FCA helps franchises to grow

The Australian franchising sector has continued to grow in the past year and through the work of the Franchise Council of Australia (FCA) and other organisations, it is gaining increasing recognition and prominence in various legal fields.

With the Franchising Code of Conduct (Code) being a mandatory code under the Trade Practices Act (TPA), the key players in the sector have engaged the Australian Competition and Consumer Commission (ACCC) in frank discussions on the role of the ACCC and the TPA in the sector. As part of the broader business community, franchisors and franchisees alike face legal challenges from a number of areas, as do all small-to-medium enterprises (SMEs).

In the following I will highlight a number of the challenges expected to confront franchisors and franchisees in the 2005 financial year and their impact on the business community.

Industrial relations or employment-related laws, like tax laws, are often confusing and contentious. I will briefly explore the rights of employees to redundancy payments following a recent Australian Industrial Relations Commission (the Commission) decision, which may have serious implications for both franchisors and franchisees.

Insurance is a major cost to any business, especially SMEs, and I will offer some tips to minimise the cost of insurance, while maintaining maximum benefits.

All businesses need to be aware of the role of the Corporations Act 2001. I will examine the most recent changes, which came into effect from 30 June and were the result of the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure Act 2004), better known as CLERP 9.

Taxation is an ever-changing minefield for the unwary. While not new, tax lawyers and accountants are now more often advising on the tax implications with respect to intellectual property (IP) in franchising transactions. With IP often becoming a franchisor’s most valuable asset, I will consider how franchisors can reduce their tax bills when dealing with IP.

On 18 May this year, the US and Australia entered into a free trade agreement (FTA). I will also preview the likely impact of the FTA on a franchisor’s IP rights.

Finally, a legal update for the franchising sector would not be complete without ‘touching on’ the TPA. In June this year, the Trade Practices Legislation Amendment Bill 2004 (the Bill) was tabled. In the same month, the Senate Economic Reference Committee released a report addressing the TPA’s effectiveness in protecting small business. Although still in consultation with the states, the Government’s response to the report is discussed further below, along with the Bill itself, which will undoubtedly lead to continued debate in franchising.

1. AIRC increases redundancy payments and widens eligibility

The recent decision by a Full Bench of the Commission in the 2004 Redundancy Test Case has implications for all Victorian and federal award employers.

The Full Bench considered applications to vary the standard provisions in safety net awards governing termination of employment by reason of redundancy. These standard provisions had remained relatively unchanged since being introduced by the 1984 Termination, Change and Redundancy Case (1984 TCR).

Prior to the Full Bench’s decision, the 1984 TCR standard provisions provided a maximum of eight weeks’ severance pay (for employees with four years or more service), but excluded small businesses from the operation of the provisions.

Major changes

The major changes introduced by the Full Bench, and which became operative on 8 June this year, are:

• An increase in the redundancy severance pay scale

• The partial extension of the redundancy severance pay scale to small businesses.

Severance pay

The Full Bench concluded that since the maximum amount of severance pay available under the 1984 TCR standard provisions would be reached after four years of service, it did not adequately take into account the effect of redundancy on employees with more than four years service.

The Full Bench decided it was appropriate to extend the severance pay scale to 10 years, with increases in the amount of severance pay with each year of service between five and nine years.

The maximum severance pay was doubled to 16 weeks pay for employees with nine years of service. Employees made redundant after 10 years or more of service will now receive 12 weeks pay, so as to avoid `double counting’ for also receiving pro-rata long service leave entitlements.

Small business exemption

The other significant change made by the Full Bench was to partially remove the small business exemption from the requirement to make severance payments. The TCR standard provision of up to eight weeks pay after four years service will now apply to small businesses that employ less than 15 employees. However, businesses unable to meet their redundancy pay obligations will still be able to rely on the ‘incapacity to pay’ provision.

There is a further qualification to the impact of this decision on small business. In a supplementary decision, the Full Bench acknowledged that many small business employers may not have the financial reserves necessary to meet a redundancy situation immediately. To overcome this, the Full Bench decided the severance payment scale, now applicable to small businesses, should not take into account service rendered prior to 8 June 2004.

Will this apply to my business?

Technically, these changes only apply to award covered employers. However, the Commission considers severance payments as reflecting a community standard and enforces their payment through the unfair dismissal jurisdiction.

This may mean that failure by a non-award covered employer to provide a severance payment to a redundant employee will result in that employer facing an unfair dismissal claim and the employer having to pay the applicable severance payment. Therefore, employers should seek legal advice on the severance payments due to redundant employees, prior to implementing the redundancies.

