The Ministry of Commerce published a revised version of the Administrative Measures on Commercial Franchise Operations on December 31, 2004, to replace the old one issued in 1997. The updated version, which became effective on February 1, 2005, aims to standardize the regulatory framework for franchise operations, protect the rights and interests of franchisors and the franchisees, and promote the healthy development of the operations.

Regulatory framework

The new measures apply to all commercial franchise operations in China, and include a specific section that allows foreign-invested enterprises (FIEs) to engage in such operations in China.

Commercial franchise operations (CFOs) are defined as a transaction under which a franchisor, by agreement, grants the right to use its trademark, trade name, patents, know-how, training programmes, business model, operational resources, etc. to a franchisee in return for the payment of franchising fees. The new measures clearly state that illegal direct selling is prohibited.

The measures also put forward the common terms and conditions in a franchise agreement, and include stipulations that oblige the franchisor to disclose related information to the franchisee 20 days prior to the execution of the agreement. They include the structure of the franchising fees and expenses, training programmes, the status of franchised trademarks, and background information regarding existing franchisees.

The franchisor must file annually with the appropriate commercial authorities information pertaining to the executed commercial franchising agreement so that the proper government departments can maintain updated records of such operations.

FIEs that intend to expand or otherwise alter their scopes of business must also apply to and submit relevant required documents to their original approval authorities for approval purposes.

The measures allow for the following two distinct forms of CFOs

1. Direct franchise - under which, the franchisor grants franchising rights to the franchisee, which is allowed to set up business operations based on the terms and conditions set out in the franchising agreement. Sub-franchising is not permitted under this form.

2. Sub-franchise - under which, the franchisor grants franchising rights that cover a particular region to the franchisee which then has the right to sub-franchise or set up its own business operations.

The revised measures specify the qualifications of the franchisor and the franchisee. In addition to the requirements under the original measures, among other things, the franchisor must own at least two outlets in China, and these outlets must have been in operation for at least one year.

The new measures also amend the rules governing the minimum period in which a commercial franchise must operate, and the government authority responsible for such operations. Under the old rules, no timeframe was specified for CFOs; however, the new measures specify a period of not less than three years in normal cases.

The government authority responsible for such operations has been changed from the Commodity Turnover Section of the State Council to the appropriate commercial authorities.

The services sectors in which FIEs are allowed in include retail, culture and sports, restaurants, hotels, and leasing services. Under the revised measures however, FIEs are prohibited from carrying out CFOs in any of the prohibited industries as classified in the Guidelines of Foreign Invested Industry.

Tax implications

Currently, there are no specific tax rules governing CFOs in China. Commercial franchising agreements normally cover the use of trademarks, trade names and other intangibles, such as business and operating models, training procedures, etc. Payments for such rights generally will be treated as the licensing fees of intangible assets and will be subject to business tax at the standard rate of 5 per cent.

Besides, franchisors (including FIEs) will also be subject to corporate income tax at their applicable tax rates, while foreign franchisors will be subject to a 10 per cent withholding tax as specified according to the applicable Chinese tax law and regulations (which may be reduced under an applicable tax treaty).

In the case of sub-franchising, payments made by the sub-franchisor to the franchisor may not be deducted in calculating the sub-franchisor's business tax liabilities. When franchising fees paid to a franchisor are charged based on the volume of goods purchased by the franchisee from the franchisor, value added tax implications will need to be taken into account.

Conclusion

Although the revised measures impose rigid rules, they represent a major step towards advancing the development of China's CFOs. When designing a business model for commercial franchise operations, adequate care should be exercised towards tax implications to avoid adverse and unexpected tax consequences.

(HK Edition 04/04/2005 page4)