pricing of Products and Services
The price-maintenance provisions of Canada’s anti-trust legislation, the Competition Act, provide that it is a criminal offence for a franchisor to directly or indirectly attempt to influence upwards, or to discourage the reduction of, the price at which a franchisee advertises or offers to supply a product within Canada. A franchisor’s suggestion of a resale or minimum resale price is––in the absence of proof that the franchisor also made it clear that there was no obligation to accept the suggestion and that business relations would in no way suffer for the franchisee’s failure to do so––proof of an attempt to influence the franchisee under the act. Since franchisors commonly suggest resale prices to franchisees, it is recommended that a franchisor issuing suggested resale prices include the statutory disclaimer language in the franchise agreement.
Note that a franchisor may suggest maximum prices (and deem the franchisee to be in default under the franchise agreement if the franchisee sells above such maximum prices) without offending the price maintenance provisions of the Competition Act.
U.S. franchisors should carefully consider how their advertising programs in Canada are structured and, in particular, how Canadian franchisees contribute to advertising funds. Naturally, Canadian franchisees expect that such contributions are being used for advertising in Canada. U.S. franchisors should consider either establishing a Canadian advertising fund for Canadian franchisees, or segregating Canadian advertising contributions in a separate fund. Canadian contributions may end up being used, in part, to defray production costs and the cost of source materials paid for out of the U.S. advertising fund. However, since some of these materials may not be appropriate for use in Canada (for language and cultural reasons), the amount of Canadian advertising contributions allocated to cover a share of these costs should only be a specified percentage of the total Canadian contribution.
Canadian privacy laws require franchisors and franchisees to obtain consent from individuals, such as customers of the franchisees’ businesses, to collect, use and disclose their information for marketing and other purposes. Franchise agreements should be revised to require franchisees to obtain the necessary form of consent from customers and other individuals whose personal information is used and shared within the franchise system.
Your Northern Neighbour Welcomes You
Franchising in Canada differs in many respects from franchising in the United States, despite similarities in customs, language, economic trends, common law and judicial principles. These differences demand considerable review, amendment and modification of standard U.S. franchise documents and practices to conform to Canadianlaws,customsandregionaldifferences.
For a U.S. franchisor to enter into an agreement with a Canadian franchisee based solely or substantially on the franchisor’s standard U.S. franchise documents is not only inappropriate but, perhaps, irresponsible, given the difficulties which will ensue in the administration and enforcement of the franchise agreement and the franchise system. Compliance with and respect for Canadian laws, practices and customs are critical for the successful expansion of a U.S. franchise system in this country. With informed appreciation of these matters, U.S. franchisors should find the transition to Canada relatively smooth and successful.