Disallowance of Depreciation on Goodwill: A questionable certainty?
In this article
Many companies will now have to dish out higher tax on past M&A deals with the budget ending the age-old practice on ‘goodwill’ accounting.
Mr. Sandeep Dasgupta and Mr. Paras Modi from Deloitte Haskins & Sells LLP write on the proposed amendments whereby depreciation on goodwill shall not be allowed with effect from Assessment Year 2021-22.
Goodwill represents the excess amount of purchase price over the net assets of a business, and is a factor of the brand value, customer base and contracts, proprietary technology etc. integral to the business. Therefore, in the context of acquisition of business or business reorganizations, goodwill represents an important consideration. Being an intangible asset, goodwill is recorded on the acquiring company’s balance sheet as a long-term non-current asset. Under the International Financial Reporting Standards (IFRS) – IAS 36, companies are required to evaluate the value of goodwill on their financial statements at least once in a year to record any impairments, based on business dynamics. While the process for calculation of goodwill may appear to be simple, in practice this calculation can be quite complex due to certain factors viz. projection of business cashflows, business certainty and economic dynamics etc. Needless to add, the value of goodwill is subject to changes both northwards and southwards in a business parlance. The business that generates goodwill cannot record it being a self-generated asset, but eventually recognized and accounted for, if such business is succeeded.
Section 32(1)(ii) of the Income Tax Act 1961, (the Act) allows depreciation on know-how, patents, copyrights, trade-marks, licenses, franchises or any other business or commercial right of similar nature. It may be noted that goodwill is not specifically included in the list of assets eligible for depreciation under the Act and thereby has been a subject matter of debate for long. In the case of CIT vs Smifs Securities Limited  348 ITR 302 (SC), the Hon’ble Supreme Court had ruled that goodwill falls in the category of ‘any other business or commercial rights of similar nature’ and would therefore, qualify as an intangible eligible for depreciation under Section 32 of the Act.
In spite of the above decision in case of Smiff’s securities, tax authorities continued to question claim of depreciation on goodwill in the context of amalgamation and intragroup business reorganisations based on the contention that the above Supreme Court decision had not considered the special provisions as contained in the law in relation to amalgamation. l. For instance, in the context of amalgamation, tax authorities continued to contend that depreciation cannot be allowed on goodwill in case of amalgamating companies since the same is self-generated and consequently not recorded in it’s books. In this case, even the amalgamated company was denied depreciation claim on goodwill. Various Courts and tribunals had divergent views on the subject.
Fundamentally, it may be noted that goodwill can be of two types a) self-generated or b) acquired / purchased goodwill. In the context of business restructuring transactions difference between self-generated and acquired goodwill lies in the manner of discharge of consideration.- In case of self-generated goodwill, consideration for all assets and liability taken over is settled through issuance shares of debt securities whereas in case of purchased or acquired goodwill, the consideration is discharged in cash. In cases where consideration is discharged by issuance of shares or securities, the department is of the view that the acquirer company has not paid anything for acquiring goodwill per-se it is merely a book entry and therefore no depreciation shall be allowed. Tax authorities place reliance on the ITAT decision of United Breweries Ltd (TS 7201 ITAT 2016 Bangalore).
The following provisions in the Act which provide guidance on depreciation claim on assets acquired in restructuring transactions are worthy to note:
• As per sixth proviso to Section 32 of the Act, the depreciation claim on assets should be restricted to the total of deprecation which would otherwise be allowed had the restructuring exercise not taken place.
• Clause (c) to section 43(6) of the Act, provides that the aggregate written down values of all the assets falling within a block of assets at the beginning of the previous year is to be increased by the actual cost of any asset falling within such block, acquired during the previous year.
• Explanation 7 to Section 43(1) of the Act, states that the “actual cost” of a capital asset transferred in a scheme of amalgamation shall be taken at the same value as if the amalgamating company had continued to hold the capital asset for the purposes of its own business.
• As per Explanation 2 of clause (c) to Section 43(6) of the Act, when a capital asset is transferred to an amalgamated Indian company, the value of such asset shall be the written down value of that block in the immediate preceding previous year of the amalgamating company as reduced by depreciation actually allowed in that preceding previous year.
In light of the above, the actual cost of self-generated goodwill may be said to be NIL and therefore, technically the depreciation claim thereon may be NIL. However, it is imperative that generally there was no debate in relation to allowability of depreciation in case of purchased or acquired goodwill.
