Tax controversy survey: Procedures and issues for selected countries
Global Norton Rose Fulbright tax controversy lawyers have prepared a sixth annual survey of tax controversy procedures and issues.
Welcome to the Autumn 2016 edition of Franchising Focus. 2015 was a year of franchising turmoil, with Code changes, unfair contracts legislation and the threat of joint employment all on the agenda, and the media largely focused on negative franchising stories. However 2016 looks much more promising, with a sense of positivity on all fronts. As this edition of Franchising Focus notes, the sky is not falling in and all regulatory changes or proposals seem manageable. The Franchise Council of Australia has pulled off a major coup in enticing former Federal cabinet member and Small Business Minister Bruce Billson to take on the role of Executive Chairman, and a new CEO is about to be announced to replace the capable Kym DeBritt.
We see the mega trends being more business oriented in 2016 - multi-unit franchising and innovative franchise funding are very topical, and industry consolidation and M&A remain high on the agenda. In our view international expansion must be on the agenda for all Australian systems, as the domestic market is mature and the high growth opportunities are beyond our borders.
Joint employment will be the issue of the next decade as unions seek to increase their influence over the largely non-unionised franchise sector, and franchise finance innovations will emerge for those systems with a proven track record of performance.
In this edition:
Those with a keen eye have already observed a few early warning signs that a new bushfire is not far away. A couple of lightning strikes have ignited undergrowth which looked green, but was surprisingly dry. Prompt action by the Franchise Council of Australia has established control lines, but the embers remain and if the wind changes we could have a major bushfire on our hands.
The recent media focus on workplace compliance breaches by 7-Eleven franchisees was not the first lightning strike, as other major brands had already been the subject of isolated media attention. But the fanning of the blaze by the media and others was unexpected. Probably the biggest lesson learnt for the broader franchise sector was that the explanation that the breaches were by franchisees, not the brand itself, did not cut it. The uproar clearly demonstrated that the public and the media have little understanding of, or interest in, the distinction between franchisor and franchisee.
It would be easy to dismiss the 7-Eleven situation as a unique event, but that would ignore international trends. In the US there is a raging bushfire on essentially the same issues – that third parties such as franchisors should have greater responsibility for workplace compliance by employers such as franchisees. The US franchise sector has spent millions of dollars in representation and in funding court actions, but is being outspent on the issue by the trade union movement by a substantial multiple. The fundamental separation between franchisor and franchisee in the context of employment issues is under threat, with the General Counsel of the National Labor Relations Board (NLRB) commenting that “business formats have become more prescriptive, so it is no longer possible for franchisors to totally disavow any responsibility for employment matters.”1
Academics are actively fuelling the bushfire, adopting new terminology of a “fissured workplace” to describe a situation where they say workplace policies are being subverted by having intermediated structures. Although labour hire companies were initially the primary target, the labour bodies have now targeted franchise systems such as McDonalds and Subway in a clear indicator of intent.
The NLRB has issued a new and expanded joint-employer test that could clearly catch some franchise systems, and the US Department of Labor has less publicly just issued a new Administrator’s interpretation on joint-employer status under the Fair Labor Standards Act. The Administrator’s interpretation, issued January 2016, adopts an expansive definition of joint employment - an employer may be jointly liable where the employee is economically dependent on the joint employer (ie: the franchisor). This is the case even when the franchisor exercises little or no control or supervision over the employees.
This interpretation goes beyond that advocated by the NLRB, which still requires control by the joint employer in relation to the setting of workplace terms and conditions. This interpretation, and indeed the NLRB test, are well beyond the current state of the law in Australia, where our Courts have to date dismissed joint employment at least at common law. However, it is currently possible for a franchisor or individual directors or managers of a franchisor to be an accessory to the franchisee employer’s contraventions under the Fair Work Act in Australia. The US franchise sector is facing a major blaze head on, and that could be replicated in Australia.