2. Having trouble getting insurance at a reasonable premium?

Since the collapse of HIH and an increase in terrorist attacks worldwide, an ongoing concern for business owners has been the spiralling cost of insurance. In the last 18 months, each state government has passed legislation which, combined with complementary federal legislation, is intended to reduce the volume of personal injury claims and litigation. That, in turn, is intended to increase the availability and affordability of public liability and professional indemnity insurance.

To a greater or lesser extent, the reforms have had the desired effect in terms of significantly reducing the volume of claims, particularly claims for ‘minor’ injuries. The jury is still out on whether the decrease in the number of claims has improved the availability and affordability of insurance. The ACCC has been charged with monitoring insurance premiums with a view to ensuring the savings are passed on by insurers to consumers. Time will tell.

In any case, the recent turmoil in the insurance market highlights the importance of establishing an effective relationship with your insurance broker. Managing this relationship can help you secure adequate and affordable insurance. To obtain better results from the relationship, there are a number of positive steps that can be taken:

• Treat the relationship as a partnership in which you sit down together and formulate a strategy for obtaining adequate, cost-effective insurance. Effective communication will allow the broker to better understand the nature and needs of your business.

• Avoid leaving it to the last minute. The old adage ‘first in, best dressed’ certainly applies to the insurance market, particularly since the ‘insurance crisis’ and tightening of underwriting acceptance criteria.

• Explain to your broker that you wish to review the insurance proposal before it is released in the market. This provides an opportunity to detect any inadequacies in the proposal. You should also get into the habit of asking your broker to provide a list of the insurers the broker has approached with your insurance proposal and the terms offered. This will demonstrate how much effort has been made to find the most appropriate cover.

• Recognise the benefits of having an underwriter who knows who you are and what you do. Australian businesses have a tendency to encourage their brokers to ‘shop around’ annually for the cheapest underwriters. But the comfort of continuous cover with the same underwriter should not be underestimated.

3. Changes to be introduced by CLERP 9

On 30 June this year, CLERP 9 received royal assent, with most of the changes coming into effect on 1 July.

CLERP 9’s primary aim is to enhance audit regulation and the general corporate disclosure framework. CLERP 9 covers various areas from audit reform, remuneration of directors and financial reporting to shareholder participation and management of conflicts.

Some of the key changes introduced by CLERP 9 that will affect most companies are outlined below.

Appointment and removal of auditors

Auditors are now required to meet a general standard of independence (including restrictions on certain employment and financial relationships with the audit client), with the auditor obligated to make an annual declaration that they have maintained their independence.

Any non-audit services provided by the auditor must be disclosed in the directors’ report, together with an explanation on why the provision of services did not impair the auditor’s independence (applies to listed companies only).

The auditor (or the audit partner in terms of an audit firm or company) is required to:

• Rotate after five years (to take effect two years after CLERP 9 comes into force). ASIC may extend the rotation period up to seven years in specific circumstances (applies to listed companies only).

• Not become a director or officer of the audit client for four years after ceasing to be a member of the audit firm or director of the audit company. The period is reduced to two years if the member or director was not involved with the audit.

• Report to ASIC within seven days any suspected contravention of the law or any attempt to influence, coerce, manipulate or mislead the auditor.

• Attend the audit client’s annual general meeting and answer shareholders’ written questions (applies to listed companies only).

Disclosure to shareholders and shareholder activism

If, in complying with accounting standards, the company provides additional information in its financial statements to give a ‘true and fair view’, the directors are required to set out the reasons why the additional information is necessary and the auditor is to form an opinion on the additional content.

The CEO and CFO are now required to declare that the financial statements were prepared in accordance with the Corporations Act 2001 and accounting standards and present a true and fair view (applies to listed companies only).

The directors’ report must provide information on operations, financial position, business strategies and future prospects of the company (applies to listed companies only).

Details on the remuneration of each director, the top five highest remunerated executives of the company and the top five highest remunerated executives of any consolidated group are required to be included in the directors’ report (applies to listed companies only).

Shareholders are to be given a reasonable opportunity to question the company’s remuneration report at the AGM and to vote on the resolution to adopt the remuneration report. However, the vote on the resolution does not bind the directors (i.e. a ‘non-binding’ vote) (applies to listed companies only).

Shareholder approval on making certain termination payments (which did not require approval previously) must be obtained if the termination payment exceeds the amount calculated in accordance with the formula in section 200G(3) of the Corporations Act 2001.

