Tax Updates on Royalty in Franchise Agreements

The gradual return of economic activities and the social life of consumers in Brazil, especially during the third quarter of 2021, are responsible for the growth of 7.8% in sales in the franchising sector, compared to the same period in 2020.

As shown in the survey carried out by the ABF – Brazilian Franchising Association – and released during the fair Expo Franchising ABF Rio, the franchise market continued its recovery trajectory, with numbers even higher than those measured in the same period in 2019.

Although the economic scenario is promising for franchises in Brazil, the challenges are still many, especially after the decision of the Federal Supreme Court (STF in portuguese), which recognized the constitutionality of the incidence of the ISSQN (Tax on Services of Any Nature in portuguese) on royalties paid in franchise contracts.

Despite the franchising activity is expressly described in the Complementary Law that regulates the incidence of the tax (Complementary Law 116/2003), the legitimacy of this charge has always been highly controversial, as it is a complex contract, the franchise does not presuppose the existence of services provision. Nevertheless, the STF’s decision on the constitutionality of the ISSQN put an end to all discussions and pacified the issue.

The ISSQN is a municipal tax, which has a variable rate between 2% and 5%. Major capitals such as Rio de Janeiro and São Paulo have their percentage set at 5%, which has a great impact on the cash flow of franchisors and franchisees, who were not prepared to pay such amounts to the municipal tax authorities.

The significant reduction of the ISSQN to its minimum percentage brings great benefit to franchise networks that are headquartered in such cities, as well as encouraging new franchisors to establish their headquarters in these cities. In addition, the municipal tax authorities benefit by preventing a real migration of the headquarters of franchise companies to other nearby cities, which have a more favorable tax regime.

It is important that the payment of taxes and the responsibility for the tax burden are well defined in the franchise agreement, considering the possibility of changing the tax burden from the franchisor to the franchisee, provided that by express contractual determination. A good contractual structure is the best way to guarantee an efficient  organization of the cash flow of the entire Franchise Network, also avoiding conflicts between franchisee and franchisor due to the lack of clear rules in this regard.

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