Avoid falling foul of the Trading Schemes Act

Confession time: many moons ago, before I qualified as a solicitor, I thought a franchise was a dodgy pyramid-selling scheme. Once I started working in the industry and met some real-life franchisees, I quickly discovered how wrong I was. But it seems I’m not the only one to make that mistake – our legislators were equally misguided when they wrote the Trading Schemes Act.

The act and its regulations were intended to outlaw dodgy pyramid-selling schemes. The kind of get-rich-quick schemes where everyone who joins pays a wad of cash to the person at the top in the hope that they too will make it up the pyramid before the whole thing collapses. The scheme’s survival depends on the continuous recruitment of new members, without supplying any actual goods or services.

Although the Trading Schemes Act wasn’t intended to target legitimate franchises, most networks are inadvertently caught by the legislation. So what do franchises need to bear in mind to avoid falling foul of the act?

Defining your model

The starting point is that the Trading Schemes Act applies to any arrangement in which participants are given the prospect of a benefit or reward for introducing other participants to the scheme or selling goods or services that were supplied by the person promoting it. Most franchise networks fall within this definition because the franchisor – effectively the promotor – offers franchisees – the participants – the prospect of a reward as a result of selling the franchisor’s goods or services to their customers.”

Exceptions to the rule

There are two main factors that exempt a franchise network from having to comply with the trading scheme rules. The first – and most straightforward – exemption is that the rules don’t apply if all of the members of the network are registered for VAT. The logic behind this is that if a business is registered for VAT, then its owners are treated as being sophisticated enough to not need the protection of the Trading Schemes Act. However, the exemption only applies if everyone in the network is registered for VAT – this is why many franchise agreements require new franchisees to register before they start to trade and why not being registered is grounds for termination. If even one franchisee in the whole network isn’t VAT registered then the exemption no longer applies.

The second exception applies to single-tier franchise systems. To qualify, all franchisees must operate at the same level with a single franchisor above them and franchisees must not receive a benefit for introducing new franchisees. This exception was introduced with the intention of exempting legitimate franchise businesses that don’t have recruitment of new members as their main purpose. However, in practice, this exemption tends to be less clear cut. For example, if a franchisee engages a self-employed contractor then arguably the contractor adds another level to the scheme – that would mean the network is no longer a single tier.

The generally accepted wisdom is that in most of the legitimate circumstances where a franchisee may want to use a self-employed contractor, the rules on trading schemes won’t be broken. But the wording in the legislation is not clear and every case would turn on its own facts. Having said this, the exemption is helpful for networks where registering for VAT is not appropriate – for instance, most care franchises are not registered because VAT is not applicable to their services.

Another potentially problematic area is where a master licensee is granted a licence for a large area and then sub-licenses parts of their territory to other franchisees. In this case, there are two tiers in the system – the franchisor at the top, the master licensee in the middle and the franchisees at the bottom. In this situation, it will almost always be appropriate to insist that all members are VAT-registered and to rely on the VAT exemption.

Right side of the law

The fact that most franchise networks are able to rely on either the VAT exemption or the single-tier exemption to fall outside the Trading Schemes Act is good news because the alternative is that networks would be regulated within the act. This means complying with various obligations that most franchise networks can’t or won’t do, such as the obligation for a regulated trading scheme to give its members a 14-day cooling-off period after joining. What’s worse, if a franchisor promotes a network that’s not exempt and doesn’t comply with the rules, then they commit a criminal offence that’s punishable by a fine or imprisonment.

Although the consequences of getting it wrong could be catastrophic, the good news is that with careful planning and a well-drafted franchise agreement, it should be possible for legitimate franchise businesses to operate within the rules.