With its large number of middle-class consumers, coupled with sustained economic growth, India has evolved into an attractive business destination, including opportunities for franchising.

In franchising, the franchisor provides the franchisee, for a consideration, representational rights to sell or manufacture goods or provide identified services under its brand name, together with the expertise and quality standards. Typically, the consideration is structured into a lump-sum fee against the use of brand name or trademark, and thereafter a fixed percentage of the revenue earned by the franchisee. Such arrangements are generally accompanied by non-compete restrictions.

The applicability of Value Added Tax and service tax on franchisee arrangements has been under litigation in recent times. Tax authorities demand both VAT and service tax on the same franchisee transaction.

In 1983 the Constitution was amended by inserting a new clause (29A) in Article 366, which earlier empowered State Governments to levy ‘tax on sale or purchase of goods’. The amendment widened the ambit of tax levy by specifically deeming six different transactions as ‘sale’, including the transfer of right to use goods. By their very nature, these transactions were held to be not ‘sales’ but ‘deemed sales’.

Some States soon began to accord the ‘sale’ definition under their respective sales tax laws, besides incorporating goods of incorporeal or intangible character, including patents and trademarks. Subsequently, any transfer of right to use a trademark or brand name attracted sales tax in such States. While the States moulded the definition of ‘sale’, Parliament did not rush to amend the definition under the Central Sales Tax law until a new litigation arose over whether States can tax an inter-State transfer of right to use goods, and which will be the appropriate State if it’s a deemed sale.

Addressing the validity of the amendment and the power of States to levy tax along with the situs of sale in an inter-State deemed sale, the Supreme Court observed the gap in Builders Association of India in 1989 and 20th Century Finance Corporation Ltd in 2000. The Parliament realised this lacuna 20 years after the amendment, and included the six specific transactions as ‘sale’ under CST law, in 2002.

Franchisee services too came under the purview of service tax in 2003. The question now was whether franchisee agreements attract service tax and/or sales tax as it involves transfer of representational right as well as an element of service?

The Supreme Court in a landmark BSNL judgment laid down various tests for determining whether a transaction involves transfer of right to use goods. It observed that in a transaction in which goods are available for delivery, the parties have the same understanding to the goods, the possession and effective control of the goods are transferred with exclusive right to the transferee, the transaction shall be said to involve transfer of right to use goods. Accordingly, such a transaction will attract sales tax/ VAT. In the absence of these criteria, the transaction will qualify as service attracting service tax.

The apex court also laid down the ‘dominant intention test’, to analyse whether the intention of the parties was to supply goods or provide services, to determine the taxability of a particular transaction. But as the above tests are subjective and factual in nature, they are not decisive and litigation still exists.

The recent related case was of Malabar Gold Pvt Ltd, where the company entered into franchisee agreements for the use of its trademark against payment of royalty, and deposited service tax for what it considered a taxable service. The franchisee also accepted the restriction of not using its showroom for any purpose other than stocking the products of the franchisor. VAT authorities contended that the franchisor transferred its trademark for use exclusively within the franchisee’s territory. Therefore, it involves transfer of right to use goods, attracting VAT. This was upheld by the Kerala High Court.

This is no stray incident, and similar matters are pending before various judicial forums, causing hardship to industry.

The need is for a progressive business policy, free of tax dichotomies, to foster a conducive and stable economic environment, as also attract more investment. The country’s most ambitious indirect tax reform — namely the Goods and Services Tax — is expected to roll out in the near future. The issue of double taxation may be cleared with the advent of GST, assuming there are uniform rates for services and goods.

The author is Senior Director with Deloitte Touche Tohmatsu India Pvt Ltd

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