Podcast transcript: intra-group franchising arrangements, with Spencer Ho

The following transcript has been lightly edited for clarity. The original interview can be heard on The LCN Legal Podcast here.

Intro: Hello, and welcome to The LCN Legal Podcast. Bringing you expert views and analysis of the legal aspects of transfer pricing compliance. Our focus is always on real-world, practical insights that you can apply in your everyday work.

In this episode, we talk to Spencer Ho from RoyaltyStat, which recently became part of Exactera. Spencer and Paul describe how franchises work in the commercial world, the key documents involved, and the key elements of the financial arrangements. They then discuss what information is available for the benchmarking of intra-group franchise arrangements, and what factors TP practitioners should consider, in addition to the headline royalty rates. We hope you enjoy the discussion.

Paul Sutton: Hi Spencer, and thank you very much for joining us on this episode.

Spencer Ho: Thanks for having me, Paul.

PS: The focus of today is franchising arrangements. So clearly it is a very common structure in the third party world. And equally many intercompany arrangements, or intercompany value chain structures, are inspired by franchising arrangements, and may also use third party franchise agreements for benchmarking, for comparables. So let's just look at it from a high-level perspective. So Spencer, how would you describe a franchise agreement or franchise arrangement in the third party world? Are there different types and what kind of elements are usually included?

SH: Well, just to touch on something you said in terms of franchising models being rather common: I would say in RoyaltyStat, in our database of licence agreements, franchise agreements are pretty common to see. There's over 4,000 of them. And franchise agreements are one of the few other sources of arm's length licencing transactions that you can find outside of the US SEC EDGAR database. So it is something that is very common, and that states see – and the FTC as well, and Congress see – as something that needs to be regulated, because it's so common. And I think it's also part of the model. So in the third party world, franchises are networks of businesses designed to take advantage of economies of scale. We see it all the time. Even in the tax world, of course, we have the Big Four that essentially operate as franchises in many respects. Not always, but a lot of times you will see franchises of the Big Four accounting firms.

And the way I see it is there are two sides. There's the franchisor who built the franchise. Initially they probably started with one office, or one restaurant, and then expanded the number of locations. And at a certain point, they probably decided to adopt the franchising model because it allows them to expand their business and bring in more revenue, build the brand as well, without investing as much of their own capital upfront as if they were to, say, go into another state or another country and start building new restaurants there, or new offices as part of the existing business.

And then the franchisees, I see the franchisees as entrepreneurs. They're risk-takers. I've known a few of them, and they see being part of a franchise as a way to mitigate some of those upfront risks such as building the brand and establishing the systems that make a business run smoothly. And of course they get access to those economies of scale.

PS: I think that's a really important point. So thank you very much. So in other words, the high-level franchisor perspective, which is the ability to take advantage of opportunities of scale or opportunities to scale a business without incurring all the capital costs. And obviously from a franchisee perspective, buying into a tried and tested model, hopefully. But equally being entrepreneurial. And I guess when many people think of franchises, they might think of McDonald's as maybe the classic example, and looking at it as a bundle of services or support which the franchisor is providing. So it's obviously the brand, it's obviously marketing assistance, it's the systems – so the operating system plus also access to supply chain. Plus, in the case of McDonald's specifically, it's actually the premises, which are provided or leased by the franchisor. So I guess that's one key feature of franchise arrangements is that it tends to be a bundle of different aspects.

SH: Yeah, and there are of course different, I would say, parts of the value chain in a franchise, right? There's the franchisor that would be the original McDonald's, I guess, or the McDonald's parent company. And then you have master franchisees, and I would say often they'll go by region. For instance, I believe the Latin American master franchisee for McDonald's is Arcos Dorados. And then in France I believe they have – that was the most recent transfer pricing case, or at least the most notorious one recently – I believe the master franchisee in France was a related party. And the way I understood that to work (although take this with a grain of salt because I don't remember exactly), and this is how the master franchisee agreements usually work, is that they have the licence to develop the franchise in a certain region or a country, and they can sub-franchise out the franchise to third parties, and they can also operate their own stores. And usually the fee that they pay to the franchisor is based on the revenue of the various franchise locations. And there may be different rates, whether it's an owned business or if it's a third party franchise.

