Goodwill - Challenges Ahead!
<p><strong>What is the Tax Controversy about? </strong></p><p>The Finance Act, 2021 (FA 2021) brought in relevant amendments in the Income Tax Act, 1961 (ITA) to establish that ‘goodwill’ will no longer be considered as an “intangible asset” and further that depreciation would not be available on ‘goodwill’ from 1st April 2020. The said amendments also warranted that goodwill would have to be removed from the block of asset (Intangibles) as on 1st April 2020, to the extent that value of that block will be reduced by the cost of goodwill, net of depreciation claimed till date.</p><p>Section 55 of the ITA, which typically explains the meaning of “adjustment”, “cost of improvement” and “cost of acquisition” for the purpose of computing capital gains was also suitably amended to inter alia insert a Proviso that seeks to reduce the “purchase price” of acquired ‘Goodwill” to the extent of total depreciation claimed from the purchase price up to 1st April 2020.</p><p>However, this was not the end of the matter. Vide the FA 2021, a suitable amendment was also introduced in the ITA to hold that where the value of net goodwill removed from the block is in excess of the opening Written Down Value (WDV) as of 1st April 1, 2020, such excess will now be eligible to tax as Short-Term Capital Gain (STCG).</p><p>A new rule (Rule 8AC) was inserted on 7th July 2021 in the Income Tax Rules, 1962 (‘the Rules’) to provide the methodology for computation of STCG on the Net Goodwill removed from the block of intangibles.</p><p> It is this latter part of the relevant amendments (Taxation under STCG of the Net Goodwill removed from the block of intangibles) that is causing ripples in the business circles in India, given that many large and medium businesses had meticulously planned their tax outlay subsequent to having acquired or merged business undertakings in previous financial years and expecting to claim a substantial amount of depreciation to the goodwill recorded in their books of account at the time of these acquisitions or mergers.</p><p><strong>Background </strong></p><p>With respect to assets that are used for the purpose of business, taxpayers are entitled to claim depreciation on such assets based on their value to be determined as per the provisions of the ITA. The depreciation, under the ITA, for such assets is computed based on a concept called ‘block of assets. For the purpose of taxation, all the assets falling under the same class and for which the same rate of depreciation is prescribed, constitute one block of the asset. Since assets typically fall under different classes/types, rates of depreciation too are different for each block. Within the block of intangible assets, 'know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature' are included. Even a single asset on which depreciation is allowed is treated as a block of asset for income tax purposes.</p><p>Unlike regular accounting where the depreciation is calculated with reference to the cost or written down value of each asset, the depreciation for a particular block of assets is computed in an aggregate manner. If there are more than one asset in one particular block of assets, the depreciation is calculated on the value arrived at after adding the cost of acquisition for the assets purchased during the year and falling under the same block of assets, to the written down value (WDV) of the block at the beginning of the year and reducing from this WDV, the sale price of one or more assets sold during that year.</p><p>So far as depreciation on goodwill is concerned, we have seen, heard, and read enough on why depreciation should be allowed on goodwill, recorded in the books as an intangible asset. It is well known that no business that is commenced for the first time possesses goodwill from the start. It is generated gradually as the business is carried on progressively and may appreciate with the passage of time. Lawson in his Introduction to the Law of Property describes it as property of a highly peculiar kind. In Chunilal Prabhudas and Co.  76 ITR 566 (Cal.) [TS-5206-HC-1969(CALCUTTA)-O], the Calcutta High Court reviewed the different approaches to the concept of goodwill thus:</p><p>"It has been horticulturally and botanically viewed as 'a seed sprouting' or an 'acorn growing into the mighty oak of goodwill'. It has been historically explained as growing and crystallizing traditions in the business. It has been described in terms of a magnet as the 'attracting force'. In terms of comparative dynamics, goodwill has been described as the 'differential return of profit'. Philosophically it has been held to be intangible. Though immaterial, it is materially valued….