Source: Allahabad High Court

Why in News?

Recently a bench of Justice Shekhar B Saraf noted that in franchise agreements, the franchisor retains control and can license the same rights to multiple franchisees, reinforcing the licensing framework rather than a full transfer.

• The Allahabad High Court gave this observation in the case of Commissioner Commercial Tax v. Pan Parag India Limited.

What was the Background of Commissioner Commercial Tax v. Pan Parag India Limited Case?

• The respondent (dealer) entered franchise agreements with various parties, granting them the right to use the respondent's brand name/title.
• The Commercial Tax department assessed that the respondent had sold its brand name/title under the franchise agreements and levied Value Added Tax (VAT) on it.
• The First Appellate Authority upheld the VAT levy, concluding that the franchise agreement constituted a sale of the brand name/title.
• The Commercial Tax Tribunal relied on the Delhi High Court's judgment in McDonald's India Pvt. Ltd. v. Commissioner of Trade Taxes (2019) and held that since the franchise granted a non-exclusive right to use the trademark, it did not constitute a transfer of the right to use goods, and hence, no VAT could be levied.
• Hence, an appeal was preferred before the Allahabad High Court.
  • The issue for consideration is whether the franchise of a trademark constitutes a transfer of the right to use goods, thereby making it subject to VAT?

What were the Court’s Observations?

• The court analyzed the definition of 'franchise' under Section 65(47) of the Finance Act, 1994, which states that a franchise agreement grants only a representational right and not an exclusive right to sell/manufacture goods.
• The court highlighted that in trademark licensing, the licensee's use of the mark is considered the owner's use, maintaining the continuity of the trademark's reputation and legal protections.
• The court observed that franchise agreements primarily involve the licensing of intangible assets, such as trademarks and business methods, rather than the sale of tangible goods.
• The court emphasized that franchise agreements involve an ongoing relationship between the franchisor and franchisee, characterized by training, support, and ongoing assistance, unlike a one-time sale of goods.
• The court noted that in the present case, the respondent had already paid service tax on the royalty amount received from the franchisees, and thus, the same cannot be subjected to VAT.
• Based on the above analysis, the court held that the franchise agreement in the present case granted a non-exclusive license rather than a transfer of the right to use goods, and therefore, the transaction did not attract Value Added Tax under the UPVAT Act.
• Consequently, the court dismissed the revision application and upheld the Commercial Tax Tribunal's order, finding no reason to interfere with its view.

What is a Franchise Agreement?

• About:
  • A franchise agreement is a contract between two parties - the franchisor and the franchisee.
  • The franchisor is the owner of a trademark, brand name, and business system, while the franchisee is granted the right to use these intellectual property assets and operate a business following the franchisor's methods and procedures.
• Section 65(47) of the Finance Act, 1994:
  • It defines a 'franchise' as “An agreement by which the franchisee is granted representational right to sell or manufacture goods or to provide service or undertake any process identified with franchisor, whether or not a trademark, service mark, trade name or logo or any such symbol, as the case may be, is involved.”
• Key Features:
  • Grant of rights: The franchisor grants the franchisee the right to use its trademarks, trade names, logos, and proprietary business methods and systems within a defined territory.
  • Non-exclusive rights: As per Section 65(47), the franchise agreement grants only a representational right, not an exclusive right to the franchisee to sell/manufacture goods.
  • Territorial restrictions: The agreement specifies the geographical area in which the franchisee can operate under the franchisor's brand.
  • Operational standards: The franchisor sets standards for the franchisee to follow regarding product quality, service delivery, marketing, etc., to maintain brand consistency.
  • Fees and royalties: The franchisee pays an initial franchise fee and ongoing royalty fees to the franchisor, typically based on a percentage of sales/revenue.
  • Term and renewal: Franchise agreements have a defined term, often with provisions for renewal subject to certain conditions.
  • Training and support: The franchisor provides initial and ongoing training, operational support, and assistance to the franchisee.

What are the Landmark Cases of Franchise Agreement?

• Bharat Sanchar Nigam Ltd. v. Union of India (2006):
  • The Supreme Court laid down a test to determine if a transaction constitutes a transfer of the right to use goods, including
    • availability of goods for delivery,
    • consensus on the identity of goods,
    • legal right for the transferee to use the goods,
    • exclusion of the transferor during the transfer period, and
    • inability of the owner to transfer the same rights to others during that period.
• McDonald's India Pvt. Ltd. v. Commissioner of Trade Taxes (2017):
  • The Delhi High Court held that since a franchise agreement grants only a non-exclusive right, it does not constitute a transfer of the right to use goods.
• Malabar Gold Private Limited v. Commercial Tax Officer (2013):
  • The Kerala High Court held that a franchise agreement does not constitute a deemed sale under the Kerala Value Added Tax Act, as the franchisor retains effective control and possession, and the transaction involves non-exclusive rights.
• Godfrey Phillips India Limited v. State of Uttar Pradesh (2005):
  • The SC held that the Constitution does not permit overlapping of taxes, and once an activity is taxable as a service, it cannot be taxed as a sale or deemed sale of goods.