PS: Right. So from a high-level perspective, we're looking at two key distinctions or two key dimensions. One distinction is master franchise versus individual franchises. So there's different types of arrangements there. And then on the other side there's: what is actually the bundle that is being provided to the individual franchisees? So that this is what you're talking about, Spencer, in terms of brand and operating procedures and supply chain and maybe premises and so on.

SH: And of course these are typical. They may not be the same – they're probably not going to be the same – for every franchise, because you have franchises across different industries. So the aspects of a Big Four franchise are probably going to be different than a franchise in the restaurant sector.

PS: Yeah, totally. Okay, so we talked about the sort of high-level commercial nature of them. Let's move on and talk about how franchise arrangements tend to manifest themselves from a legal perspective in the third party world. So what are the core legal documents involved?

SH: Like I touched on earlier, one of the nice things about franchises is that they're regulated. So we get a good idea of the documents that govern the franchise models. Because, for instance, in California and I believe Michigan and two other states, not only are the franchises required to register all of their documents, including the franchise disclosure documents, they're also published online. And that's where we get them in RoyaltyStat. Franchise disclosure requirements are regulated in the US. (Under the CFR, chapter 1, sub-chapter D, part 36.) And they're regulated by the FTC. The requirements there: they list what must be in an FDD, a franchise disclosure document. There's, I think, 23 items. We don't have to go through all 23 of them. And they also require that the franchisor discloses the FDD to the franchisee, I believe, within 14 days of any payment or signing of any document that would kickstart the transaction.

Other countries have similar rules. I've done a lot of research on it, looking for other countries that may have franchise agreements. Found a few in Australia, and they're pretty similar. I would say they're pretty similar. Some countries, some states are more stringent. They say that the FDD has to be disclosed 30 days or maybe more before the transaction. And that's to make sure that the franchisee has the opportunity to review it – of course by themselves, and probably with counsel. And that also comes, I think, into the dynamic between franchisors and franchisees. Franchisees can, of course, be successful business people or even corporations, but they can also be somebody who has never had their own business before, and is taking a big risk that they can pull this off. And they have to understand everything that goes into it. And that's why the FDDs are very, very detailed. You have estimated upfront costs to get the business started. All of the agreements are provided, and there are even certain regulations that you can't make certain changes within seven days of signing. And anything negotiated, of course, is not part of that. But there is a big idea that you have to protect the franchisees.

PS: Yeah, and I guess that the fact that franchise arrangements are regulated in the US and elsewhere means that it's helpful in terms of that disclosure and transparency, and that's reflected in the information available on your database and so on. So just to add to that, from the perspective of a commercial lawyer, including in my former life as a primarily commercial and corporate lawyer... the kind of things that we would look at is obviously the franchise agreement. The agreement would refer to the manual or operating procedures and brand guidelines and so on. But it would commonly also have, as you touched on, conditions precedent that the franchisee needs to fulfil before the commencement of the franchise arrangement. So that would be things like completing training programmes for key members of staff. It would often also include pre-approval of premises and so on. So that tends to be the overall structure.

SH: Yeah, definitely. And the FDDs are very long. And in addition to that, the franchisor will usually disclose audited financial statements as part of that. It is a pretty arduous process – and personally, I also wonder how it's carried out. How much of this is relevant in the step-by-step process of creating an intercompany transaction?

PS: Yeah, fine, so we can come onto that, perhaps. So let's just drill down a little bit into the financial arrangements. So what are the typical elements that you would see, Spencer? What's reflected in your databases?

SH: Of the typical financial arrangements, the big one, of course, is the initial franchise fee, sometimes called a buy-in. And that will be a pretty substantial upfront payment, depending on the franchise. I don't know how precisely they are determined, but you could see initial franchise fees anywhere from say, 20,000 to maybe 100,000, and that's an important one to take into account. And then you have the royalties – they're usually called royalties or maybe ongoing franchise fees. And those would be often your typical royalty rate, expressed as a percentage of revenues from the business. And that is what is paid in consideration for the licence to the brand and the franchise system, which you could call the intangibles.

And then on top of that, another big one that we see almost all the time is a marketing contribution to the brand fund, which everybody contributes to in the franchise. And it's used to fund building the overall brand. And then in addition to that, you'll also often have a minimum local advertising spend. Which, of course, is not a payment necessarily to the franchisor, but it's a commitment so that the franchisor knows that the franchisee is going to invest in building this market. Which is probably their number one responsibility, and probably the make-or-break part of being a franchisee. Can you develop this local market?

