Legal and Regulatory Considerations in Global Franchising
Failure to consider the impact of legal and regulatory issues in granting international franchises could lead to various problems, incuding program failure.
By Carl Zwisler, CFE
A franchisor is only as successful as the individual. What does it take to succeed in international franchising? Finding the right franchise partner? Commitment of the franchisor’s CEO and board of directors and the dedication of every department in the franchisor organization? Selecting the right markets?
Each of these keys to success is important, but if a franchisor fails to consider the impact of legal and regulatory issues that affect the process of granting of an international franchise and setting up and operating a franchised business in a new country, the franchise program can fail.
Because legal and regulatory issues determine when or whether a franchisee may be offered, whether the franchisor’s trademark can be used, the fees that may be collected by the franchisor, how franchisees can be supplied and the cost of starting and operating a franchised business, franchisors should be aware of these issues before making a commitment to doing business in a country.
The process of learning about a country’s laws typically begins with an international franchise lawyer retaining franchise counsel in a country under consideration to prepare a franchise issues memorandum which outlines issues confronted by franchisors there, supplemented with industry-specific legal analysis. (Several organizations publish overviews of national franchise laws which franchisors and their international counsel may consult in their preliminary analysis of a host country for their franchises.)
The memorandum should explain whether and how the franchised business may be lawfully established in the market, what the time and cost of concluding a transaction will be, and what local conditions will impede or facilitate profitability. After determining whether compliance with a franchise sales law is required and, if so, how to comply with it, the franchisor will need to know whether its assets — trademarks, domain names, and other intellectual property — can be protected in the country. If a franchisor’s IP is placed at unreasonable risk for any reason, franchisors should determine whether the risk of doing business in the country is offset by the rewards if everything works out.
The first step in evaluating IP risks is to perform a search to determine if someone else has registered or is using the franchisor’s IP. If others are already using or have registered the IP, the franchisor may face a costly and lengthy fight with the users and registrants.
The third concern of an international franchisor should be to determine whether the local laws and legal system will allow the franchisor to collect and keep the benefits of the bargain it strikes in its franchise agreements. Are franchise agreements enforceable as written? Will courts efficiently enforce agreements and arbitral awards granted elsewhere, or will a franchisor or its master franchisee confront years in court before they can expect to recover fees owed?
Can the franchisor easily collect full benefit of the fees the franchisee has agreed to pay, or will withholding taxes take a big bite out of payments? Do exchange controls or currency restrictions limit payment in the currency specified in the agreement? Do they limit the full amount of fees that may be sent out of the country? Is the process of obtaining payment approvals so cumbersome that compliance burdens will lead franchisees to shirk payment obligations? Are all requisite trademark registrations and payment permits in place so that the franchisee can actually send payments to the franchisor? If not, how long will it take to obtain the necessary approvals?
The fourth concern is whether the franchisee will be able to obtain the furniture, fixtures, equipment, supplies and inventory needed to carry on the business in compliance with the franchisor’s standards. Will local laws require use of products sourced locally, even if the franchises are retail outlets that primarily sell products sourced in other countries? Will laws regulate products contents, or labeling restrict importation of the products generally used in the franchise program? Will duties be imposed upon imported products that will make their use or sale too expensive?
Wise franchisors will obtain answers to their questions before deciding whether to do business in a country, regardless of the qualifications of a prospective franchisee. They will not spend weeks negotiating with the perfect candidate only to learn that legal or regulatory issues either cannot be overcome or will impose such costs that entering into a franchise relationship in the country would be too costly.
Because a franchisor should be concerned with net return from the investment made in an international franchise program, it will need to evaluate the cost and time required to implement the international expansion strategy it proposes to use.
Although most U.S. franchisors use master franchising to enter foreign markets, the transaction costs of that strategy are higher than area development franchising, in part because of the number of different agreements and franchise disclosure documents required. A master franchise program requires a master franchise agreement, and a unit/subfranchise agreement. Because the latter agreements reflect obligations between the master franchisee and the unit/subfranchisee, as opposed to obligations between the franchisor and a unit franchisee, international franchisors must revise their domestic unit franchise agreements for use with master franchise agreements. All agreements must be modified to reflect local laws and business practices before they may be used in a new country.
Franchisors that either choose to use an international Franchise Disclosure Document (FDD), or that must prepare them to comply with laws of the franchisee candidate’s country, normally will invest in the preparation of documents to describe both the master franchise program, and a template unit/subfranchise FDD for use and adaptation by the master franchisee. (Although franchisors usually have no legal obligation to prepare unit/subfranchise FDDs for a master franchisee, most will reflect information about the unit franchise agreement and program, as well as information about the franchisor. Franchisors will find that the cost of preparing the model document for the master franchisee’s adaptation to include information about the master franchisee and any changes made to the unit/subfranchise arrangement required by local law, will be much less than the cost of paying an international franchise lawyer or local franchise counsel to review and negotiate documents prepared by the master franchisee’s counsel.) When budgeting for an international transaction, franchisors also must consider the time and cost of preparing a letter of intent and negotiating all agreements.
Almost every country imposes a withholding tax on franchise fees and royalties paid to a foreign franchisor. The tax can be as high as 35 percent. Bilateral double taxation treaties often reduce the amounts due. Before even drafting a letter of intent, franchisors must understand how tax laws will affect their return, and whether strategies such as use of a “gross up,” (a technique designed to enable to allow the franchisor to collect the full payment stated in the contract.) The franchisee is required to pay the withholding tax imposed on the fees (which are required to be paid by the foreign franchisor) and remit the stated value of the fees to the franchisor. For example, if the payment due is $100 and the tax is 20 percent, the franchisee would pay the $20 tax to the government and the $100 fee to the franchisor, rather than deducting the $20 from amounts paid to the franchisor. (When technical service fees are taxed at a lower rate than royalty fees, a franchisor may be able to characterize a portion of the standard ongoing fees as technical service fees and reduce taxes owed.)
Granting multi-country franchise territories can compound the legal analysis and cost of a transaction. Franchisors operating on a tight budget should approach transactions involving multi-country territories with caution. Every country in a multi-country territory has its own independent laws and taxes. An analysis of each country’s laws is needed before executing a letter of intent. Although it may seem attractive to grant a franchise covering six Caribbean countries, the cost of the legal analysis required to do business in each country, and the cost of modifying and negotiating legal documents, as well as the cost of dealing with the tax regimes in each country, must be considered. If very few franchised outlets may be established in each country, the legal transaction costs may not warrant the investment for many franchisors.
What is the most important factor in the success of international franchising? That question is open to debate. But no international expansion program can be rationally undertaken without an analysis of legal and regulatory issues in the very early stages of the discussions.
Carl Zwisler, CFE, practices international franchising law with Gray Plant Mooty in Washington, D.C. Find him at fransocial.franchise.org.