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Legal advice 2016-08-22

VAT or Not for Subway – The Real Account

Bombay High Court’s judgment for Subway reflects upon the states supportive approach towards the international F&B brand. Let’s get a better understanding of the matter.

VAT or Not for Subway – The Real Account

Franchising industry is one of the preferred models for entering into Indian market. One of the reasons behind this,there is no specific law that governs franchising business and with no stringent regulatory system foreign investors prefer to open a franchise in India. Since there is no separate franchising law, it cannot be said that franchising is not governed in Indian laws. Although franchising is free from regulatory procedures governing terminations, transfers or any other matter pertaining to franchise business relationships despite this fact, India is regulating cross-border franchising under various laws such as Indian Contract Act, 1982, which governs the agreement between the foreign franchisor and Indian franchisee. It also specifies essential requirements for the franchisee, Intellectual Property Acts, The Competition Act, 2002, The Foreign Exchange Management Act, 1999, Income Tax Act, 1961, The Consumer Protection Act, 1986, The Arbitration & Conciliation Act, 1996 and FDI Policies.

Franchise Friendly Code of Law

India has been liberalizing its regulations which created good environment for franchising industry and constantly making policies for ease of doing business. But the recent judgment of Bombay High Court which was delivered on 11 August, 2016 in the case of Subway Systems India Private is a step ahead to enable franchising industry to extract economic gains from growth in franchising sectors, if they are into similar agreements as the case of Subway. Since, in India, franchise arrangement is largely contractual in nature, thereby nature of the franchise agreement is extremely important.

In the case of Subway Systems India Private the issue was whether in respect of the transactions in the light of agreement, Subway is liable to a levy of service tax or sales tax?

The Agreement

Generally, Subway enters into franchise agreements with third parties, under which it provides specified services to the franchisee. In return, the franchisee undertakes to carry on the business of operating sandwich shops in Subway's name. Under this agreement, Subway receives two kinds of consideration, one being a one-time franchisee fee which is paid when the agreement is signed; and the second is a royalty fee paid weekly by the franchisee on the basis of its weekly turnover.

Analysing the Verdict

The Hon’ble High Court held that the agreement between Subway and its franchisee is limited to the precise period of time stipulated in the agreement and at the end of the period of the agreement, or before in case there was any breach of its terms, the right of the franchisee to display the mark 'Subway' and its trade dress, and all other permissions would also end. The Hon’ble High Court has clarified that it is not to be suggested that every franchise agreement will necessarily fall outside the purview of the amended MVAT Act. There is conceivably a class of franchise agreements that would have all the incidents of a 'sale' or a 'deemed sale' i.e., a transfer of the right to use.

The Court further held that there is no exclusivity in the Subway agreement, which is necessary for the transaction to fall into sale category. As per agreement the franchisee cannot unilaterally sub-franchise, if it could do without Subway's prior permission or leave, then the consideration might be wholly different and it may then be possible to say that there is a transfer of the right to use. The Court found that the right of transferability is extremely restricted and is impossible without Subway control throughout.

But in the light of this judgment it cannot be said that every franchise is outside the purview of the MVAT because the Court has clarified that the judgment is limited to the Subway franchise agreements, which was in question in that case and Court has not expressed any opinion on any other form of franchise agreement or on any broader question of whether all franchise agreements falls outside the MVAT despite the amendment. They only said that Subway franchise agreement which was before Court did not constitute a sale to bring it within the purview of that MVAT.

The Hon’ble High Court further held that mere inclusion of the term 'franchises' under the MVAT Act would not automatically make all franchise agreements liable to sales tax. What must be looked at is the real nature of the transaction and the actual intention of the parties. The agreement must be considered holistically, and effect must be given to the contracting parties' intentions. The label or description of the document is irrelevant. An agreement styled as a franchise might, on a proper examination, turn out to be nothing more than a mere license as it became in Subway's case. On the other hand, an agreement that calls itself a license might actually be a franchise.

Hence the decree…

If, in a given case, a franchise agreement is effectively nothing more than a mere permissive use, it cannot be made liable to VAT. It would be a service, and hence liable to service tax. This judgment can be a message to the franchise industry in India that the agreement has the potential effect on their business therefore one has to be give extra attention before entering into market.

The Author of the article is Advocate-On-Record, Supreme Court of India

(Formerly Asst. Professor NLSIU Bangalore

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