And then, of course, like you mentioned, you have the other aspects of the system, that are not considered intangible. They're services provided by the franchisor. It might be training, like you mentioned, certain administrative services. There might be a technology package that they buy into. It wouldn't be a unique piece of software that was developed to run the business – that would normally be covered under the licence – but QuickBooks, things like that that they're required to have. And maybe the franchise gets a deal for them on it. So those are all types of things that you would see in a franchise arrangement in terms of financials.

PS: OK, so my next question was going to be: What kind of information is available from the third party agreements on your database or elsewhere which may be relevant in designing intergroup franchising arrangements? I think you've covered a lot of that already, in terms of the structure of the fees and what they cover, and also structure of payments which may not be to the franchisor but may be required under the agreement. The detail of those arrangements may be relevant. Is there anything else that you would call out, Spencer?

SH: Well, like I said, I think how the fees are broken out is very important. You need to really establish what is being paid by virtue of the royalty rate. What is part of the intangibles – the brand and the system? So we mentioned some things. You'll see a technology fee and you might say, ‘Oh, that's part of the intangibles,’ but no, this is just a technology package made up of third party systems. Whereas other times you will see the system defined as... it could be anything. It could be software included in it, patents, other types of IP. And that's really important, I think, when you're breaking out the fees and understanding what the royalty is paid in consideration for.

And then also how the royalty rate is structured. What if the franchisee is allowed to open other locations? Is there a specific payment? Is the franchising fee the same as the initial franchise fee? Is it lower? Is the royalty on the sales of those locations the same? Or is it lower, or higher? So these are all things I think you would want to take into consideration when designing an intra-group franchising system. You do have to keep in mind that it is not ‘one size fits all’. There are different conditions for every transaction that goes on. It's not as simple as it seems.

PS: Absolutely. Sorry, and just to jump in there, there’s a high-level commercial point about what's included and what's not included in the franchise fee. But also, if it is decided that actually a franchise model, or third party franchise comparables, are an appropriate way to go, how you implement that or how that might manifest itself from an intra-group perspective. Clearly what you're not trying to do is to replicate all the complexity of a third party franchise agreement. What we're trying to do is achieve an overall result – or design a relationship, design a transaction – such that the comparables can be taken as a reasonable approximation of an arm's length outcome and an arm's length arrangement.

SH: Right. And I think that does touch on one other point, which is the franchise financing. Of course, the franchisee has to be capitalised. They have to be able to cover the upfront costs, and also some ongoing costs before they start generating enough revenue to cover their ongoing costs. And sometimes you'll see – I would actually say fairly often – that the franchisor will offer some form of financing on the initial franchise fee. For instance, I was reading one the other day, just to prepare for this, and the franchisor would allow the franchisee to pay only half of the initial franchise fee and the rest could be paid off over time. Of course there was an interest rate on it. I think it was the Bank of America prime rate plus something else. And I think when you're in the intra-group setting, there will probably be intercompany financing to capitalise the franchisee. But also when you're designing that, you may want to take into account that in the third party world, the franchisee may not take everything out as a loan. They may finance certain things with the franchisor.

PS: Yeah, I think that's a really interesting point and from my perspective it goes to comparability. So to the extent that a third party franchise arrangement is being used as a relevant comparable, but that franchise arrangement provides or includes preferential financing terms – terms which would not be arm's length on a standalone basis – then maybe an adjustment might need to be made in terms of comparability and assessing royalty rates.

SH: Yeah, and you may want to also assess ahead of time, or do some research: whether this financing offered by the franchisor is really preferential. The franchising world is not beyond being a little ‘dog eat dog’. So of course if there's a realistic alternative where the franchisee can finance that initial franchise fee on better terms, then you would want to take that into consideration as well.

PS: OK, so I guess the overall picture that we're painting here is the fact that there is a lot of detail, which is available from your databases and so on, in terms of the actual terms and the way that third party franchises operate. So my next question was going to be: how might tax authorities use this kind of information when they're reviewing intergroup arrangements?

SH: Well, I don't have personal experience of how they would do it, but I can think of a few ways, based on seeing some cases where it's come up. I think it was the litigation in Denmark with Adco where they brought in some third party franchising agreements and the court sort of disregarded them, because they didn't bring any support in terms of the profit potential. But like I was saying before, profit potential is always difficult in terms of comparability. But we do get a lot of information in the FDDs to assess the market size, to assess the franchisors’ profitability as well. And you can also make some calculations in terms of the expenses to projected revenue, for instance. The upfront expenses. And also – since they estimate the ongoing expenses from time to time in these FDDs – it's a very valuable research document for tax authorities and also taxpayers. of course, when you're trying to build a defensible royalty rate study or franchise study. Or to counter a study that maybe was not as diligent.

