Franchising Focus newsletter

Welcome to the Winter 2016 edition of Franchising Focus.

Since our last edition of Franchising Focus the Federal election has been run and won, returning the Coalition to power for another three years by the barest of margins. As a result, the issue of joint employment continues to be a key issue for franchising given the Coalition’s pre-election policy to Protect Vulnerable Workers. As part of that policy, the Coalition indicated that it would introduce new provisions that would apply to franchisors. In particular it would amend The Fair Work Act to “make franchisors and parent companies liable for breaches of the Act by their franchisees or subsidiaries in situations where they should reasonably have been aware of the breaches and could reasonably have taken action to prevent them from occurring.” Although one might normally expect an issue such as this to be lower down the Government's list of legislative priorities, the fact  that there is general cross-party support for such an initiative (with both Labor and the Greens having conceptually similar proposals) could well see the issue promoted ahead of others. We are closely following this issue given the significant impact that it could have on our industry if any legislation is not appropriately drafted, with Stephen Giles leading industry efforts to ensure franchising is not unfairly singled out and legislation, if enacted, is workable.

One of the biggest stories internationally during the past three months was BREXIT – the vote by the United Kingdom to leave the European Union. While the vote is not technically binding, the new Prime Minister has been consistent in maintaining that “BREXIT means BREXIT”. The issue for businesses with operations or trading relationships with Europe is that no one actually knows what BREXIT will actually look like in practice. It is likely to present both challenges and opportunities for anyone dealing with the region, but the greatest issue at the moment is the lack of certainty. There will be no immediate changes to English law, and it is anticipated that the process to remove the United Kingdom from the European Union will take some years to finalise. If you have any concerns or questions about how BREXIT will impact you and your network, please contact us as we have lawyers in both Australia and the UK who can guide you through the potential issues.

Closer to home, the Australian Competition and Consumer Commission (ACCC) announced that it will probe Australia’s new car industry following its investigations into Volkswagen and Fiat Chrysler. As part of the probe, the ACCC has indicated that it will look into issues such as false representations and misleading or deceptive conduct in relation to a range of matters such as car performance, fuel efficiency, fuel consumption and emissions. The extent of the ACCC’s proposed investigations is unknown but it’s likely to capture all participants in the local car industry.

Finally, a reminder to all those franchisors who operate on a 30 June financial year that is now time to update your disclosure documents. While you have until the end of October to attend to this, franchisors often underestimate how long this task will take and find themselves without a current disclosure document in early November. For any franchisors that have not undertaken a review of their documentation in light of the unfair contract terms legislation coming into effect, it’s an opportune moment to conduct both tasks simultaneously.

In this edition of Franchising Focus:

• We look at the concept of fraud. Franchisors are often quick to claim that a franchisee has acted fraudulently but what, in a legal sense, is fraud? And how can you establish that a franchisee has engaged in fraud? In our article we consider the concept of fraud and how it can be established.
• With the dawning of a new financial year, comes new tax laws! Our tax update provides you with details about some of the new tax laws that have recently been introduced and what they mean to franchise networks.
• We consider the case of Guirguis Pty Ltd & Ors v Michel’s Patisserie System Pty Ltd & Ors in which the Court confirmed the important of prior representation statements as a tool to defend claims made by franchisees.
• We provide details on Queensland’s new environmental laws, which have widened the scope of persons who may be liable for compliance with an environmental protection order.

Fraudulent conduct is an occasional feature of behavior within franchise relationships. Most commonly, it involves concerns over the misappropriation of money or the under-reporting of sales by the Franchisee resulting in reduced royalties being paid to the Franchisor. This article provides a brief refresher on the key principles regarding establishing fraud by Franchisees and it also provides a perspective on the non-monetary types of fraudulent conduct which may arise.

