GERMANY: Tax Neutrality for Advertising Cost Contributions.

Marco HERO | GERMANY | 2008-07-15

Marco HERO

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That decision also has consequences for foreign systems which develop the German market with a company of their own or have a place of business in Germany.

I. Civil-law background of the advertising cost contributions.

Franchise contracts usually require the franchisee to participate in the supra-regional advertising costs of the franchise system, in addition to the franchisee fees. [1] Such a contribution from the franchisee is legitimate, because benefits for its own franchise business accrue to it from the supra-regional advertising measures. Usually, a sum of c. 1% – 3% of the gross turnover is levied as an advertising fee per month.

The franchisor is contractually obliged to use that advertising cost contribution exclusively for supra-regional advertising purposes, even if this is not expressly stipulated in the franchise contract. The administration of the advertising cost contributions is similar to a fiduciary relationship.[2] At the same time, the franchisor takes on the obligation to stipulate the nature, the scope and the time of the use of the advertising contributions, in its reasonable discretion (§ 315 of the German Civil Code (BGB)). However, in continuous case law, the German Federal Supreme Court obliges the franchisor to take account of the reasonable interests of the franchisee.[3]

It is obliged to provide the franchisee with information and an account concerning the use of the advertising cost contributions, because the advertising expenses paid constitute for the franchisor an advance on expenses pursuant to § 669 of the BGB until use.[4]

If the franchisor does not use the advertising cost contributions for supra-regional advertising measures, contrary to the contractual agreements, but rather e.g. for the recruitment of new franchisees, then the franchisor renders itself liable to criminal prosecution pursuant to § 266 of the German Criminal Code (StGB) due to criminal breach of trust (Untreue). Due to that criminal act, the franchisee is directly entitled to compensation claims (§ 823.2 of the BGB in association with § 266 of the StGB). [5]

II. Tax treatment of the advertising cost contribution at the franchisor.

After a long dispute, the BFH as the highest German fiscal court has now made it clear that advertising cost contributions which the franchisor receives from its franchisee do not increase the taxable result, even if they have not been spent yet at the end of the year.[6] The long-standing uncertainty concerning the tax treatment of advertising cost contributions has thus finally been clarified in favour of the franchisor.

A franchisor which showed in its balance sheet the unspent advertising cost credit balance at the end of every year as profit-reducing liability accrued and deferred items (PRAP) pursuant to § 250.2 of the German Commercial Code (HGB) and § 5 paragraph 5, sentence 1, number 2 of the German Income Tax Act (EStG) sued. The fiscal authorities discovered these facts in an external audit and did not allow that profit reduction. The franchisor’s extra-judicial appeal and its lawsuit at the fiscal court were unsuccessful.

The Düsseldorf Fiscal Court was of the view that the franchisees’ ongoing advertising cost contributions were to be shown on the franchisor’s balance sheet as income, even if they had not been spent yet at the end of the year.[7] A reclassification as PRAP was not permissible, because a PRAP only served the profit allocation in the valid accounting period, and not setting profit off against an expense. In the same way, showing an amount as a reserve pursuant to § 249 of the HGB and § 5 paragraph 1, sentence 1 of the EStG was not permissible either, because the obligation to use the advertising cost contributions in future was only abstract and therefore not yet probably enough.

This legal view would have led to a substantial liquidity detriment for franchisors, because income tax would have had to be paid on the unspent advertising cost contributions, which would only have been capable of neutralisation in the following years via the advertising expenditure.

Fortunately for franchisors, the German Federal Finance Court has gone against this view. Advertising cost contributions paid on an ongoing basis were initially to be treated by the franchisor as income, but the franchisor must be entitled at the end of the year to the right to neutralise that income in that amount insofar as the advertising cost contributions had not yet been spent. Because the franchisor had no other possible way of using these advertising cost contributions than in accordance with the intended purpose. It was contractually obliged to do so. The BFH correctly oriented towards the civil-law evaluation that the franchisor is usually only an administrator of the advertising fees in accordance with the instructions. Ultimately, therefore, for the franchisor the advertising cost contribution only constitutes an item in transit. The BFH clearly rejected the view that the obligation to use the advertising cost contributions in future was just an abstract possibility. Against the background of the criminal-law consequences of not using the advertising cost contributions, that view is untenable. In the same way, the general view conflicts with the franchisor’s obligation concerning use of the advertising cost contribution in accordance with the purpose.[8]

However, the BFH goes even farther. It sees the franchisor’s obligation to use the advertising cost contribution as being so concrete that the balance sheet item entitled ‘other liability’ must be used for reclassification. This means that the obligation to use the advertising cost contributions is already certain. If the amount of this were not yet quantifiable, disclosure as a reserve pursuant to § 249 of the HGB and § 5 paragraph 1, sentence 1 of the EStG would have needed to be done.[9]

The balance-sheet treatment of the advertising cost contributions at the franchisor has thus been clarified for the future. For franchisors this means: The franchisee’s ongoing advertising cost contributions are firstly to be booked as income at the franchisor. Advertising measures of the current year constitute business expenditure of the franchisor (§ 4.4 of the EStG) and neutralise that income. If not all advertising cost contributions have been spent at the end of the year, then the franchisor can book out the existing advertising expense credit balance as expenditure. An ‘other liability’ is to be shown for that expenditure on the liability side. If in the following year, the advertising expense advance is then spent, then the ‘other liability’ is to be liquidated so that it affects net income. The income arising thereby is neutralised through the corresponding expenditure booking for the specific advertising measure.

Ultimately, advertising cost contributions of franchisees are not reflected at the franchisor – not even occasionally – in a way that affects net income. This applies in the same way for both national and international franchisors if the latter have their own company or a place of business in Germany. The decision is also transferable to other cost allocations which the franchisor receives and administers for the franchisee. The BFH decision accordingly constitutes a correct and important decision in favour of franchisors.

[1] inter alia Flohr, Franchise-Vertrag, 2nd edition, p. 151

[2] HRC Munich dated 25 August 2005, 6 U 4084/04, OLG Report 2006, p. 414.

[3] inter alia BGH v. 23.07.1997, VIII ZR 130/96, NJW 1997, S. 3304.

[4] Flohr in ZAP-Formularbuch Vertragsrecht, 2nd edition 2006, Part 15 Rz. 63.

[5] Palandt-Sprau, BGB, 67th edition 2008, § 266 Rz. 69.

[6] BFH dated 22 August 2007, X R 59/04, BHF/NV 2008, p. 427ff.

[7] FG Düsseldorf dated 21 September 2004, 9 K 6438/03, EFG 2005, p. 27f.

[8] Sistermann, Praxishandbuch Franchising, § 28 Rz. 9.

[9] Hoyos/M. Ring in Beck´scher Bilanzkommentar, 6th edition 2006, § 266 Rz. 247.



Marco Hero and Georg Schmidt, Germany.



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