In Australia the politicians and regulators have also become involved. The Senate Standing Committee on Education and Employment inquiry into the impact of Australia’s temporary work visa programs on the Australian labour market and temporary work visa holders was substantially consumed by inquiries into the 7-Eleven situation. The resultant report by the Labor majority, “A National Disgrace: The Exploitation of Temporary Work Visa Holders” (the Report), made key recommendations that could, if implemented, directly impact franchise networks. In addition to proposing a review of the powers and resources of the Fair Work Ombudsman (FWO) and increasing the penalty regime under the Fair Work Act 2009 (Cth), the Report recommended that there be a review of the Franchising Code of Conduct to consider:
While the Report did not recommend joint employment legislation, preferring a review of powers and penalties with a view to imposing higher penalties for accessory liability and granting FWO greater enforcement and investigative powers, the resulting outcome for franchisors is similar.
The report was not unanimously accepted, with the Liberal minority denouncing the report.
Clearly, this issue and the debate are alive and well. Prudent Australian franchisors will start immediately reviewing their workplace arrangements, with a particular focus on the following:-
The Australian franchise sector has taken initial steps to conduct “controlled burns” to limit the risk of the expected bushfire conditions, such as supporting the development of an industry standard that frames the desired outcome – that franchisors and franchisees are not jointly liable, but that franchisors accept they have a training and support role and a responsibility to take action in the event of serious breach by franchisees. This initiative should be supported. However this new bushfire threat is potentially the biggest risk ever faced by Australian franchising, and it could well become a political issue in the next election as the Greens seek to target Labor supporters and Labor seeks to differentiate itself from the Coalition and counter campaigns based on trade union corruption allegations.
As the bushfire advertisements say, have a fire safety plan! The first steps are to carefully consider the role you want to play in franchisee workplace issues, form a view on the level of workplace risk and then develop a plan to give effect to your desired objectives. For assistance, or more information, contact Stuart Kollmorgen or Stephen Giles.
Change management is complex in a franchise network, as change cannot be imposed upon a network of independent business owners in the same way as it can across a corporate network. Franchisees rightly need to be part of the decision making process, but there is also a need for confidentiality. Leadership needs to be provided, but consultation is essential, and decisions need to be embraced to deliver a consistent customer outcome.
The decision in Diab Pty Ltd v Yum! Restaurants Australia Pty Ltd  FCA 43 provides good guidance to franchisors seeking to manage significant network change, but it also demonstrates the challenges in achieving consensus across a network of independent business owners. Each franchisee will bring their own perspective to the matter, and assess the need for change against their own circumstances. Despite the need for a consistent approach across a network, and general acknowledgement of the strategic challenges, the fact is that not all franchisees will see the issues the same way. A franchisee in a rural or regional location is likely to face less competitive pressure than a franchisee in a high traffic city location, and may have less potential to pick up market share due to the absence of a direct competitor.
The Yum decision was not surprising, and is consistent with similar cases decided in Canada in relation to the Canadian duty of good faith. However the case also shows that a franchisor can be “damned if you do, damned if you don’t” in the eyes of a franchise network. The cost of the litigation, and the extent to which franchisees challenged Yum, are sobering elements for any franchisor to note.
In 2014 Yum! Restaurants Australia Pty Ltd (Yum) implemented a strategy known as the “value strategy” (VS) across the network of Pizza Hut stores. The VS was comprised of a number of elements. Crucially though, the VS provided for (1) the removal of 2 lines of pizzas; and (2) the reduction of the price of 2 lines of pizzas.
Prior to implementing the VS, Yum trialled the VS in the Australian Capital Territory (the ACT Test). Yum took steps to normalise the results and, based on these adjustments, predicted that the introduction of the VS should result in an increase in sales across the majority of Pizza Hut outlets.
Following the ACT Test, Yum met with franchisees in a number of States to discuss the ACT Test and the outcomes from the test. Yum also prepared a “model” (the Yum Model) to further assist in considering whether to implement the VS. The Yum Model was a tool that could be manipulated by inputting different information to see the impact on outputs. Diab Pty Ltd (DPL), the Applicant, suggested that the Yum Model was essentially a model of profitability. However, Yum contended that the Yum Model was used simply as a “break even” assessment to determine how many additional transactions would be required for the national average store to retain the same level of profitability. There were several reiterations of the Yum Model and evidence was given that at least one version of the model was shown to a number of franchisees prior to the introduction of the VS.