Enforcement – general

Officers, employees and subcontractors that report suspected breaches by the company of the Corporations Act 2001 to ASIC are afforded protection (whistleblower protection).

ASIC can apply to the courts to extend a director’s disqualification period by an additional 15 years.

Enforcement of continuous disclosure

The maximum civil penalty (including for a contravention of continuous disclosure provisions) has been increased from $200,000 to $1 million for a body corporate and $200,000 for an individual.

Any individual who is involved in a company’s contravention of the continuous disclosure regime is subject to civil penalties (applies to listed companies only).

ASIC may issue infringement notices for contravention of the continuous disclosure regime with penalties of $33,000, $66,000 or $100,000 applying (depending on the market capitalisation of the company) (applies to listed companies only).

4. Tax and IP

CGT concessions on sale of IP

Did you know that a straight sale of most IP is no longer subject to capital gains tax? However, do not be deceived into thinking that represents a good outcome for businesses wishing to sell their IP.

In the past few years, the reforms resulting from the Ralph Review have kept tax lawyers and accountants very busy, as they are forced to come to terms with new concepts, compliance issues and concessions.

While in the past, the capital gain on the sale of IP could be dramatically reduced or eliminated by using the small business CGT concessions and the 50 percent CGT discount, now such a sale could prove a disaster.

Since the introduction of the Uniform Capital Allowance (UCA) regime on 1 July 2001, most depreciation and capital allowance provisions have been grouped into one consolidated division, Div 40 of the Income Tax Assessment Act 1997 (‘the 1997 Act’).

To facilitate the consolidation of these separate depreciation and allowances regimes, a set of core rules has been adopted, which aim to provide consistent rules and definitions. For example, the definition of a ‘depreciating asset’ includes “items of intellectual property”. These are, in turn, defined as patents, copyright and registered designs.

As a result of this definition of a depreciating asset, most items of IP can be depreciated over their effective lives using the UCA rules. Similarly, gains and losses realised on the disposal of most items of IP after 30 June 2001 are assessed as a revenue gain or loss under these rules.

To prevent double taxation arising on the disposal of IP, the exemptions contained in Div 118 of the 1997 Act stipulate that a capital gain on disposal of depreciating assets will be disregarded if a balancing adjustment event has occurred and the taxpayer depreciated the asset.

The bad news is, since a gain on disposal of IP will be taxed as a revenue gain in preference to a capital gain, the various small business CGT concessions and the 50 percent CGT discount will no longer be available to reduce the tax payable on the gain.

In such cases, consideration should be given to selling shares/units in an entity that owns the IP rather than selling the IP itself. This may permit access to the 50 percent discount and other concessions.

However, all IP is not covered by the UCA rules. Importantly, the definition does not include trademarks (presumably because they do not have a limited effective life and do not, therefore, depreciate). So, when considering whether to sell your IP, bear in mind just what is being sold. If it is predominantly trademarks (or most of the sale proceeds will be for trademarks), a sale of assets may be acceptable rather than a sale of the shares of the company that owns the IP.

Similarly, changes to the treatment of IP also make it imperative to differentiate goodwill from IP and identify individual market values when allocating sale proceeds among the various assets.

Treatment of IP expenditure

It is worthwhile considering the general treatment of IP under Division 40 of the 1997 Act. The characterisation of IP is relevant to such issues as:

• Is it capital or deductible expenditure?

• If it’s deductible, when?

• If it’s capital, what outright or upfront/specific deductions are available?

• If it’s capital and there are no upfront deductions, what annual write-offs are available?

Some types of expenditure incurred in developing IP may be deductible under the general deduction provision irrespective of whether the IP developed is a capital asset, depreciating asset or otherwise. This may be the case for salary and wages paid to an employee where the employee is not engaged solely to perform work of a capital nature.

In some instances the cost of researching and developing new technology is a recurrent business expense that is deductible on revenue account, rather than being an outgoing of a capital nature.

Under Division 40 of the 1997 Act, the holder of a depreciating asset can deduct its cost over its estimated effective life.

When you cease to hold the depreciating asset there is a balancing adjustment. If the proceeds from the disposal of the asset (called the termination value) exceed the adjustable value, the difference is assessable. If the proceeds are less, the difference is deductible.

What happens if I licence my intellectual property?

If you licence your intellectual property, you are treated as having split the IP and disposed of that part of it. This means you have to assess the written down value of the licence and the consideration for its disposal.

Under section 40-205, the first element of the cost of each of the separate assets is a reasonable proportion of the sum of:

• The adjustable value of the original asset just before it was split; and

• Any amount taken to have been paid for the economic benefit involved in splitting the original asset.