The Refresher

The key principles regarding fraud are as follows:

1. Fraud typically involves conduct which is dishonest and which is directed at, or results in, a monetary benefit being improperly obtained by a person at the expense of another. Deliberate under-reporting of sales by a Franchisee is a common example of fraudulent conduct.
2. Given the seriousness of an allegation of fraud and the serious consequences of a determination that it has occurred, the Courts require strict proof of it. The evidence of fraud must be compelling before a Court will make a determination that it has occurred.
3. Most Franchise Agreements contain an express term that entitles a Franchisor to terminate a Franchise Agreement immediately for fraud.
4. Under the Franchising Code of Conduct, a Franchisor may terminate a Franchise Agreement immediately, without complying with other Code provisions requiring that a period of notice of the termination and an opportunity to remedy misconduct be given, provided that the Franchise Agreement gives the Franchisor the right to terminate should the Franchisee act fraudulently in connection with the operation of the franchised business.
5. Typically, the amount of money involved in any fraudulent conduct is immaterial to the entitlement of the Franchisor to terminate the Franchise Agreement. The relationship of trust and confidence and the need for the parties to act honestly towards each other are of such paramount importance in franchise relationships that even a triflingly low amount of money which is the subject of fraudulent conduct can be sufficient to warrant legitimate termination.

Common ways in which evidence is typically obtained by Franchisors to establish fraudulent conduct by Franchisees involved in retail businesses include a combination of the following:

1. Patterns of unusually high levels of voided sales occurring, as being indicative of under-reporting.
2. Mystery-shopper evidence of specific transactions being made at the franchised business which then directly correspond to transactions which have been voided.
3. A consistent and significantly higher volume of goods being purchased for the operation of the franchised business than that which would typically be required to generate the level of reported sales.
4. Whistle-blowing disgruntled employees or business associates of the Franchisee.
5. Covert surveillance of the operation of the franchised business.¹
6. Non-Monetary Perspective

Fraud is usually considered by Franchisors in a monetary context. However, fraud can occur in a wide variety of non-monetary ways.

The following points are worth noting:

1. The term “fraud” is used in a relatively wide sense under the law. It can involve conduct where the wrongdoer has gone beyond that which merely amounts to a civil wrong,. Perhaps the Franchisee has indulged in sharp practice, something of an underhand nature where the circumstances required good faith, something which commercial people would say was a fraud or which the law treats as entirely contrary to public policy.²
2. Fraud can take the form of a false representation if the Franchisee made the representation knowing it to be false, or recklessly, neither knowing nor caring whether it was false or true. This could occur in a variety of circumstances – examples could include:
   
   a. The provision of false information about the operation of the franchised business or its performance.
   
   b. The provision of false information about the status of commercial arrangements that the Franchisee has in place with 3rd parties – such as the tenure under a lease, the payment of monies owed to creditors or compliance with obligations owed to employees.
   
   c. The provision of false profit and loss information in relation to the Franchisee.
   
3. Fraud can also involve the Franchisee’s conduct vis-à-vis 3rd parties. Examples of this could include:
   
   a. Underpayment of staff in breach of workplace laws and the resulting underpayment of group tax and superannuation contributions.
   
   b. Under-reporting of income to the ATO and thus the underpayment of tax and any applicable superannuation.
   
   c. Dishonesty in dealing with suppliers.

A Final Note of Caution

Franchisors need to remain constantly vigilant in monitoring Franchisees’ conduct for evidence of fraud. This article encourages Franchisors to familiarize themselves with key concepts in relation to fraud and to think outside of the normal monetary focus when considering the types of conduct which might be fraudulent.

However, establishing fraud to the satisfaction of a Court is usually a challenging task. It requires carefully prepared and compelling evidence. Accordingly, prior to alleging fraud and certainly prior to terminating for fraud, Franchisors must proceed very carefully and with considerable caution and with the benefit of legal advice.

A new financial year often brings with it change to our tax laws – and 2016 is no exception. On 1 July a raft of changes were made, both at a State and Federal level, to a variety of tax laws. In this article, we consider some of the key tax changes that are likely to impact franchise networks.

