Originally published in Canadian Business Franchise magazine on January 10, 2012
Q: I am thinking of acquiring a franchise from a U.S. franchisor with no Canadian offices, employees or operations. Are there any specific considerations I should take into account in this scenario?
A: Canada has long been the first choice for international expansion by many U.S. franchisors. Although there are many similarities between the two countries, there are also significant differences. Quite frequently, Canadian adaptations of U.S. franchise documents do not reflect these differences.
There are a number of points of concern you must review in your franchise agreement before proceeding with this type of purchase. Here are some of the most common:
Legal structure of the franchisor
A U.S. franchisor may directly offer Canadian franchises from the same entity that offers U.S. franchises. This is most desirable, since the U.S. franchisor has an established revenue stream and asset base.
However, many U.S. franchisors incorporate a Canadian subsidiary or, depending on tax considerations, a U.S. subsidiary, to conduct Canadian franchise operations. This insulates the franchisor’s U.S. assets and revenue stream from any problems or losses that may arise in Canada. The subsidiary, however, will have limited assets and revenue, making it more difficult for you to seek damages in the event of a dispute. If the franchisor is very anxious to sell to you, you could ask for a guarantee of performance of the Canadian franchisor by its parent company in the U.S.
As a Canadian franchisee, you have certain obligations under Canadian income tax legislation, but most U.S. franchisors do not carry on business or have a permanent establishment in Canada. As a result, you must withhold tax, generally at the rate of 10 per cent, on certain types of payments to a U.S.-based franchisor. Payments normally subject to withholding include initial franchise fees, royalties, interest and rent. Payments for actual services rendered, supplies and inventory are not subject to withholding tax.
If you fail to withhold the required taxes and remit them to the Canada Revenue Agency on the franchisor’s behalf, you will be personally liable for the amount not properly withheld. Many U.S. franchisors (and Canadian franchisees) are unaware of these requirements.
Virtually every franchise system has a strong identification with one or more trademarks used in association with the goods or services associated with the franchise system. Many U.S. franchisors mistakenly believe acquiring trademark protection in their country will protect them in Canada.
In actuality, these franchisors must apply for and register trademarks in Canada in order to grant valid and enforceable rights to franchisees to use them in Canada. Even if trademarks are properly registered, the registrations may not be valid if the marks are not properly licensed to the franchisees. You need to ensure your prospective franchisor has taken all necessary and appropriate steps to register its trademarks in Canada, and that your franchise agreement gives you the right to use them.
Another trademark related concern is that some terms commonly used in the U.S. either have no meaning or different spelling in Canada. In the U.S., the term ‘service marks’ is used in association with services, while trademarks refer to products. In Canada, the term trademark is used for both products and services.
Canadian and U.S. franchise agreements often contain very different non-competition covenants, which prevent you from competing with the franchisor both during and after the term of your agreement. Under Canadian law, non-competition covenants are valid if they are reasonable, both between the parties and in the public interest. To be deemed reasonable, the covenant must protect a proprietary interest of the franchisor, but must not be broader in geographical area, time or scope than is necessary to protect these interests.
In the U.S., non-competition covenants tend to be much broader, often restricting competition by a franchisee “in a competing business” or in respect of “products or services similar to those associated with the franchise system.” These covenants are usually unenforceable in Canada because they are generally considered too broad to protect the franchisor’s legitimate business interest and unfairly restrict your economic freedom.
In this case, however, you may not object to these differences. Failure to modify the non-competition covenant will work in your favour should you ever need to challenge the covenant’s enforceability.
Choice of law provisions
U.S. franchise agreements often state the law of the franchisor’s home state will apply, and will attempt to grant the courts of that state exclusive jurisdiction over matters in dispute under the franchise agreement. However, in provinces where franchise legislation has been enacted, the law requires any disputes over your rights must be determined in accordance with the provincial law and be conducted in that province.
If the franchise agreement requires that U.S. law governs, or that disputes be conducted in a state court, you should not only object based on applicable franchise legislation, but on the basis that it is impractical for a Canadian franchise agreement to be governed by foreign law, and unfair for you to be required to appear in a foreign court over on a dispute relating to your Canadian franchise business.
Some U.S. franchise agreements provide that interest rates on overdue amounts be the “maximum interest rate allowed by law.” In Canada, this concept does not generally exist, except when interest rates in excess of 60 per cent are charged. Also, unless the rate is specifically disclosed as an effective annual interest rate, the franchisor will only be entitled to the rate of interest set by Canadian federal law, which is presently five per cent. If you are faced with a U.S. interest rate clause, you should insist your agreement clearly specify the actual rate of interest being charged, disclosed on an effective annual rate.
Canadian privacy law can affect many aspects of your franchise business, and will differ from U.S. practices. For example, you must obtain consent from your customers before collecting, using or disclosing their personal information to your franchisor. Provisions requiring you to share this data with your franchisor will put you in breach of privacy legislation if consent is not obtained; as such, you must resist these clauses.
Almost all franchise systems make reference to policy and procedures manuals as the instruments through which franchise system standards, specifications and procedures are established. However, U.S. manuals will inevitably contain chapters dealing with certain laws, practices or customs relevant south of the border. You should always ensure that any manuals referred to in the franchise agreement or made available to you have been modified to comply with Canadian legislation, customs and practices.
If you are required to contribute to a national advertising fund, you should determine whether a separate fund is being maintained for Canadian franchisees, and ensure the franchise agreement confirms that your contributions will be spent in Canada. If advertising payments are made to a U.S.-based advertising fund and combined with contributions from U.S. franchisees, you may not get a proportionate benefit. For example, national advertising placed on U.S. TV networks will be blocked on Canadian cable stations and replaced by Canadian ads. You must insist on advertising adapted for use and direction to the Canadian marketplace.
If your prospective franchise system involves the sale of pre-packaged products, these products must comply with the federal Consumer Packaging and Labelling Act. This legislation specifies certain information be included (in English and French) on all pre-packaged products including standardized container sizes, warnings and information symbols; metric product quantities; the name and address of the importer; and the country of manufacture.
You must be certain that any prepackaged products supplied by the franchisor are compliant with the legislation in order to sell them to Canadian consumers.
Finally, if your prospective franchise involves a regulated industry, there will likely be considerable differences between U.S. and Canadian regulatory requirements. For example, real estate brokerages, personnel and employment agencies, professional services, pharmacies, travel agencies and health care systems are all subject to specific Canadian regulations. You must be aware of any professional accreditations, licences or permits you need to run these types of businesses in Canada. U.S. franchisors will frequently not have researched these issues.
Know the differences
In summary, while opportunities abound for Canadian franchisees to become a part of, or even establish a Canadian presence for, U.S. franchisors, you must always be aware that franchising in Canada and the U.S. differ in many respects. You must do as much research as possible, get appropriate legal, accounting and tax advice, and ensure your prospective franchisor has made the necessary and appropriate changes to its system to make it workable and compliant with Canadian standards, customs and legal requirements.
© Frank Zaid 2021