Query:

We are dealing in Wooden flooring material. We have appointed franchisees in various States and receiving non-refundable franchisee fees from them. We are attaching herewith two franchisee agreement formats, one for the year 2015-16 and other 2016 onwards for your kind perusal.

We require your valuable opinion whether this franchisee income will attract tax under MVAT Act in view of the Subway’s High Court judgment?

Opinion:

1. Before expressing our views on the query raised by you, we would like to bring to your kind notice some important observations of the Hon’ble Bombay High Court in Subway’s case.

2. The Court, in that judgment, has rejected the Revenue’s argument that the eligibility of VAT is to be determined by the State, and therefore, it could levy a sales tax on a transaction which already attracts Service Tax. The Court held that the decisions in BSNL, Imagic Creative, and Associated Lease Finance are exactly on the same issue. Service tax and Sales Tax are mutually exclusive of each other.

3. The Court said that the introduction of the word’franchise’ in the amended MVAT Act would have to be read to mean those franchises that can reasonably and plausibly be construed to have the effect of a sale; it cannot be widened to include agreement styled as’franchise agreement’ simply because of the nomenclature. The Court further said, indeed, it seemed to them clear that if they accept that the franchise agreement is, by definition one that requires territorial exclusivity, then the Subway’s Agreement was not franchise agreement at all, but purely licensing agreement. The Court found that Subway’s Franchise Agreement granted to the franchisee nothing more than mere permissive use of defined intangible rights. It is therefore a service, and not amenable to VAT. However, the Court also hastened to clarify that they were not determining whether any particular kind of arrangement was or was not a franchise.

4. Thus, the Court has held that the agreement between Subway and its franchisees is not a sale, but is in fact a bare permission to use. However, the decision of the Court is based on the terms of the agreement involved in Subway’s case. Some of the clauses of the agreement on which Court has relied are stated below:

A. The agreement between Subway and its franchisee was limited to the precise period of time stipulated in the agreement. At the end of the period of the agreement, or before in case there was any breach of its terms, the right of the franchisee to display the mark’Subway’ and its trade dress, and all other permissions would also end. On the basis of this clause in the agreement the Court held that there was no passage of any kind of control or exclusivity to the franchisees.

B. The Court relied on the definition of the word franchise stated in Blacks’ Law Dictionary and Chambers Dictionary.

Black’s Law Dictionary defines a franchise, in the context of a commercial transaction as:

The sole right granted by the owner of a trade mark or a trade name to engage in business or to sell a good or service in a certain area.

Chambers’ Dictionary too describes it as:

A commercial concession by which a retailer is granted by a company the exclusive right of retailing its goods in a specified area.

Relying on those definitions the Court observed that there is conceivably a class of franchise agreements that would have all the incidents of a’sale’ or a’deemed sale’ (i.e., a transfer of a right to use). However, the Court found, on facts, that the Subway franchise did not meet these tests.

C. There was no exclusivity. The agreement itself said that Subway might itself open and operate its own outlets in direct competition with the franchisee. The Court observed that the agreements themselves expressly contemplated that Subway might create further franchisee in the very area in which this franchisee operates. The franchisee could not unilaterally sub-franchise.

5. The Court considered these terms and held that the right of transferability was extremely restricted and was impossible without Subway control throughout. It said, similarly, if there was no requirement of having to cease display and use, or return the intangible property at the end of the franchise agreement’s term, then the transaction might arguably be a sale. It further observed, exercises in co-branding or sub-branding, where one party franchises its mark on a territorially- restricted basis and allows the franchisee to combine it with its own or other marks may also well have an element of sale. Similarly, where a dealership for, say, automobiles, has territorial exclusivity, then it may amount to a franchise. The Subway franchise model, the Court said had none of these elements. The so-called’system’ was controlled by Subway and it is exclusive to Subway. At the end of the franchise term, it cannot be used. Some (though not all) of the ingredients – breads, salad dressing and other’key’ items – were to be sourced from Subway or Subway-authorised vendors and nowhere else. The Court said, this gives Subway deep and pervasive control and dominion over the franchisee’s daily operations, without at the same time ceding to the franchisee the slightest hint or latitude in what it may do with the permitted marks and technology.

6. Here it should be noted that there were two petitions before the Court on the same issue. Monsanto India and the Subway were those two petitioners. Monsanto India supplies to third parties a certain type of hybrid cotton seed. This seed is impregnated with a proprietary technology (BT-infused seeds) that protects it against the boil-weevil, a known menace to cotton crops. From these hybrid seeds, these third parties then generate large quantities of sowable seeds, which they then sell to cotton farmers. Monsanto India itself sells nothing to end users. The process thereafter is as follows. Monsanto India enters into sub-licensing agreements ( The Licensor being Monsanto, USA) with other seed companies through which it claims to brand permissive use of technology via donor seeds. Monsanto India delivers fifty samples BT’donor seeds’ to the seed companies for BT cotton hybrid production, along with standard operating procedure (SOP) manual prepared by Monsanto USA. The seed companies produce or generate additional donor seeds from these given seeds. Monsanto India provides initial training to the seed companies to assist them in using the donor seeds and developing foundation seeds, which will enable them to eventually produce BT cotton hybrid. Monsanto India thereafter provides training to the seed companies to carry out the zygosity test, which tests the execution of breeding plan. The sub-lincensees are thereafter required to take approval from the concerned Ministry of the Government. Once such approval is obtained each sub-licensee can produce BT cotton hybread seeds. These BT cotton hybreed seeds are then sold to farmers. Under the sub-licensing agreement, Monsanto India receives consideration from the seed companies in the form of a one time fixed fee and a recurring variable based on the sale of the genetically modified seeds; in essence a trait fee.

7. The agreement of the Monsanto India provides for few restrictions on the seed companies: the technology is non-transferable, non-exclusive, and can’t be assigned except in the manner provided in the agreement. The seed companies can’t grant further sub-licences, and the sub-licensee is not permitted to reverse, engineer, modify or use the BT gene without the prior consent of Monsanto India. It was the claim of Monsanto India that such agreements fall within the ambit of permissive use rather than a transfer of right to use. They submitted that it was a service and not a deemed sale within the meaning of Article 366(29A) (d) of the Constitution of India.

8. The Court held the agreement of Monsanto is diametrically opposed to the Subway model because Monsanto India has no control whatever in what it’s licensee does with the BT- infused donor seeds. That licensee may choose not to use those at all. There is also no question of any in’return’ or’cessation’ to Monsanto India. The seed companies could do as they please with the seeds, they could alienate or even destroy them. Thus, the Court held that in Monsanto case there was transfer of right to use and therefore the provisions of the MVAT, 2002 were applicable.

9. The querist submitted with us two kinds of franchise contracts. The first one is named as agreement for annual franchisee contract and the second one is named as Memorandum of Understanding. We have examined these contracts keeping in mind the aforesaid observations of Hon’ble Bombay High Court in both the petitions. We found that many of the clauses such as duration of the franchise, control of the querist over the activities of the franchisee, termination etc. are similar to those in the Subway’s agreement. These terms clearly prove that the querist has granted to the franchisee nothing more than mere permissive use of its intangible rights and it is not a case of transfer of right to use. Therefore, in our view the querist is not liable to pay VAT.

10. We should also bring to the kind notice of the querist that certain, though few in number, clauses which were there in the Subway’s agreement and which were relied on by the Hon’ble Court for the purpose of the coming to the conclusion are missing in this agreement. We suggest that all new agreements of the querist should include those clauses.