Small Business Restructure Rollover

The Tax Laws Amendment (Small Business Restructure Rollover) Act 2016 (Cth) was passed by Federal Parliament.  The new legislation provides significant flexibility for small businesses to restructure their business without the obstacle of paying income tax, effective 1 July 2016.

This legislation forms part of the federal Government’s small businesses tax package which was announced in the previous Budget.  Other Budget measures which were part of that package include the immediate deductibility of certain expenses, FBT benefits, employee share scheme reforms and a cut to the tax rate applying to small businesses.

What is the impact of the rollover?

A small business owner may now:

• defer gains or losses on a transfer of business assets to another entity; and
• obtain a rollover for gains and losses arising from the transfer of active assets that are CGT (capital gains tax) assets, trading stock, revenue assets or depreciating assets between entities as part of a genuine restructure of an ongoing business.

These rules are in addition to the existing CGT rollover rules which all businesses can access.

Who can benefit from the rollover?

To be eligible for the roll-over, each party to the transfer must be either a “small business entity” or a relevant related party.  Broadly, an entity is a “small business entity” if it carries on a business and the combined annual turnover of the entity, and other entities that are affiliated or connected with it, is less than $2 million. Importantly, the new rules extend to the restructure of discretionary trusts.

Businesses should always seek professional advice before restructuring their business as per the rollover, however this change is certainly something to consider if your business is a “small business” and you are considering some form of restructure.

Abolition of some NSW duties

On and from 1 July 2016, mortgage duty, marketable securities duty and transfer duty on non-real property business assets was abolished in New South Wales.  These changes bring NSW into line with most of the other States and Territories of Australia.

Summary of changes

Amounts secured by a mortgage that is executed on or after 1 July 2016 will not be liable to duty.  NSW was the last remaining Australian jurisdiction to charge mortgage duty.

The following types of property ceased to be subject to duty if transferred pursuant to an agreement entered into on or after 1 July 2016:

• a ‘business asset’, which is specifically defined as the goodwill of a NSW business, the intellectual property of a NSW business, or a statutory licence or permission under a Commonwealth law if the right is exercised in NSW;
• a statutory licence or permission under a NSW law (eg a tax licence); and
• a gaming machine entitlement within the meaning of the Gaming Machines Act 2001 (NSW).

NSW marketable securities duty was abolished for agreements entered into on or after 1 July 2016 to transfer shares in a NSW company or units in a NSW unit trust scheme.

What is the impact of the change?

The abolition of mortgage duty means that finance can be obtained without the added cost of mortgage duty.

The abolition of NSW marketable securities duty will also reduce the cost of buying and selling NSW companies and NSW unit trusts (but such transactions will still be subject to the landholder duty rules).

The biggest change is the abolition of NSW duty on the transfer of ‘business assets’, being primarily goodwill and intellectual property that is attributable to NSW.  This will significantly reduce the amount of duty that is payable on the sale of NSW businesses.  Generally, for contracts entered into on or after 1 July 2016, NSW duty will only be imposed on land and interests in land in NSW (including leasehold interests and fixtures), and certain goods transferred as part of an arrangement concerning land in NSW.

Stamp duty law are complicated and the above is only a summary of the changes. It is always important to get specific, professional tax advice about the duty implications of a potential transaction. We recommend obtaining such advice early in the transaction so that you are well aware of the tax implications of the transaction and can consider that advice accordingly.

New foreign resident capital gains tax withholding rules

If you enter into a sale and purchase agreement with a foreign vendor on or after 1 July 2016 you need to consider whether the new foreign resident capital gains withholding payment rules (New Withholding Rules) will apply.

Summary of New Withholding Rules

The New Withholding Rules apply where the vendor is a foreign resident (but can also apply in some circumstances where the vendor is an Australian resident).

