Tax Implications of Franchise Agreements in India: A Comprehensive Guide

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Adhering to the taxation policies of the nation in which the business is set up is very crucial. India has been making significant changes over time to simplify its tax implications and attract more businesses to come and establish their presence. This led to significant growth of the franchise model in India, attracting both franchisors and franchisees to establish and expand their businesses in India. After 2017, the government to simplify tax obligations, different taxes were abolished and a uniform tax called Goods and Services Tax (GST) was introduced.

Following is a discussion of the tax obligations for both franchisors and franchisees under the GST regime to comply with:
• For franchisors, if their franchise yearly turnover for the goods exceeds Rs. 40 lakhs and the yearly turnover of the services exceeds Rs. 20 lakhs (as of 2024), then such a franchise company needs to be registered under GST.
• The rate of GST depends on the nature of the franchise agreement and the services provided by the franchisor. For instance, if the franchisor offers training and support services to the franchisee, GST is chargeable at 18%, whereas if the franchisor only gives authorization to use its brand, GST would be charged at 12%.
• The initial franchise fee paid by the franchisee to the franchisor is also covered under the GST regime as it is considered a supply of service. Thus, the franchisor has to issue a GST-complaint invoice and levy GST as per the prescribed rate, generally 18% for services.
• Later on, the royalty fee paid by the franchisee for continued use of the brand is also considered a service and thus subject to a similar rate of GST. The franchisor needs to make the necessary invoices for the same and make GST payments.
• For franchisees, they can claim the Input Tax Credit (ITC) on the GST paid on franchise fees and royalties. This means the tax paid by the business when making a purchase can be used to decrease its tax liabilities when making sales.
• Also, if the franchisor is a non-resident or doesn’t have a PAN, then the franchisee, on behalf of the franchisor, pays GST under the reverse charge mechanism on the franchise fees and royalties. However, if the franchisor has any fixed establishment in India, then he shall be liable for charging and collecting the GST.
• The franchisee shall file GST returns timely, maintain records, and ensure periodic payment of the GST to avail ITC benefits and avoid fines and penalties.

Section 24 of the Central Goods and Services Tax Act (CGST Act), 2017 talks about the categories of persons who are required to get compulsorily registered under this Act. A few of the categories are mentioned below:
• those conducting any inter-State taxable supply;
• casual taxable individuals engaged in taxable supply;
• individuals obliged to pay tax under reverse charge;
• individuals obliged to pay tax under Section 9(5);
• non-resident taxable individuals engaged in taxable supply;
• such other individuals or classes of individuals as mentioned in Section 24 or notified by the Government on GST Council recommendation.
The obligations of paying taxes shall be discussed beforehand and written in the franchise agreement to avoid any dispute. However, the main issue persists when the franchisor resides outside India.

Under the Indian taxation system, the taxation of franchise fees and royalties depends upon the residential status of the franchisor, which is decided as per the Income Tax Act, 1961:
• If the franchisor is a resident of India as per the Act, the franchisor is liable to pay tax on the franchise fees and royalties received by him from the franchisee as business income. Along with this, the franchisor is equally allowed to claim deductions for the expenses associated with the franchise business.
• And if the franchisor is a non-resident of India as per the Act, the Indian franchisee is required to deduct tax on the franchise fees and royalties paid.
• The franchisee is mandated to deduct a 10% withholding tax on technical service fees, and the same is paid to the resident franchisor. The Double Taxation Avoidance Agreement (DTAA) may offer a reduction on this rate if deemed applicable.
• The franchise fees and royalties are considered business income and thus liable for tax. The corporate tax is levied at 30% on such income.

Compliance with tax implications has several benefits, and it eases the working of the franchise to a great extent.

Following is a discussion of some pointers which explain the importance of complying with tax obligations:
• Adhering consistently to the GST regulations plays a crucial role in building trust and credibility with stakeholders, encompassing customers, suppliers, and financial institutions.
• Proper compliance minimizes the risk of disputes with tax authorities, which could harm the reputation and goodwill of the franchise, which could further create a loss of opportunity.
• Failure to register under GST when required can result in fines or penalties.
• Making any sort of mistake while filing the return, like incorrect returns filed or filing of less amount than actual, or being delayed in filing the returns can attract penalties or interest payments on late payments.
• Proper filing of the documents and returns ensures that the franchisees can claim ITC on the expenses made for the GST payments on franchise fees and royalties. This helps reduce the tax liability and strengthens financial stability by enhancing cash flow. Any delay in complying with rules can result in blockage or denial of the ITC.
• Continuous non-compliance with tax regulations can hamper the operations of the franchise because of legal actions and other restrictions hindering day-to-day working.
• Business efficiency also increases as for regular compliance, automated systems and meticulous record-keeping are required. Business processes are streamlined, which reduces the risk of errors and improves operational efficiency.

Adhering to taxation rules is essential, but it has its own challenges as well. Understanding the local taxes of the region is crucial, which include local sales tax, property tax and withholding tax, which vary from location to location. Moreover, filing the tax returns sometimes becomes a complex task as tax regimes and slabs can change anytime with the new financial year, leading to no use of the financial plans made. The treaties between the nations also significantly impact the structure used for tax matters.

Thus, in conclusion, it would not be wrong to say that comprehending and complying with the GST and other tax regulations is imperative for franchisors and franchisees in India if they want to minimize or avoid unhealthy outcomes involving legal issues and disruptions in business operations.
Authored by: Adv. Anant Sharma & Sahil Arora

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