On 10 June 2014 the decision to implement the VS, with effect from 1 July 2014, was announced to Pizza Hut franchisees.
On 24 June 2014 the Federal Court heard and determined an interlocutory application made by A & A (Sydney) Pty Ltd and 80 applicant franchisees (including DPL) seeking to restraining Yum from implementing the VS. The application was not successful and the Federal Court did not grant the interlocutory injunction.
Meanwhile, Domino’s had learnt of Pizza Hut’s proposed plan to introduce reduced price points. On 19 June 2014 Domino’s notified its franchisees of its decision to pre-empt Yum and to launch an all-day every day $4.95 price point. The Domino’s pricing strategy was essentially limited to one range of pizzas (take away) only – it did not extend across the entire range and Domino’s did not delete any lines. Domino’s implemented their reduced price strategy on 24 June 2014, before Pizza Hut implemented the VS, and therefore obtained any “first mover” advantage.
Yum implemented the VS on 1 July 2015.
DPL, acting both in its own capacity and as the representative applicant for approximately 190 franchisees operating under an international franchise agreement (IFA) with Yum, commenced action against Yum following the implementation of the VS. DPL made a number of claims against Yum.
All Pizza Hut franchisees were party to an IFA with Yum. The IFA, which was essentially a standard form document, included a number of relevant clauses. In particular, the IFA:
DPL argued that pursuant to Clause C1, Yum was obliged to set profitable prices – being prices that allowed franchisees to maintain or increase their profits.
DPL also argued that Yum was subject to, and breached, a number of implied duties including:
Negligence and unconscionability
In addition DPL argued that Yum:
The Federal Court generally accepted Yum’s submissions and found that DPL had not established that Yum was in breach of its legal obligations in implementing the VS.
Implied duty of profitability?
The Federal Court considered that an obligation to ensure profits for each franchisee with respect to a given promotion was not only contrary to the express terms of the IFA, but was also commercially unrealistic. Given this, the Federal Court found that no such implied obligation should be imported into the IFA. To do so would be to essentially rewrite the bargain between Yum and the franchisees.
While accepting that Yum could set maximum prices, the Federal Court J noted that Yum’s discretion under the IFA was not unfettered and:
“…had to be exercised in good faith and reasonably with reasonable cause. Yum had an obligation to act honestly and with fidelity to the bargain but that does not mean that Yum was under a strict liability to make decisions that only resulted in success and more profits for the Franchisees. That does not mean that a decision made in good faith and on reasonable grounds that proved to be unsuccessful in realising profits…renders Yum liable for any Franchisee losses.…”
Breach of good faith?
DPL suggested that Yum had implied duties to cooperate with franchisees to achieve the objectives of the IFA and to comply with standards of conduct that were reasonable having regard to the parties of the IFA. DPL sought to establish a breach of these implied duties by pointing to a number of different matters including:
In considering, and ultimately rejecting DPL’s argument, the Federal Court noted that:
The Federal Court’s position supported the findings of the earlier interlocutory application. During that interlocutory application, the Federal Court had found that DPL’s argument, “that Yum had not cooperated with the Franchises in the advancement of interests of the business in good faith about the modelling and that modelling was not objectively reasonable…was a weak one.” The Federal Court noted, in considering the interlocutory application, that Yum had “shown great care in developing the VS and that it was not a strategy that was developed capriciously or arbitrarily…even if the modelling was wrong, it did not necessarily mean that Yum had breached any implied term or engaged in unconscionable conduct.”
DPL argued that Yum owed a duty of care to franchisees in respect of any conduct or decision by Yum in providing services as franchisor and in the exercise of its powers under the IFA. DPL argued that the duty takes into account the franchisee’s vulnerability to risk of harm and its reliance on Yum to deliver its services with all due skill and care. DPL alleged that the services included the preparation of plans, policies, models and forecasts.