The example given in the legislation involves apportioning the cost between the new assets on the basis of relative market value, which is easier said than done. It is a difficult task to split the written down value. The fact that you grant a licence may not diminish the value of the ‘original’ IP anyway. It is going to depend on the nature and extent of the licence; for example, you might need to consider if it is an exclusive licence for a large segment of the market.

If you have managed to split the written down value, you would then have to work out the balancing adjustment, because the licensing is a disposal.

As such, you need to work out the ‘termination value’. If there is an upfront lump sum payment for the grant of the licence, you may say that is the termination value. Equally though, the present value of the expected royalty stream may be the termination value, especially if there is no upfront payment. This could lead to an absurd result because the royalty payments will be assessable as ordinary income when received in later years.

But as we know, absurd results do happen in tax.

5. Franchising and the FTA

The FTA between Australia and the US (AUSFTA) was announced on 8 February 2004 and the agreement signed by Australia’s Trade Minister, Mark Vaile, and US Trade Representative Robert Zoellick, on 18 May.

Along with a raft of diverse legal implications, the advent of AUSFTA also brings with it proposals for an overhaul of Australia’s many IP laws.

Although AUSFTA still requires the approval of Australia’s Parliament and US Congress before it becomes law in both countries, there is a strong drive in both countries to approve AUSFTA in the near future.

Chapter 17 of the agreement deals specifically with IP rights and how the laws of both countries should implement and protect them. From a franchisor’s point of view, the AUSFTA brings with it greater opportunity to utilise IP rights, which is usually the cornerstone of a successful franchise.

Trademarks

Registered proprietors of, or applicants for, trademarks will not find any substantive change to the way they currently register or use trademarks in Australia within AUSFTA. But franchisors should be aware of how AUSFTA will make it easier to register geographical indication or origin as a trademark. Currently, IP Australia, the government agency responsible for granting rights in patents, trademarks and designs in Australia states:

“Although geographical names have the potential to be registrable, traders will generally not be able to obtain a monopoly on the name of a place or region with a reputation for the designated goods or services unless overwhelming evidence of use is provided, e.g. Hunter wines.

“It is worth noting that if the geographical origin has no relationship to the goods at all (e.g. North Pole bananas) then it may be registrable.”

Under AUSFTA, a geographical indication is registrable to the extent that “it consists of any sign, or any combination of signs (such as words, including geographic and personal names, as well as letters, numerals, figurative elements and colours, including single colours), capable of identifying a good as originating in the territory of a party, or a region or locality in that territory, where a given quality, reputation, or other characteristic of the good is essentially attributable to its geographical origin.”

Copyright

In the area of copyright, AUSFTA will have a much greater effect. It increases the level of protection for copyright holders and, therefore, the opportunity for franchisors to utilise their IP rights.

These changes include:

• Extending the term of protection of copyright materials from 50 to 70 years after the death of the author or first publication of the copyright material.

The extension (affectionately known as the ‘Mickey Mouse’ extension, as one of its driving forces was that the copyright relating to ‘Mickey Mouse’ was about to expire) will allow copyright holders an extra 20 years to utilise their IP rights.

• Increasing the effectiveness of technological protection measures (TPMs) by making it easier for a copyright holder to prevent third parties from circumventing TPMs.

TPMs allow the copyright holder to set the terms of use of its copyright material and thereby enable the copyright holder to improve the economic utilisation of its IP rights.

An example is the way Sony is able to set different prices for its products in different regions. This is achieved by segregating the world into different regions for its Playstation console and games so that Playstation games purchased in the US cannot be played on a Playstation console purchased in Australia and vice-versa.

This also allows a copyright holder to charge different rates depending on the consumer’s usage of the copyright material. An example is that consumers can now purchase songs from the internet which contains certain codes governing how many times the song can be played or whether it can be copied to another computer or medium. If the consumer wants to copy the song to an unauthorised computer or medium, the consumer would have to make further payments to the copyright holder.

This means franchisors would have greater control over their IP rights and the way their franchisees utilise them.

• Stronger protection for copyright holders as well as making it easier for copyright holders to enforce their rights.

If a franchisor finds that someone is pirating its IP rights on the internet, it currently needs to seek a court order before it can obtain access to that person’s personal information from their internet service provider. Under AUSFTA, the franchisor can request that information directly from the ISP.

AUSFTA also extends the coverage of criminal sanctions for copyright infringement from the distributors of pirated materials to include consumers.

