What Allahabad High Court held on taxation of franchise agreements

The Allahabad High Court recently highlighted the need for a nuanced tax policy on franchise agreements [Commissioner Commercial Tax vs Pan Parag India Limited]..Justice Shekhar B Saraf said that taxation of franchise agreements and sale of goods represents a complex and multifaceted issue that defies easy categorisation under the tax laws. “While both involve commercial transactions, they embody distinct economic realities and legal considerations that necessitate differential tax treatment. By recognizing the unique characteristics of franchise agreements, including the prevalence of intangible assets and the importance of intellectual property, tax authorities can develop nuanced tax policies that promote fairness, efficiency, and compliance,” the Court said.It added that ultimately a balanced approach, which takes into account the economic substance of franchise transactions and the need to prevent tax arbitrage and avoidance, will ensure the integrity and effectiveness of the tax system.The Court made the observation while upholding a tribunal ruling that held that no Value Added Tax (VAT) can be levied when franchise of a trademark does not involve transfer of an exclusive right to use the goods..The Court was hearing a revision plea moved by Commissioner Commercial Tax of Uttar Pradesh in a case against Pan Parag India Limited under the UP Value Added Tax Act, 2008.The first appellate authority had earlier ruled that since Pan Parag had “sold” its brand name under the franchise agreement, it was to be considered a sale and therefore, VAT had to be levied on it.However, the Commercial Tax Tribunal held that since the franchise of a trademark can be transferred to several persons simultaneously, it is merely a licence to use the goods and not a transfer of the exclusive right to use the goods .Before High Court, the Commissioner contended that since franchise or trademark falls within the meaning of transfer of right to use the goods, VAT is leviable even when service tax was paid. Considering the revision, the Court considered whether franchise of a trademark constitutes a transfer of the right to use goods - which will make it subject to VAT.The Court observed that the Finance Act of 1994 created a distinction between the transfer of right to use a trademark and its assignment. Licensing agreements, where the franchisee is granted limited rights to use a trademark or business concept, are clearly delineated from outright assignments or sales of trademarks, it noted.“This distinction is crucial for tax purposes, as it determines the nature and extent of tax liability for the parties involved,” the Court said..The Court also looked at the decisions on taxation of franchisees by Delhi High Court and Kerala High Court.The Delhi High Court had held that since a franchise agreement grants only a non-exclusive right, it does not constitute a transfer of the right to use goods. Similarly, the Kerala High Court had noted that terms of agreement “made it clear that the franchisor retained effective control and possession, preventing a transfer of possession to the franchisee”..In this backdrop, Justice Saraf observed that franchise agreements typically grant non-exclusive rights to use trademarks and business systems.The non-exclusive nature of these rights ensures that the franchisor retains control and can license the same rights to multiple franchisees, reinforcing the licensing framework rather than a full transfer, the Court added.“When trademarks are licensed, the licensee’s use of the mark is considered the owner’s use, maintaining the continuity of the trademarks’ reputation and legal protections. This distinction between ownership and licensed use is crucial for determining the scope of rights and the corresponding tax liabilities. For instance, in typical licensing arrangements, the licensee does not acquire the right to initiate infringement proceedings, which remains with the trademark owner. This legal nuance affects the control dynamics and the nature of the transaction, influencing whether the arrangement is taxed as a service (licensing) or as a transfer of goods (sale). The retention of ownership and control by the franchisor or licensor ensures that the transaction remains within the purview of service tax rather than sales tax,” the Court explained further..Observing that franchise agreements have become a ubiquitous feature of modern commerce, the Court said their tax treatment poses intricate challenges.“Unlike a one-time sale of goods, which concludes once the transaction is complete, franchise agreements involve continuous interaction and collaboration between the parties. The financial aspects of franchise agreements further underscore their distinction from sales transactions. Franchise fees and royalties are payments made by the franchisee to the franchisor in exchange for the right to use the franchisor's brand and system. These payments are not for the purchase of goods but rather for the ongoing support and benefits provided by the franchiser.”.In the present case, the Court said since the franchise agreement granted a non-exclusive licence rather than a transfer of the right to use goods, the transaction does not attract VAT. Pan Parag had received royalty from various dealers under the franchise agreement and then paid service tax on the same, it added.“If these payments have been subjected to service tax, they cannot be recharacterized as the sale of goods to levy VAT or sales tax. The prevention of double taxation is a fundamental principle of tax law. Double taxation occurs when the same income or transaction is taxed more than once by different tax authorities or under different tax regimes. An activity once taxed as a service cannot be taxed again as a sale of goods. This principle is crucial for ensuring fairness in the tax system and avoiding undue tax burdens on taxpayer,” the Court said as it dismissed the revision plea..Additional Chief Standing Counsel Bipin Kumar represented the Commissioner Commercial Tax UP.Advocate Shubam Agarwal represented Pan Parag India Limited.[Read Judgment]