Based on the existence of a duty of care, DPL alleged that Yum had acted negligently in relation to modelling, the likely Domino’s response and the design and implementation of the VS. In making the accusations, DPL pointed to a number of matters, including:
Yum denied a duty of care as argued by DPL. Yum argued that, if such a duty cannot be implied into the contract, there cannot be such a duty as it would be inconsistent with the terms of the contract. Further, Yum argued that a duty of care in tort will not be imposed between parties where a contract is intended to be a complete statement of the parties’ obligations.
In support of its arguments, Yum submitted that:
Yum refuted the major basis of the alleged breach of duty (incorrect labour assertions, the form of analysis undertaken, failing to model the cost of capital) and the allegation of negligence for entering into a “price war” with Domino’s.
The Federal Court ultimately accepted Yum’s submissions as to its obligations under the IFA and the exercise of those powers. The Federal Court held that DPL had failed to establish that Yum owed the franchisees a duty of care in relation to the provision of services provided by Yum as franchisor. The Federal Court also held that Yum was not under a duty to ensure profitability of each franchise, nor under a duty to ensure that profits were maintained or increased.
DPL also sought to argue that Yum had acted unconscionably, in breach of section 21 of the Australian Consumer Law. Specifically, DPL suggested that:
Yum countered DPL’s arguments noting that the franchisees had entered into the IFA without any promise of profitability. Yum argued that it made a number of decisions in relation to its own business which, pursuant to the IFA, became binding on the franchisees. Additionally Yum argued that “is not for the Court to rewrite or reshape that contractual, commercial bargain and that the fact that a commercial bargain is disadvantageous to a party does not make it unconscionable”.
While finding that Yum may have been naïve or demonstrated poor business judgement, the Federal Court found that this did not equate to unconscionable behaviour. The Federal Court found that Yum had made what it considered to be the best decision from the point of view of Yum and the future profitability of the franchisees. Whether the reasons for such belief were right or wrong, they were made reasonably. On this basis, Yum did not act unconscionably.
Yum was ultimately successful in this case, even if the implementation of the VS did not have the positive impact on Pizza Hut businesses that Yum had hoped for.
The evidence in this case indicated that Yum expended considerable time and effort considering, developing and testing the VS. Yum looked to other jurisdictions to see what had worked there, developed its own plan then sought to test and improve the strategy before implementing it. Yum also consulted with franchisees about the VS prior to it being implemented. The considerable care shown by Yum in developing the VS was highlighted by the Federal Court in both the interlocutory application and in the judgement following the trial.
This case clearly offers support for franchisors seeking to make substantive changes to their operations. However, it also confirms that there is a relatively high bar that franchisors must meet in implementing changes - not surprisingly, franchisors cannot simply do as they please. In order to ensure legal compliance franchisors should ensure that they:
Change management is probably the most complex challenge faced by franchise networks, particularly where changes are fundamental and involve some commercial risk or uncertainty. Franchisors are expected to show leadership, but they must objectively consider all of the above factors and consult in a manner that is genuine and respectful of the interests of all franchisees. Although the Yum case provides helpful guidance, our experience is that franchisors seeking to implement network change sometimes can be too close to the decision making process to be objective.
For more information contact Allison McLeod.
Until now, the principle of freedom of contract has been sacrosanct in the context of business to business contracts. However, from 12 November 2016, this premise will change because unfair contract terms will be prohibited in standard form contracts where one of the parties is a small business. The prohibition will be achieved through the Treasury Legislation Amendment (Small Business and Unfair Contract Terms) Act (UCT Legislation) which amends the Australian Consumer Law (ACL) and the Australian Securities and Investment Commission Act 2001 (Cth) (ASIC Act) to extend the application of the existing consumer-focused unfair contract term protections to small businesses.
The UCT Legislation aims to protect small businesses from “unfair” contract terms in standard form contracts. The UCT Legislation will come into full force on 12 November 2016 (after a 12 month transition period) and will apply to standard form contracts, where one or more parties to the standard form contract is a small business, entered into, varied (but only to the parts varied), renewed or rolled over after that date.
