Trading places

Franchising is a very popular business model and is used for ever-more diverse businesses. As a result, franchising schemes need to become increasingly innovative, and we are seeing more potential franchisors with business models that require participants working for franchisees who will not want to be registered for VAT. This is specifically where there is a need for part-time, self-employed sales people or service providers - perhaps hairdressers (so called chair renters) working in a franchised salon.

The Trading Schemes Act 1996 and regulations made under it are intended to outlaw pyramid selling schemes but impact on franchising. Multi-level franchises are caught by the legislation and will be 'trading schemes' if not all the participants are VAT registered. Promoting a trading scheme that does not comply with the Trading Schemes Regulations is a criminal offence.

Conventional wisdom is that it is practically impossible to have a franchise scheme that complies with the Regulations. As a result, there are businesses where franchising has been rejected in favour of other models because of the complications created by the legislation. It may however be possible with creative drafting and careful interpretation of the legislation to bring a franchise system within the rules.

The legislation specifically prohibits trading schemes where participants are told that they will obtain a benefit from the introduction of others to the scheme, or their continued participation. This means that if the scheme involves a lower-level participant paying a franchise fee, marketing fee or indeed anything to an intermediate-level franchisee, it would make it almost impossible for the scheme to comply. The Department of Trade and Industry, however, has issued guidance that makes it clear that rewards based on the genuine sales of goods or services to end users and the recruitment of others are not illegal, provided that recruitment rewards are not the main motivation for joining the scheme. Thus arrangements of this kind can be acceptable, provided the franchisees do not benefit from the mere presence of lower-level participants in the scheme.

Having now considered regulated trading scheme franchises for clients, we believe that it is possible to have such a business model and for the promoters to stay within the law.

The Regulations create unusual requirements for the scheme documentation in the context of franchising. For example, a franchisee must be able to terminate the agreement on 14 days written notice, all the financial obligations of the participant for the first 12 months of the agreement must be set out in the agreements and anybody joining the scheme or purchasing an existing franchise has to be given a two-week cooling off period after signing up. There are also statutory statements, which have to be included in the agreements. It is, however, significant that franchisees leaving the scheme on 14 days' notice are not entitled to a refund of their upfront fee and they can still be bound by post-termination restrictions.

Where a franchised business has a genuine need for its franchisees to use lower-level participants who are self-employed individuals and who will not be VAT registered we believe that it is possible to set up a system that is compliant with the legislation. We expect to see a number of such schemes operating in the near future.