Franchise 101: No Tax on Renewals; and Franchisor’s Tough TRO Mountain

Franchisor 101: No Tax on Renewals

A federal court in Virginia denied tax franchisor, Liberty Tax’s, motion to dismiss complaints by two of its area developers (“ADs”). The ADs claimed Liberty Tax breached their contract for wrongfully terminating, failing to pay royalties for franchisees in their territory and failing to renew on the same terms as prior area development agreements (“ADAs”). Liberty Tax argued that the ADs were not terminated, but rather, that they were not renewed. Liberty Tax argued that e-filing payments were not part of the royalty fees owed under the ADAs.

Both ADs sent renewal notices to Liberty Tax. Liberty Tax acknowledged receipt of the notices but did not provide a renewal agreement. One AD sent a follow up notice and received a message from Liberty Tax that because it failed to meet development obligations under the ADA during the COVID pandemic, the ADA would not be renewed and all the AD’s rights were terminated. Then Liberty Tax revised its standard ADA to be materially different from the ADAs signed by the ADs when they tried to exercise their renewal rights.

The court analyzed whether the ADAs were terminated or not renewed. Liberty Tax claimed the ADs had not alleged termination, but non-renewal. The court disagreed, viewing the claim as being for wrongful termination. One of the ADAs had an addendum that changed the term from six years to ten years. The court held that if the ADA had not expired, it was plausibly terminated, instead of not renewed, and let the claim proceed.

The court considered whether e-filing fees were included in the definition of royalties under the ADAs. The ADs asserted that e-filing fees were part of the fees for tax preparation services and should be included in royalty payments owed to them. Liberty Tax responded that this interpretation of royalties was not supported by the ADAs, but failed to point to language in the ADAs defining “royalties” that would preclude e-filing fees as revenue for purposes of royalties. The court held this ambiguity should be construed against the drafter, Liberty Tax, and ruled in favor of the ADs.

As to renewal requirements, the ADs claimed the only requirement to renew was to give proper notice, which ADs did. Liberty Tax stated it was under no obligation to renew the ADAs under the same terms. The court found that neither party identified contractual provisions in support of their positions. Nevertheless, the court determined no word or clause will be treated as meaningless if a reasonable meaning can be attributed. The court let the claim proceed because the renewal provision was plausibly ambiguous and would be construed against the drafter.

Franchise agreements and area development agreements outline renewal conditions and termination requirements. Franchisors should work with franchise counsel to ensure renewal conditions are drafted to give the franchisor adequate discretion and determine if the franchisor has good cause for non-renewal or termination prior to taking any action.

Franchisee 101: Franchisor’s Tough Mountain to Climb for TRO

A California federal court denied Mountain Mike’s Pizza a temporary restraining order (“TRO”) against one of its franchisees who did not renew its franchise agreement and opened a new restaurant under a different name.

In response to franchisee’s notice of non-renewal, Mountain Mike’s notified the franchisee of its right to buy the franchised restaurant and assume the franchisee’s lease. Franchisee refused and signed an amendment to the lease to operate a pizza restaurant under the name, Viscuso’s Pizza and Draft House. Mountain Mike’s alleged franchisee used the brand’s goodwill to profit at its expense, and requested a TRO based on trademark infringement.

Mountain Mike’s provided evidence that franchisee advertised Viscuso’s on a third-party delivery app, while orders were picked up from the Mountain Mike’s still operating business. Viscuso’s online menu was copied directly from Mountain Mike’s menu, including product names, pizza sizes and descriptions. The delivery app said Viscuso’s was opening a month after the non-renewal notice.

Franchisee countered that it did not intend to operate the restaurant as a Mountain Mike’s after the franchise agreement ended. Franchisee stated the delivery app was not supposed to take effect until after the franchise agreement ended and it deactivated the app when the first app order as Viscuso’s was received. The franchisee claimed it deidentified Mountain Mike’s signage when requested.

A TRO will only issue if four elements are established by the plaintiff: (1) it is likely to succeed on the merits; (2) it is likely to suffer irreparable harm in the absence of preliminary relief; (3) the balance of equities tips in its favor; and (4) an injunction is in the public interest.

The party seeking a TRO must establish it is likely to suffer irreparable harm in the absence of preliminary relief. The court held Mountain Mike’s could not prove it would suffer irreparable harm because the damage it claimed was in the past and did not show a substantial threat of future harm from the franchisee. The court noted Mountain Mike’s did not provide sufficient evidence to prove irreparable harm, and such harm is not inherent or presumed.

Franchisees may want to leave their franchise system at the end of the term and start their own business. This is especially true in California, given the public policy against enforcing non-compete agreements. A franchisee contemplating this course of action should consult franchise counsel to ensure it is not infringing franchisor’s marks and is abiding by post-expiration covenants.