These proposed changes under AUSFTA would reduce the differences in law and practices, in the areas of IP rights, between Australia and the US. Franchisors should capitalise on this opportunity by researching how successful franchisors in the US conduct their business with the view of emulating that success in Australia.

6. TPA Reforms

The legislative response to the Dawson Committee’s Review of the TPA in January 2003 is contained in the Trade Practices Legislation Amendment Bill 2004 (the Bill). The Bill, introduced into the House of Representatives on 24 June 2004, contains some significant reforms to the anti-competitive provisions of the TPA.

Amendments were also proposed to section 46 (misuse of market power) and to section 51AC (unconscionable conduct) by the Senate Economic Reference Committee’s report on the effectiveness of the TPA in protecting small businesses, released on 1 March 2004. Unfortunately for small business, the Bill does not incorporate these amendments, however the Government formally responded to the Senate Committee’s report on 23 June 2004. Therefore, legislative change to these provisions looks likely.

The Bill will nevertheless have an impact on small businesses in two specific areas.

New notification process for collective bargaining

Firstly, the Bill provides a simpler notification process for small businesses wishing to collectively bargain with big business. Currently, section 45 of TPA generally prohibits collective bargaining as a form of collusive conduct.

The new notification procedure would be an alternative to the current authorisation regime that requires net public benefits be established before permitting collective bargaining. Further, at $7500, authorisation is often too expensive for small businesses to obtain. Instead, the proposed notification process would shift the onus onto the ACCC, which must determine within 14 days whether the proposal would have a net detrimental effect on the public and whether the purpose or likely effect of the proposed conduct will be to substantially lessen competition. A collective bargaining notice provides three years immunity.

A transaction limit of $3 million in any 12-month period applies to small businesses wishing to benefit from this new notification process for collective bargaining. But it is expected that a higher limit will be set since some small businesses, such as motor vehicle dealers and petrol station owners, have high turnover but small profit margins.

Abolition of per se prohibition of third line forcing

The Bill also proposes reforms to the TPA’s outright prohibition of third line forcing.

Third line forcing occurs when a franchisor supplies goods or services to a franchisee on condition that the franchisee will buy other goods or services from another supplier.

Third line forcing will no longer be prohibited per se but rather will be subject to a substantial lessening of competition test – the same test applied to other forms of exclusive dealing.

Therefore, third line forcing would be permitted, provided it does not have the effect of substantially lessening competition in the relevant market.

Likely future amendments: Government response to the Senate Committee’s report

The Government’s formal response will not be introduced as legislation until after the states have been consulted, a process likely to take several months. Until then, it is worthwhile considering the impact of the tabled reforms, which address the misuse of market power and unconscionability on SMEs.

Misuse of market power

The Government has indicated that section 46 of TPA, which relates to misuse of market power, should be amended as follows:

• Courts may consider predatory pricing and whether a corporation has a reasonable prospect to recoup (i.e. recover costs through a future reduction in competition) when determining if a corporation has misused its market power.

• A contravention of section 46 may occur in circumstances where a corporation uses its power in one market to achieve an anti-competitive purpose in that, or any other, market.

It should be noted that proving neither predatory pricing nor recoupment will be essential in order to find that the misuse of market power provisions have been contravened. Further, the proposed amendments do not shed any light on what constitutes predatory pricing. This will be a matter for the courts to assess in light of the circumstances of each case.

The proposed amendments do, however, provide clarification on the misuse of market power prohibition.

Unconscionability

The proposed amendments to the provisions of the TPA dealing with unconscionability will also benefit small business (section 51AC).

Firstly, the cap for its application to small business transactions will be raised from $3 million to $10 million. In addition, the imposition or use of unilateral variation clauses in a contract is to be included in the list of factors the court may take into account when considering whether unconscionable conduct has occurred.

The FCA will no doubt keep its members up-to-date with the progress of the proposed TPA amendments. However, if you have any concerns, consult your lawyer.

Conclusion

In running a business, whether it’s a public company or an SME, you will always confront numerous legal, regulatory or compliance issues.

Those listed above are by no means exhaustive.

Other challenges businesses are forced to deal with include managing occupational health and safety and risk management issues, an ATO clampdown on SMEs, privacy law considerations and, of course, the Code. Effectively managing these issues is fundamental to the success of any franchise, which involves keeping abreast of changes in the law.

I recommend all readers consult the FCA, Franchising magazine and a lawyer to ensure you are being compliant with your legal obligations and keeping on top of issues affecting the franchising industry as a whole.

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