And then I think of a couple of other things. Again, the tax authorities have been interested in: when there's a service fee, is the service actually provided? When you're designing the agreements, and you're saying, well, the service fee is in consideration for this support service, that support service and so on. You're going to have evidence in the third party world of what services are typically included and paid for, and what services are typically provided, for instance, for free. Or some services may be optional. And again, you get into the realistic alternative discussion.

PS: That's incredibly helpful. Well, unfortunately, we're running out of time, so I'm just going to try and wrap up. One is that in the context of intra-group arrangements, and in particular designing intercompany arrangements on a forward-looking basis, the franchise word is often used. Sometimes it's just meaning that what we're talking about or what is proposed is a franchise-like arrangement. So it's a bundle of different elements. But sometimes it means specifically that the intention is to use third party franchise arrangements as comparables. And it's really important to be clear on which situation we're talking about here. And if the taxpayer is going down the ‘franchise arrangements as a third party comparable’ route, then it's important to be clear about when this may not be appropriate at all. So franchises, as we talked about before, they presuppose that the franchisee is actually assuming risk, including market risk, operating risk, currency risk and so on, which in turn presupposes that the franchisee has the financial capacity to bear that risk. So clearly it's not an appropriate model for things like limited risk arrangements or target margin arrangements or something like that. So that's the first point.

The second point is that – as we've discussed a number of times – a key question in terms of the royalty is what is included and what's not included in the royalty. So that is relevant in terms of looking at third party comparables, in terms of franchise arrangements. And it's important in terms of replicating that, albeit on a simpler basis, in the intercompany arrangement and the intercompany agreement. So just to give a specific example, are there additional services which are going to be charged for separately in addition to the royalty fee? Second point.

The third point is just a practical point: as we've discussed, a royalty payment typically covers a bundle of different elements like brands, the access to the system or brand manual, or operating know how, together with services and maybe goods. And from a wider tax perspective, those different elements may well have different treatments from the perspective of withholding taxes, VAT and sales taxes, customs and so on. So, although in a third party arrangement it may be a single amount, a single percentage for that royalty, in the intercompany agreement it may be important to break down that amount and allocate different elements to those different aspects of it.

And then finally, we are creating a very specific new arrangement and it's important to document it upfront. It's not the kind of thing that could be made up after the event, because it's just too complex. Spencer, any additional points that you'd like to emphasise before we finish?

SH: I think the one point to emphasise (and you mentioned it also) is that franchisees, they're risk-takers. And I think in addition to when you're designing the intercompany structure, you also have to monitor at the operational level that the franchisees are actually operating as risk-takers. That they're not just limited risk retailers or limited risk distributors masquerading as franchisees. Because your entire system is going to break down if you do that.

And in terms of comparability as well, I've seen some people try to extrapolate certain things from franchise arrangements and apply them to different types of arrangements. For instance, the contribution to the marketing fund and the required local ad spend. Just because that applies to a franchisee who is licencing the brand, it doesn't apply to a limited risk distributor. So we really need to pay attention to how the entity is characterised and how they're actually operating when considering franchise agreements as comparables – and even getting any insights from them. Because they're generally very different transactions than even your typical trademark licence agreement.

PS: Yeah, absolutely. Well, Spencer, thank you so much for spending the time with us. It's been really insightful and interesting for me and I'm sure for our listeners as well. And just to let people know we'll include Spencer's contact details in the notes for the podcast so that you'll know how to contact him if you need any help in terms of accessing agreements or arranging that kind of data.

SH: Thanks Paul, and thanks for having me despite my inexperience as a podcast guest.

PS: Not at all. Thanks very much.

Outro: Thanks for listening to The LCN Legal podcast. We really would like to hear what you think. You'll find the contact details on our website: lcnlegal.com. You'll also find a transcript of this episode in the blog section, which will include Spencer's contact details. And in the Training Hub and on the blog section, you'll also find much more about many of the issues discussed in this episode. If you enjoyed it, please subscribe. Go to your podcast provider and search for The LCN Legal Podcast. Until next time, thank you and goodbye.