Broadly, these rules require a purchaser to withhold and remit to the ATO 10 per cent of the gross purchase price on the:

1. acquisition of a “Taxable Australian Real Property” (TARP) which is Australian real property (including a lease) and mining interests (ie. a mining, quarrying or prospecting right if the minerals, petroleum or quarry materials are situated in Australia) with a market value of $2 million or more, if the vendor does not provide to the purchaser on or before settlement a valid clearance certificate obtained from the ATO;

2. acquisition of shares in a company, or units in a unit trust, where:

1. the interest that the vendor has in the company or the unit trust is an “indirect Australian real property interest” (IARPI) (ie. the vendor together with its associates has a 10 per cent or more interest and 50 per cent or more of the market value of assets of the company or unit trust are TARP); and
2. the vendor does not provide a written declaration that:
   
   - the vendor is an Australian tax resident; or
   - the vendor’s interest it is disposing of is not an IARPI;  and

the purchaser does not know this declaration to be false; and

3. the grant or transfer of a call option to acquire TARP or an IARPI where the grantor or transferor does not provide a written declaration referred to in paragraph (2)(b) above.

What is the impact of the new rules?

If you are looking to enter into any form of transaction referred to above, you need to consider the New Withholding Rules.  In a franchising context, the most relevant situation is likely to be where a franchisor seeks to acquire assets from a foreign vendor.  While there are some exceptions to the rules, franchisors should be cognisant of the rules if dealing with any foreign vendors.

The changes set out above are not all of the tax changes that came into effect on 1 July. However, these are some of the key changes that are likely to impact on franchisors and their networks.

If you would like to discuss the above changes, or obtain details about any other tax issues, please contact Andrew Spalding (Tax Partner, Melbourne) on 03 8686 6949 or Ellen Thomas (Tax Partner, Sydney) on 02 9330 8355.

Representations made to a franchisee prior to entering into a franchise agreement should not be taken lightly. Often, it is these representations that form the basis of claims made by franchisees against a franchisor if the franchise business fails. In the circumstances, franchisors ought to exercise care in making any pre-contractual representations to ensure that the representations are accurate. Care also ought to be taken in ensuring that franchisors do not mislead or deceive franchisees by omitting to reveal to them the true state of affairs of the franchise network prior to the franchise agreement being signed.

The recent decision in Guirguis Pty Ltd & Ors v Michel’s Patisserie System Pty Ltd & Ors [2016] QDC 117 provides a good example of how diligent risk management by a franchisor prior to entry into a franchise agreement can assist in defeating claims made by a franchisee down the track.

Background

On 26 March 2012, the plaintiffs, Guirguis Pty Ltd, as the franchisee, and Mr and Mrs Guirguis as guarantors, entered into a franchise agreement with the principal defendant, the franchisor, concerning the operation of a Michel’s Patisserie outlet in a shopping centre in Townsville.

Mr Guirguis gave evidence that he conducted a lot of research and spoke to a large number of stakeholders before making the decision to enter into the franchise agreement.

Evidence was also led at trial that, prior to entry into the franchise agreement, the plaintiffs signed a Deed of Prior Representations and Questionnaire. This document asked the plaintiffs to write down full details of any verbal or written statements, representations or warranties which may have been made to them prior to the entry into the franchise agreement and which influenced their decision to enter into the agreement.

Other than some representations regarding lease terms, skills and ongoing support, the plaintiffs did not list any other representations said to have influenced their decision to enter into the franchise agreement. This was despite the franchisor sending a follow up letter after the franchise agreement had been entered into, querying whether there were any other representations on which the plaintiffs had relied.

On 18 July 2013, the plaintiffs abandoned the franchise business and sought to terminate the franchise agreement on 22 July 2013. On 25 July 2016, the franchisor issued its own termination notice based on the plaintiffs’ abandonment of the franchise business.

The plaintiffs subsequently brought proceedings against the franchisor on the following bases:

1. that they would not have entered into the franchise agreement but for certain representations made by the franchisor to the plaintiffs prior to the entry into the franchise agreement concerning regular deliveries from Brisbane to Townsville of snap- frozen products;
2. that the franchisor failed to disclose to the plaintiffs a number of matters concerning uncertain future supplies from Dysons (a Brisbane bakery used as a supplier of products); and
3. breach of contract.