In respect of the franchising sector, the UCT Legislation will be enforced by the ACCC and to some extent by Small Business Commissioners in each State and Territory. Despite the protections for small businesses in the Franchising Code of Conduct, franchise agreements will not be exempt from the UCT Legislation and the ACCC has advised that it will be focusing on the franchising sector as a priority with respect to compliance with the UCT Legislation.
What is a “small business”?
A small business is defined as being a business with less than 20 employees. This is assessed on a head count basis at the time the contract is entered into, varied or renewed and includes casual employees employed on a regular and systematic basis.
What is a “small business contract”?
A “small business contract” is a contract where:
The upfront price is the consideration (which may comprise a number of different types of payments) under the contract, that is disclosed at or before the time the contract is entered into (or varied or renewed). It is important to note that the upfront price can comprise amounts that are payable by the franchisee to the franchisor (for example, the franchisee fee) and conversely, by the franchisor to the franchisee (for example, a predetermined royalty amount). However, the total potential value of the contract cannot be used to determine the monetary threshold. Accordingly, a franchise agreement under which a franchisee may receive more than $300,000 (or $1 million in the case of multi-year contracts) through commissions and percentage based royalties will not be exempt from the UCT Legislation, because whether or not such amounts will be earned by the franchisee is not certain at the time the contract is entered into; the payment of such amounts will ultimately be determined by the franchisee’s performance under the franchise agreement.
What is a “standard form contract”?
The term “standard form” is not defined in the UCT Legislation, the ACL or the ASIC Act. However, it is generally understood to be a contract that is provided by one party to another on a “take it or leave it” basis. Accordingly, most template franchise agreements will be caught by the UCT Legislation, unless the parties have engaged in a genuine negotiation of the contract.
In the recent case Diab Pty Ltd v YUM! Restaurants Australia Pty Ltd  FCA 43 (discussed in more detail in this edition of Franchising Focus), the Federal Court noted that the international franchise agreement to which Yum and the franchisees were parties, was a “standard form” contract.
Accordingly, unless there has been extensive negotiation of the terms of a franchise agreement, we consider it likely that most franchise agreements will be considered standard form contracts.
What is an “unfair term”?
A small business contract will be “unfair” if it:
For a court to declare a term to be unfair, all three of the above elements must be proven. The burden of proof is on the party advantaged by the term to prove the term is reasonably necessary to protect their legitimate interests. In determining whether a term is unfair, the court must take into account the extent to which the term is transparent, and the context of the term in the contract as a whole. A term will be transparent if it is expressed in reasonably plain language, legible, clearly presented and readily available to any party affected by the term. However it is important to note that a term may be transparent, but still be declared unfair.
The ACL contains a list of the types of terms which may be unfair, however these are largely generic terms that would be found in most commercial contracts. Of greater practical assistance when reviewing template contracts for unfair terms, are the 8 core areas identified by ACCC as being of concern. These are:
The ACCC has also published a list of ten scenario-based examples of terms which it considers may be unfair. Notably, 3 of the examples relate to franchise agreements.
If a court declares a provision “unfair”, the term will be void and therefore unenforceable. However, the contract will continue to bind the parties if the contract can operate without the unfair term. A franchisor who seeks to enforce a declared unfair term, will contravene the ACL. Such a contravention may result in an injunction, an order to provide redress to the small business affected, or any other order that the court considers appropriate.
There are some terms to which the UCT Legislation will not apply. Section 26 of the ACL provides that the unfair contract term provisions will not apply to the term of a small business contract to the extent, but only to the extent, that the term:
Terms that set the upfront price payable
The upfront price payable includes any consideration (including future payments) payable under the contract which are referable to the supply, sale or grant the subject of the contract and which are disclosed at or before the time the contract is entered into.
