Cross Border Franchising: A First Look
It is currently quite common to find a franchisor operating internationally without having planned and considered the tax consequences in advance.
By Aaron Chaitovsky, CFE, and Jeffrey Slavet
It is often said that the world, from a business point of view, is becoming smaller and smaller. It now seems that international business is no longer reserved for the large multinational enterprises, but rather even small- and medium-sized enterprises are going global. One of the key motivators in this international expansion has been the ease of communications and transportation within this new and ever-expanding commerce. However, one major stumbling block to this global expansion is the lack of modernization when it comes to tax laws in the various countries around the world.
These tax systems have not changed or adapted enough to make this type of commerce easy, and to a great extent the governments tend to be even more territorial and more problematical. The franchise community as well has been seeing international expansion as the obvious future growth opportunity path, especially with the ease of implementation of electronic monitoring, system replication, and electronic operational controls.
This international franchise expansion has taken the form of both inbound (foreign franchise concepts entering the U.S. market) and outbound (U.S. franchisors expanding into foreign markets). Unfortunately, it is currently quite common to find a franchisor operating internationally without having planned and considered the tax consequences in advance, thereby creating additional tax concerns after the fact. Attempting to correct and restructure the international franchise concept is made more difficult, as the concept may have already established potentially significant value.
Royalties and withholding taxes
As franchisors expand beyond their borders, one of the most common tax concerns relates to royalties paid by franchisees to franchisors who reside outside of the franchisee’s country. By the term royalty, we are referring to the payment by a franchisee to a franchisor based on a percentage of franchisee income.
If this royalty payment is made from a non-U.S. franchisee to a U.S. franchisor, based in the U.S., the withholding tax on that royalty will be based on the laws of that particular country. These laws can vary widely from country to country. For example, Hong Kong currently has no withholding tax at all. However, these withholding taxes may be modified by international tax treaties between the countries just as it is for non-U.S. franchisors with U.S. franchisees, as explained below.
If a U.S. franchisee must pay a royalty to a franchisor not based in the U.S., the withholding tax rate in the U.S. is generally 30 percent. This is dictated by U.S. law. It must be noted that the burden for withholding the tax from the payment, and remitting it to the U.S. government, is on the entity that pays the royalty. That would be the franchisee. If that paying entity fails in its burden, it will be responsible for the tax. That is, the franchisee will be responsible for the franchisor’s tax liability plus interest and penalty. This is a heavy burden to put on any franchisee, especially a small enterprise.
It should be noted that the franchisor that is outside the U.S., and bearing this withholding tax, will generally be able to take a tax credit, on its home-country income tax return, for the withholding tax collected by the U.S. government, but only up to the tax assessed on this income by its home country.
However, this may not be the case in all countries. Another complication results from the many international tax treaties that exist between countries. For example, the U.S. has 58 such treaties with other countries and each of these treaties have differing provisions concerning royalty payments. Many of these provisions may sound alike at first reading but one must be very careful as they often differ. They dictate how the royalty payments are to be handled and sometimes dictate lower withholding rates, sometimes even zero. They also dictate how the withholding tax may be used to produce tax credits on income tax returns in the particular jurisdiction.
It is very important to note that the burden of interpreting these treaties falls on the franchisee paying the royalty. If the franchisee misinterprets the treaty it will suffer the consequences of under-withholding or of misclassifying the franchisor. These treaties are quite complicated and the use of the treaty is generally restricted to entities that qualify under the limitation of benefits provisions that are contained in most, if not all, U.S. treaties. A limitation of benefits provision will not allow an entity or individual to utilize the treaty benefits unless it meets the requirements of the provision, which generally requires the subject entity to have substance within the particular country.
The franchisee will also have the burden of obtaining a W-8BEN-E Form from the franchisor. This form classifies the franchisor and claims any treaty benefit. This is an extremely complex form and difficult to interpret. It is quite a burden, especially for a small enterprise, as the franchisee is responsible for making sure that the form, on its face, is correct.
Remedy for withholding concerns
Although a withholding tax issue seems like a formidable problem, particularly for the U.S. franchisee paying royalty to the foreign franchisor, there are ways to ease this burden. For the franchisor one of the most common solutions is to form a U.S. corporation that will be owned by the foreign franchisor. This corporation, commonly referred to as a blocker corporation, will insulate the U.S. franchisee from the problem of withholding. This is because the U.S. franchisee will be paying its royalty to a U.S. entity rather than a foreign entity, thus avoiding the need for Form W-8BEN-E and its problems.
Another benefit of this structure is that it gives the non-U.S. franchisor the flexibility of having the U.S. blocker corporation pay its tax on a net basis in the U.S. That is, it will pay tax on income less expenses, rather than a withholding tax on gross royalties. This blocker corporation could also have the flexibility to reinvest the income after taxes in the U.S., generally without tax in its home country. The blocker could also choose to structure a royalty payment to its parent company, subject to U.S. withholding, or it could pay a dividend to its home country, also subject to U.S. withholding. It could do any combination of these strategies.
The best strategy of course would depend on the needs of the enterprise for cash in the U.S., perhaps to expand, or the cash needs in the home country. It would also depend on the relative tax burden generated by the laws of the U.S. versus its home country, tempered by any tax treaty relief, and tax credits.
Advance planning is key
As is evident from the foregoing discussion, the planning and resulting structure is not a simple task. There are many difficult moving parts that must be analyzed. Selecting the applicable countries, understanding the respective tax treaties (if they exist), understanding the intended use and accumulation of funds and the potential repatriation to the ultimate beneficiary, all need to be the first stage of the international growth plan.
In the end, it is this careful planning and structuring that can make it possible for a happy and successful franchisee-franchisor relationship while at the same time creating those significant tax savings.
Aaron Chaitovsky, CPA, CFE, is practice leader of the franchising accounting and consulting practice of Citrin Cooperman. Jeffrey Slavet, CPA, is a tax partner and member of the international tax and business consulting practice at Cirtin Cooperman. Find them at fransocial.franchise.org.