Taxing times

Taxes can be taxing, we all know. What makes them worse is when cumbersome indirect tax glitches inhibit survival of chain store business and eat into their profits.

VARUN Arora took up the franchisee of a fashion brand in his city, a small yet lucrative market. He believed in the brand, knew the name will get him customers and had already assessed the consumption potential of his city. Everything was in place, a shop was rented in a mall at a prominent high street, the agreement was signed, the outlet was well stocked, the staff trained and finally, the business venture was inaugurated.

As anticipated, the store got customers , the brand was well-received. However, Varun was unable to reap profits. Reason, the profitability of the franchise business model experienced erratic tax structure at different levels of value chain.

This plight is common to the franchise industry and the burden of regulatory procedures has made survival difficult for entrepreneurs. Franchising has been a significant organiser as well as facilitator of small and medium businesses across industry verticals. It has galvanised the evolution of organised markets. However, policy makers are yet to deliver a conducive ecosystem for the growth of the franchise community, which incidentally includes a new breed of Indian entrepreneurs. The policy makers are either ignorant about the potential that US$ 7.2 billion industry holds or have not been able to comprehend the industry growth figures.

Dual taxation policy dilemma

Under Notification No. 7/2003 dated 20.06.2003, service tax is payable on the gross amount charged by the franchisor from the franchisee. However, the definition of franchise services flawlessly comprehends the scope of the business activity. The implementation triggers a lot of impact on the functioning of the format. Franchise services are subject to dual taxation, both service and sales tax. Product franchising, being a mode of product distribution, is subjected to VAT. At the same time, franchisors are liable to pay service tax on franchise service given to the franchisee.

Also, franchisors prefer to call their partners dealers instead of franchisees to avoid the service tax accrual. The final burden of the service tax is passed on to the franchisee, as the franchisor is unable to forgo his share of franchise fees, which dampens the entrepreneurship spirit of small businesses. This becomes critical in case of franchisors of big brands where the franchisee has little negation power. It also creates liquidity crisis on the franchisees' balance sheet.

More woes: Service tax on rentals

Real estate has become one of the most important aspects of franchise preposition or for that matter, a retail success. The rental lease cost is a significant contributor to the franchisee's running cost when the real estate prices are exorbitant. The industry seeks abolition of service tax on the rental leases. This affects the cash flow and the operational cost of the franchisee, thus, eating into trade margins. For franchise industry to thrive successfully, it would require abolition of service tax currently levied on transportation, rent and commission.

Whilst taxes are nonetheless critical, however, in a franchise operation, the implication of these taxes are not justified and commonly lead to situation where franchisors, particularly retail franchisors, are shying to term themselves as franchisors and have diluted the business practices fundamental to the success of franchising format. There is also strong opposition from the franchisees, as the franchise system is yet to establish itself as a business model.

The need of the hour is to send a positive signal on stability and friendliness of the regulatory environment for investment. India should carefully assess whether the franchise industry should be squashed or be used as a vehicle for progress.

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