The Finance Bill, 2021 has now proposed to amend certain provisions of the Act, whereby depreciation on goodwill shall not be allowed with effect from Assessment Year 2021-22. The key amendments are as follows:
• It is proposed to amend the definition of section 2(11) of Act to exclude “goodwill” from block of asset. Thereby any form of goodwill will not be considered as a depreciable asset.
As mentioned above, the value of goodwill recorded on amalgamation or merger which was settled through issuance of shares is considered as NIL. However, pursuant to this amendment, even in cases where goodwill was acquired by paying cash shall also be valued at NIL for tax purposes. As a rationale to the proposed amendment the Government has stated that goodwill in general, is not a depreciable asset and in fact depending upon how the business runs; goodwill may see appreciation or in the alternative no depreciation to its value. Therefore, there may not be a justification of depreciation on goodwill in the manner there is a need to provide for depreciation in case of other intangible assets or plant & machinery.
• It is proposed to amend clause (ii) of sub-section (1) of section 32 of the Act to provide that goodwill shall not be considered as an asset for the purpose of the said clause and therefore not eligible for depreciation.
• In sync with the above, it is also proposed to amend explanation 3 to 32(1) of the Act to provide that goodwill of a business or profession shall not be considered as an asset for the said sub-section.
• The only relief in case of acquired goodwill is that the purchase price of such goodwill will be considered as cost of acquisition for the purpose of computation of capital gains under section 48 of the Act. However, if the assessee has claimed depreciation on such goodwill in prior years i.e. assessment year prior to AY 2021-22, then the quantum of depreciation so claimed by the assessee shall be reduced from the amount of the purchase price of the goodwill.
• The provisions of section 50 of the Act are also proposed to be amended to provide that goodwill forming part of a block of asset for the assessment year beginning on the 1 April 2020 ,depreciation is claimed under the Act till such date, the written down value of such block of asset and short term capital gain if any shall be computed in the manner as may be prescribed.
• Besides Section 55(2) of the Act is also proposed to be amended to provide that the cost of an asset shall be:
o Purchase price where the asset is acquired by the assessee by paying cash to the previous owner;
o Cost to the previous owner i.e. purchase price paid by the pervious in case of succession, inheritance or distribution of assets on the dissolution of a firm, BOI, AOP or on any distribution of assets on the liquidation of a company or under a transfer to a revocable or an irrevocable trust
o NIL in all other cases.
Additionally, it is proposed that the above cost shall be further reduced by the depreciation claimed in any previous year preceding the previous year relevant to the assessment year commencing on or after the 1 April 2021.
In light of the above, it is imperative to note that the controversy on claim of depreciation on goodwill arising on account of re-structuring transaction is being largely put to rest. However, the following aspects are worthy to note.
- In the process of settling the debate on depreciation on self-generated goodwill, the government has also proposed to claim depreciation on goodwill arising on account of acquired business. Therefore, the amendment applies to all M&A transactions whether inter-group or intra-group.
- The Government qua the Memorandum to the Finance Bill cites the moot rationale of these amendments as goodwill being an asset whose value cannot decline – the value either appreciates or remains constant. This rationale appears to be contrary to the business / commercial and accounting perspectives as various factors like economic, socio-political, technology, customer preference changes etc. may impact business dynamics.
- Business acquirers aiming at growth from potential synergies through transactions will now have to think differently while deciding on additional consideration for business acquisitions viz. a commercially justifiable valuation report backed by proper allocation of purchase consideration across all business assets (tangible and intangible).
- While the above amendments are effective from assessment year 2021-22, it may be hoped for good that the tax authorities do not seek to apply the ratio of these amendments for prior assessment years, as that would only pile up litigations before the Courts. It may be worthwhile for CBDT to issue an internal Circular / Instruction Memorandum to clarify that tax authorities refrain from disallowing depreciation claims on purchased / acquired goodwill, in case of business reorganisation transactions.
Any amendment imparting clarity in tax treatments is a welcome move but based on the above, is the proposed denial of depreciation on goodwill, a questionable certainty?
Mr. Sandeep Dasgupta is a Director with Deloitte Haskins and Sells LLP
Mr. Paras Modi is a Manager with Deloitte Haskins and Sells LLP