Estonian tax treatment of franchise agreements

November 2012

Over the past year the Estonian media has published several pieces on major multinational brands planning to start up in Estonia (for example Starbucks and Subway).  Often the preferred strategy for multinationals to enter new markets is to work with local partners via franchise agreements.

By definition, a franchise is a contract under which one person (the franchisor) promises to grant another person (the franchisee) a set of certain rights and information, including trademark, designs, artwork and know-how.  Based on this mix of tangible and intangible assets, the franchisee can then copy the business model of the franchisor and start trading. In return the franchisor receives monetary consideration.

This is, perhaps, an appropriate time to take a look at the Estonian tax implications of fees payable to foreign companies under a typical franchise agreement. Considering tax issues early can mean big savings.

Most countries apply withholding tax to certain payments made to foreign recipients (non-residents). Quite commonly withholding tax applies to dividends, interest, royalties, rent and certain service fees paid to non-residents.  Withholding tax is always applied to the gross payment, meaning that the non-resident cannot deduct any related expenses.

The Estonian tax system is more generous towards non-resident investors than most other countries since there is no withholding tax on dividends and interest. However, certain types of payments under a franchise contract can be subject to a withholding tax. According to the law, it is the Estonian company’s obligation to withhold, report and remit the withheld amount of tax to the tax authorities. It is not possible to delegate the payment of the applicable withholding tax to the non-resident franchisor under a contract but the parties can freely decide who actually bears the tax cost. In simple terms - the fees payable under a franchise agreement can be agreed on a net or gross basis. From the franchisor´s perspective it is more beneficial to agree on fees payable on a net basis. This makes sense since it can be difficult for a foreign company to keep abreast of the Estonian tax legislation and therefore evaluate tax costs.

In practice both types of contracts are concluded, often depending on which party is more knowledgeable of tax issues.

From the foreign company´s perspective it is also worth noting that Estonian tax legislation differs from several other countries´ in one particular respect. Namely, the non-resident becomes liable to declare and pay tax on fees, which should have been subject to a withholding tax but where the tax was not withheld by the Estonian company. In practice this may happen simply for the reason that the Estonian franchisee is not aware of its obligation to withhold tax. Consequently, the Estonian tax authorities may seek the payment of this tax directly from the foreign franchisor.

It is not overly surprising that Estonian companies can sometimes omit the obligation to withhold tax on payments made from a franchise agreement. This is due to the “mixed nature” of franchise agreements. Under the franchise agreement the franchisee receives a variety of rights, goods and services. Consequently, the fees which are payable as a consideration, vary by nature. Under a typical franchise agreement, some payments are classified as royalties, some as service fees for services performed in or outside of Estonia and some as consideration for goods received.

For example, let’s assume that a foreign retailer is planning to open a few stores in Estonia, which will exclusively sell its brand “X”. Under the franchise, the Estonian franchisee is granted the exclusive right to market and distribute “X” brand products in the “X” store(s) under the trademark, initials, logotypes and artwork. The contract prescribes that the stores will have the exact same design and set-up as the original stores.

For this, the franchisor receives various fees, for example an entrance fee for receiving the exclusive right to market and distribute the products, a shop fee per opening each store, design project fees and consideration for shop equipment and merchandise sold.

In this type of contract, where the franchisor grants knowledge and experience to the franchisee and provides varied technical assistance which is backed up by supply of goods, the first step should be to break down the fees. The breakdown of fees should be based on the nature of various goods and services provided under contract. The second step should then be to apply the proper tax treatment to each item. Exceptionally, if one part of what is provided constitutes by far the principal purpose of the contract and other parts are of only minor significance, then it should be possible to apply to the whole amount of consideration the tax treatment applicable to the principal part.

For tax legislation purposes, payments for know-how and intellectual property elements such as trademarks and commercial equipment are generally deemed royalties and payments for technical assistance are categorized as service fees.

In practice it can be difficult to distinguish between payments for know-how (royalty) and payments for the provision of services. The main rule is that the supply of know-how concerns information that already exists and the transfer of that information to the franchisee. In the case of the provision of services, the supplier undertakes to perform services, which may require the use of special knowledge, skill and expertise but not the transfer of such special knowledge, skill or expertise to that other party.

Payments for exclusivity, which mean that franchisor agrees not to supply or grant anyone else that information or right, for example the use of trademark, should generally fall under the definition of royalties. Exclusive distribution rights, meaning payments that are solely made in return for obtaining the exclusive distribution rights of a product or service in a specific territory do not generally constitute royalties.

Under the Estonian domestic tax regime, royalty payments to foreign companies are subject to a withholding tax at a reduced rate of 10%. Fees paid for services which are performed in Estonia are also subject to a withholding tax at a reduced rate of 10%. Service fees paid for services, which are performed outside Estonia as well as payments for goods, are generally not subject to withholding tax.

In addition to domestic legislation, Estonian double tax treaties should be taken into account when making payments under a franchise agreement to a foreign company. Currently Estonia has some 50 effective double tax treaties and several more have been signed but have not yet entered into force. Whenever Estonia has an effective double tax treaty with the home country of the franchisor, it is always worth checking whether the double tax treaty provides for a more beneficial tax treatment than the domestic legislation. For example, service fees, which are paid to a foreign franchisor for the services provided in Estonia are exempted from withholding tax under treaties. Also, most of the double tax treaties provide for a lower, 5% withholding tax rate (instead of the 10% domestic rate) in case of royalties paid for commercial equipment (shop equipment). A few treaties may even exempt such royalty payments.

Moreover, certain royalty payments made to associated companies resident in a European Union member state or Switzerland can be exempt from withholding tax altogether. However, this requires that certain mandatory conditions regarding the group structure and holding period are met.

In conclusion, the application of the correct tax treatment on fees payable under a franchise agreement is not always an easy task. It is certainly always easier to sort out tax issues before signing a contract than trying to do so later when problems come up. In order to make sure that no surplus withholding tax is applied, or on the contrary, that the applicable withholding tax really is withheld, it is always best to consult the rules or contact a tax advisor.