Legal and Tax Aspects of International Franchise
- Nicaragua
- 12/01/2001
- Sesma, Sesma & McNeese
Generally speaking, there are three ways to franchise in foreign countries:
1. National Direct Franchising
2. International Direct Franchising
3. International Master Franchising
1. National Direct Franchising:
This is the typical structure of any commercial franchise. In this case, the Franchisor, a Mexican company incorporated by SCM, will grant to third party franchisees the exclusive right to sell a good or service in a specific area under SCM’s trademark and tradename. The franchisees are in turn obliged to fulfill certain ongoing requirements with regard to quality of service, image, publicity, etc.
This type of franchise requires from SCM to incorporate a Mexican company, the franchisor, with local capital and management which will contract with third parties (the franchisees) to operate facilities that offer SCM’s brand of goods and services. This structure will allow the franchisor a direct and immediate control of the franchisees with regard to the fulfillment of their obligations established in the franchise agreement and the keeping of the standards that the franchisor requires for its trademark or tradename. This structure will require strong investment from the part of the franchisor with regard to establishing and running a Mexican corporation.
2. International Direct Franchising
Also called Unit Franchising. This type of franchise grants franchises to individual franchisees in a foreign country. There is an international agreement between the franchisor and the franchisee. This kind is used mostly between countries that are culturally close to each other. This type of Franchise gives the franchisor a direct control over the franchisees with less impact on the franchisor’s capital investment given that the franchisor is in a foreign country and the franchisee in Mexico. No Mexican company is incorporated in this case.
3. International Master Franchising
Now, if the intention of SCM is to refrain from incorporating a Mexican company and to do business solely with its franchise agreement, there are 2 possible options of doing this operation:
A. MASTER FRANCHISE AGREEMENT
The franchisor grants another person the sub-franchisor (a third Mexican Company, not incorporated by SCM), the right (most of the cases exclusive) to grant franchises to franchisees within Mexico or any other territory and/or open franchise outlets itself, with the obligation of paying financial compensation for this right. The form of this financial compensation (that may be an initial fee) vary from country to country, and franchise to franchise.
Two agreements are involved in Master Franchise Agreements:
a) International Agreement between the franchisor and the sub-franchisor (Master Franchise Agreement)
b) Domestic Franchise Agreement between the sub-franchisor and each of the franchisees (Sub-Franchise Agreement)
Rights and duties of the sub-franchisor:
1. The sub-franchisor assumes the right to grant licenses, within the specific territory or country, to the franchisees, as would the franchisor, and undertakes the duties of a franchisor to the franchisees.
2. Is responsible for the enforcement of the sub-franchise agreements and for the general development and operation of the network in the country or territory it has been given the right to develop.
3. To intervene if a sub-franchisee does not fulfil its obligations.
Benefits of Master Franchising:
A) For the franchisor:
1. The possibility to extend its network without investing as much as would be necessary if it were setting up the foreign operation itself.
2. It is able to rely on an individual or entity that will be familiar with the country concerned, that will know how the local bureaucracy works.
3. The economic and logistic burdens involved may in fact be such that it would not be economically viable for the franchisor to enforce the terms of the unit agreements.
4. The contribution of a local sub-franchisor that is able to step into the franchisor’s shoes in the country concerned, is therefore of the utmost importance.
B) For the sub-franchisor:
1. They are worth investing in.
2. The technical know-how that accompanies a franchise might also be of considerable interest to a sub-franchisor.
3. Sub-franchisers need to be large, as the amount of the investment will be of major importance.
Problems associated with Master Franchising:
1. Limited control of franchisor over Franchise Network.- When there is no direct contractual relationship between the franchisor and the franchisees there is a diminished control. Further the franchisor is obliged to rely on the sub-franchisor to enforce the sub-franchise agreements and to ensure that its rights, such as intellectual property rights, are not infringed upon. Problems arise where the sub-franchisor does not perform its obligations as it should.
2. Problems with Terminating Master Franchise Agreements: The consequence could be that the franchisor continues in an unprofitable and undesirable business relationship with its sub-franchisor. The sub-franchisor should have no guarantee that the agreement will always be renewed in case we want to go for an early termination.
3. Sharing of Income derived from fees: The question is related to whether the revenue from these fees is sufficient for both the franchisor and the sub-franchisor.
4. Finding an interested Mexican Investor
B. AREA REPRESENTATION AGREEMENTS
These agreements are sometimes presented as Master Franchise Agreements or Development Agreements. These are not franchise agreements but are rather more in the nature of agency or commercial representation. Under this arrangement the franchisor will typically grant a third party, the area representative, the right to solicit prospective franchisees, as well as to provide certain specific services on behalf of the franchisees within an exclusive territory.
Sometimes these arrangements are treated as a variation of master franchising in which the franchisor receives the same benefits as in master franchising while avoiding certain of the problems associated with it. Area representatives traditionally do not make the same investment as sub-franchisor under a Master Franchise Agreement. Area Representation Agreements are associated with direct franchising, it seeks out prospective franchisees, interviews them and makes a recommendation as to their suitability to the franchisor. The franchisor remains with control over franchisees and does not invest heavily in Mexico. Finding an interested Mexican Investor is easier.
TAX ASPECTS
With regard to the taxes to be paid, the following applies for each of the defined structures:
a) Direct Franchising
This structure involves a Mexican entity, which would be incorporated (franchisor) and several Mexican independent companies or individuals (franchisees) that declare and pay taxes as any other Mexican company or individual would. Income Tax, in Mexico is up to 35% for entities and up to 40% for individuals.
b) Direct International Franchising
This structure involves a foreign company, the franchisor, and several Mexican companies or individuals, the franchisees, also independent from each other. In this case, the Mexican companies or individuals would declare their income tax apart from the franchisor. The foreign entity would declare its taxes before foreign authorities, but their income derived from fees paid by the Mexican franchisees would generate income tax in Mexico, which in turn would be retained by the franchisees (in accordance to the percentages applicable for the country of residence of the franchisor) in order for the franchisor to credit such payment in its own jurisdiction.
c) International Master Franchising
This structure involves a foreign company (the franchisor), a third Mexican company (sub-franchisor) and several Mexican entities or individuals (franchisees). Basically the same principle applies. Every party to this agreement is independent from each other and sole standing. The franchisor would pay income tax in Mexico that derives from the fees and amounts paid by the sub-franchisor (the sub-franchisor will retain this tax in accordance to the applicable country percentage).
d) Area Representation Agreements
This agreement involves a Mexican entity or individual (representative), the foreign company (franchisor) and several Mexican entities or individuals (franchisees). In this case, franchisor incurs in income tax with regard to the fees paid by franchisee, which in turn, will retain said income tax and pay it. The representative would have to pay its own income tax derived from payments made to it by franchisor.
NOTE: This legal opinion is issued exclusively with regard to the applicable legislation in force in the Mexican Republic at the date of issuance (December 4, 2001).