The franchisor counterclaimed against the plaintiffs for breach of the franchise agreement (and related occupancy licence) and sought payment of royalties, rent and outgoings, lease surrender costs and fees for removal of plant and equipment. Mr and Mrs Guirguis were included in the counterclaim as guarantors of the franchisee’s obligations under the franchise agreement.

The plaintiffs’ claim

Misrepresentation

In order to succeed in a claim for misrepresentation, the plaintiffs had to show that:

1. the alleged misrepresentation was made;
2. the plaintiffs relied on the misrepresentation; and
3. suffered loss and damage as a consequence.

The plaintiffs’ claim for misrepresentation failed. The Court held that the plaintiffs did not rely on the representation by the franchisor concerning the regular deliveries from Brisbane to Townsville of snap- frozen products. Central to the Court’s decision was the Deed of Prior Representations and Questionnaire signed by the plaintiffs. Despite a number of opportunities being provided to them, the plaintiffs did not identify within the Deed the alleged representation as one which influenced their decision to enter into the franchise agreement. This, coupled with Mr Guirguis’ own evidence at trial that he took a lot of care to ensure that what he writes down is completely accurate, convinced the Court that no reliance had been placed on the above mentioned representation even if the representation was made (an issue which the judgement did not address in detail).

The Court also dismissed the plaintiffs’ argument that they would not have entered into the franchise agreement if they had known about certain matters concerning the franchisor’s supply chain arrangements. The Court found that some of the matters the plaintiffs referred to were not within the franchisor’s knowledge at the time the franchise agreement was entered into. Others had no basis in circumstances where, at the time, there were no acute problems with the supply of products to Townsville.

Negligent misstatement and breach of contract

The Court held that a claim based on negligent misstatement or breach of contract was unsustainable. The franchise agreement contained clauses which in essence prevented the plaintiffs from recovering any loss or damage allegedly suffered by them as a consequence of any failure by a manufacturer, producer or supplier approved by the franchisor or in connection with the supply or non-supply of products. Therefore, even if a negligent misstatement or a breach of contract claim could be made out, the Court held that the franchise agreement precluded any monetary recovery. Interestingly, it appears that the franchisee did not seek to challenge these clauses, or even raise the issue as to whether they could be considered general releases which are prohibited by the Franchising Code of Conduct.

The franchisor’s counterclaim

The Court found for the franchisor on the counterclaim. The plaintiffs did abandon the franchise business. Their purported termination of the franchise agreement was unlawful as it did not comply with the terms of the franchise agreement. The franchisor was awarded $650,552.24 in damages.

Practical implications

There are a number of lessons that franchisors can take away from the Guirguis case. These include:

1. ensuring that any representations made to franchisees are accurate;
2. including appropriate warranties and disclaimers in franchise documentation to minimise risk and to displace reliance on any representations that may have been made;
3. actively encouraging franchisees to undertake extensive research and to seek independent financial and legal advice prior to entry into the franchise agreement; and
4. considering the use of prior representations statements/deeds that give the franchisee the opportunity to specify any representations that have been made that need to be addressed.

Third parties such as lessors, lenders, investors and franchisors could now be exposed to liability for the actions of related companies operating under the Environmental Protection Act 1994 (Qld) (EP Act). Amendments to the EP Act have widened the scope of persons who may be liable for compliance with an environmental protection order (EPO), a statutory enforcement tool which can be issued by the Department of Environment and Heritage Protection (DEHP) to require a person to undertake specific actions, such as the clean-up and rehabilitation of land, within specific timeframes.

The amendments, made by the Environmental Protection (Chain of Responsibility) Amendment Act 2016 (Qld), which commenced on 27 April 2016, were intended to facilitate enhanced environmental protection of sites operated by companies in financial difficulty and avoid the State bearing the costs for their management and rehabilitation, said to be a "looming major problem" posed by the downturn in the mining sector. But the scope of the new powers is very broad and could have significant implications for those operating and investing in a range of different sectors.

