INTM467210 - Establishing the arm's length price: gathering your own evidence

Franchise models

Establishing the arm’s length return for granting rights to use valuable intangibles is a complex exercise. Finding comparables is usually difficult. Companies will sometimes use franchise agreements to support a royalty rate in this situation.

Information on franchise agreements is more readily available. Potential franchisees will need access to such information.

Franchises are fairly common in the retail world, particularly in the fast food sector. McDonalds and Burger King are two of the best-known worldwide franchises. Outside the retail sector, franchises are less common although some businesses in the services sector use franchises.

A franchise agreement will run for a number of years. In return for regular payments, the franchisee can use the business name and will probably be provided with procurement facilities for goods and services to support the franchise. The fees are generally made up of two elements, a turnover fee for the use of the brand and a turnover fee for centralised services (predominantly advertising and promotion). Under a franchise agreement for a well-known global brand, the franchisee might pay an annual fee consisting of an amount for the name and an amount for the services. Under a franchise, a company buys into an existing proven business model. The risk to a new business venture should be lower – others have been there before and showed that the business model is sound. Obviously some franchises are better known and more successful than others. Some franchises will operate worldwide – others will only operate in one country. The more successful the franchise, the more recognition it has, the higher the fees a franchisee will probably have to pay.

Always consider the differences between a franchising arrangement and a licensing arrangement:

• A licence agreement is not a franchise agreement. Each will offer different rights and a different type of trading relationship.
• Transfer pricing cases may involve royalty rates for start-up businesses. Usually the brand or product is being launched in a new market. There is no proven business which has already built up brand recognition.
• Franchise businesses work on the concept of a lot of franchisees, each owning one outlet and covering a set area. A licensee may operate in an entirely different way, will cover probably a whole country and will incur different types of costs.

Consider the facts to see if the terms between connected parties resemble franchise agreements or arrangements where in fact a full license has been agreed because this will affect the arm’s length price.