In franchise agreements, terms that set the franchise fee, annual administration fee, royalties, bonuses and commissions are all terms which set elements of the upfront price payable under the agreement, and would be exempt from the UCT Legislation. It is important to note the distinction between the use of upfront price to determine whether the contract falls within the ambit of the legislation (in which case royalties, commissions and bonuses based on a percentage of a franchisee’s earnings are excluded) and the application of the UCT Legislation to terms which impose an obligation on a party to the contract to pay certain amounts under the agreement.
Amounts which are contingent on the occurrence or non-occurrence of a particular event are not exempt from the Legislation and could be declared unfair. Examples of such amounts are penalty interest, termination fees, renewal fees, relocation fees, transfer fees and premises upgrade fees.
The most obvious risk is, of course, the declaration of an “unfair term” in a small business contract resulting in either a term, part of a contract or an entire contract being found enforceable. The flow on effect of terms being unenforceable is much more uncertain and potentially far reaching.
Brand and reputation damage following class actions or other legal proceedings is also a foreseeable risk. This risk is particularly relevant to franchise networks, where disgruntled franchisees are more likely to collaborate.
Notwithstanding the above risks, franchisors can take some comfort from the significant disclosure requirements placed on franchisors under to the Franchising Code of Conduct. Given the emphasis on disclosure and transparency, if franchisors have been compliant with the Franchising Code of Conduct in their dealings with franchisees, it is less likely that terms in franchise agreements, in particular those regarding an amount or obligation arising from a contractual term that is further explained in the disclosure document, will be considered unfair. That said, disclosure of information does not necessarily equate to transparency. Accordingly, franchisors should ensure that the terms of their franchise agreements are transparent (expressed in reasonably plain language, legible, clearly presented and readily available to a party affected by the term) to further reduce the risk of a declaration of unfairness. Franchisors may also wish to consider reducing the size of their agreements.
Franchisors also need to be aware that the UCT is not limited to just franchise agreements. It covers all standard form contracts, where one or more parties to the contract is a small business, entered into, varied (but only to the parts varied), renewed or rolled over after 12 November 2016. As such, franchisors should also be considering and reviewing any other agreements that they routinely use, such as supply agreements.
Review of contracts
We recommend that franchisors conduct a term by term review of their franchise agreements for potential unfair terms. Such a review should include any additional documents or conditions which are referred to in the franchise agreement, such as the operations manual as they will form part of the agreement.
In reviewing each term consider:
In addition, franchisors should consider whether they use any other standard form contracts that may be impacted by the UCT Legislation. If so, these contracts should also be reviewed on the same basis that the franchise agreement is reviewed.
Drafting trends in franchise agreements
We consider that the implementation of the UCT Legislation will see some new drafting trends in franchise agreements. In particular, it is quite possible that franchisors will want to move to shorter form documents as they seek to ensure that their franchise agreements are transparent and easier to comprehend.
In relation to the subject matter of the franchise agreement, clauses which grant the franchisor a unilateral right to vary certain terms of the franchise agreement (for example, increasing minimum performance standards, increasing fees or decreasing commissions) may need to be amended to allow franchisees the right to dispute the variation or to terminate the franchise agreement on notice following a variation if they can show that such a variation jeopardises their franchise business.
Providing a franchisee with the right to exit the business if a unilateral change decreases the viability of its business beyond originally expected limits , is fairer than requiring the franchisee to “stick it out” for the remainder of the contract term. Such a right, though not traditionally present in franchise agreements, is not as alarming a prospect as it initially appears because it provides franchisors with opportunities to avoid having to enforce performance management criteria for franchisees who have already emotionally left the system. Accordingly, a right of termination for convenience in such circumstances does provide franchisors with a timely opportunity to “refresh” their network.
The UCT Legislation has the potential to have a big impact on standard form agreements used within franchise networks. However, by spending some time reviewing and considering your standard form agreements now, you can minimise the likelihood that your agreements will be found to contain unfair clauses which are then struck out.
For more information contact Fleur Shaw-Jones.
Global Norton Rose Fulbright tax controversy lawyers have prepared a sixth annual survey of tax controversy procedures and issues.
Our aim is to help our clients understand the potential opportunities and challenges that COP25 may have on their business.