What is the effect of the new laws?

Under the amended EP Act, DEHP can now issue an EPO to:

• a related person of a company that is being, or has already been, issued with an EPO (in the circumstances listed in section 358 of the EP Act, which include the purpose of securing compliance with the general environmental duty); or
• a related person of a “high risk company” (including a company in administration, liquidation or receivership, or an associated entity of such a company), irrespective of whether the high risk company is being, or has been, issued with an EPO.

In the first scenario, the EPO issued to the related person can impose any requirements imposed (or to be imposed) on the company. In the second scenario, where an EPO is issued to a related person of a high risk company, DEHP may impose any requirements that it would otherwise be permitted to impose under the general EPO provisions of the EP Act, as if the related person were the high risk company. Specifically, it can require the related person to take actions to prevent or minimise a risk of environmental harm, take actions to rehabilitate or restore land, or to give a bank guarantee or other security for their compliance with the order.

Who could be a related person?

A “related person” of a company means:

• a holding company of the company;
• a person who owns land on which the company carries out, or has carried out, a relevant activity other than a resource activity;
• an associated entity of the company who owns land on which the company carries out, or has carried out, a relevant activity that is a resource activity (eg. a mining or petroleum activity); or
• a person who DEHP decides has a relevant connection with the company.

A “relevant activity” means an environmentally relevant activity under the EP Act that was, or is being, carried out by the company under an environmental authority, or that was, or is being, carried out by the company and has caused, is causing, or is likely to cause, environmental harm. Environmentally relevant activities include mining and other resource activities, as well as a whole suite of particular industrial and manufacturing activities such as activities relating to food processing, chemical storage, waste management and water treatment services.

DEHP may decide that a person has a “relevant connection” with a company if it is satisfied that:

• the person is capable of significantly benefiting financially, or has significantly benefited financially, from the carrying out of a relevant activity by the company; or
• the person is, or has been at any time during the previous 2 years, in a position to influence the company’s conduct in relation to compliance with its obligations under the EP Act (including by giving a direction or approval, or by making funding available).

There are a number of factors DEHP may consider when deciding whether a person has a relevant connection with a company. They include:

• the extent of the person’s control of the company;
• the extent of the person’s financial interest in the company (ie. a direct or indirect interest in shares in the company, the income or revenue of the company, or a mortgage, charge or other security given by the company); and
• the extent to which dealings between the person and the company are at arm’s length, on an independent, commercial footing, for the purpose of providing professional advice, or for the purpose of providing finance (including the taking of security).

The definition of a “related person” remains quite broad in its potential application, particularly because of what can constitute a “relevant connection” with a company. There is a real concern that all company directors may have that relevant connection. Even the franchisor-franchisee relationship could be capable of being a relevant connection for the purpose of the EP Act.

Mitigating factors

In deciding whether to issue an EPO to a related person of a company, DEHP:

• must have regard to applicable statutory guidelines (which are yet to be released); and
• may consider whether the related person took all reasonable steps having regard to the extent to which the person was in a position to influence the company’s conduct to ensure it complied with its obligations under the EP Act and made adequate provision to fund the rehabilitation and restoration of the land because of environmental harm from a relevant activity.

What you need to do

The applicable statutory guidelines, which are expected to be released later in the year, may assist to clarify the intended scope of the new laws. In the interim however, anyone who contracts with, leases land to, invests in, or is otherwise in a position to influence the conduct of a company carrying out an environmentally relevant activity under the EP Act (or that otherwise has obligations under the EP Act), should consider the potential impact of the new laws.

For entities with potential exposure as a related person, it will be important to be able to demonstrate taking all reasonable steps to ensure the operator company’s compliance with the EP Act. It may be prudent to update relevant agreements or other documentation to require operator companies to comply with their obligations under the EP Act and make adequate provision for the environmental rehabilitation and restoration of land. More proactive measures, such as compliance audits and inspections, may also be warranted.