</p><p> ….Biologically, it has been described by Lord Macnaghten in Trego Vs. Hunt  AC 7(HL) as the 'sap and life' of the business. Architecturally, it has been described as the 'cement' binding together the business and its assets as a whole and a going and developing concern." A variety of elements goes into its making, and its composition varies in different trades and in different businesses in the same trade, and while one element may preponderate in one business, another may dominate in another business. and yet, because of its intangible nature, it remains insubstantial in form and nebulous in character. Those features prompted Lord Macnaghten to remark in IRC v. Muller and Co.'s Margarine Limited  A.C. 217(HL) that although goodwill was easy to describe, it was nonetheless difficult to define. In a progressing business, goodwill tends to show a progressive increase, and in a failing business, it may begin to wane. Its value may fluctuate from one moment to another depending on changes in the reputation of the business. It is affected by everything relating to the business, the personality and business rectitude of the owners, the nature and character of the business, its name and reputation, its location, its impact on the contemporary market, the prevailing socio-economic ecology, introduction to old customers and agreed absence of competition. There can be no account in value of the factors producing it. It is also impossible to predicate the moment of its birth. It comes silently into the world, unheralded and not proclaimed and its impact may not be visibly felt for an undefined period. Imperceptible at birth it exists enwrapped in a concept, growing, or fluctuating with the numerous imponderables pouring into, and affecting the business."</p><p>In Skyline Caterers [TS-59-ITAT-2007(MUM)-O], the Mumbai Bench of ITAT held that “Even if an asset is described as a goodwill but if it fits in the description of section 32(1)(ii), depreciation is to be granted on the same; the true basis of depreciation allowance is the character of the asset and not it’s description.” Eventually, the controversy on availability of depreciation on goodwill was laid to rest by the Hon’ble Supreme Court of India in Smifs Securities  348 ITR 302 (SC) [TS-639-SC-2012-O] wherein it held that goodwill falls in the category of ‘any other business or commercial rights of similar nature and should hence be eligible for depreciation as per the provisions of section 32 of the ITA.</p><p>Given this position in law, on the admissibility of a claim of depreciation on acquired goodwill under the ITA, a large number of mergers, acquisitions, slump sales and share sales that were undertaken in the past few years have been really well thought out from a tax planning perspective so as to enable the acquirer of business to mitigate the post-merger/acquisition tax liability of his business by virtue of the claim of depreciation on goodwill in successive financial years.</p><p><strong>The Revenue’s Point of View on Admissibility of Depreciation on Goodwill </strong></p><p>The Tax Authorities in India have always steadfastly maintained in most of the cases where claims of depreciation on goodwill have been litigated that allowance of depreciation to the successor / amalgamated company in the year of amalgamation would be on the WDV of the assets in the books of the amalgamating company,</p><p>Also, as per Explanation 2 to section 43(6), where any block of assets is transferred by the amalgamating company to the amalgamated company, the actual cost of the block of assets in the case of the amalgamated company shall be the WDV of the block of assets as in the case of the amalgamating company for the immediately preceding previous year as reduced by the amount of depreciation allowed in relation to the said preceding previous year.</p><p>This provision has been interpreted by Tax authorities to imply that the amalgamated company would only be eligible to claim depreciation on assets in respect of which the amalgamating company claimed depreciation. Since goodwill is a self-generated asset and does not exist as an asset on the books of the amalgamating company, the amalgamating company could not have claimed depreciation on goodwill.</p><p>Further, the Tax Authorities in India based their submissions by placing reliance on the erstwhile Accounting Standard-14 (AS-14) that warranted creation of goodwill in case of amalgamation. AS-14 required that the excess payment made by the acquirer of business over and above book value of tangible movable assets (net of liabilities) acquired can be towards goodwill if there is acquisition of business contracts, customer orders, customer business information etc. They would contend that the purchase price allocated to goodwill in the accounts of the acquirer may actually represent appreciation in the fair value of other tangible assets acquired and does not represent any stand-alone intangible asset. In the Authorities’ contention, the taxpayer could be allocating a separate amount to Goodwill merely to avail depreciation, and thereby circumvent Explanation 7 to Section 43(1) or the sixth proviso to Section 32. Therefore, to keep the challenge of the Tax Authorities at bay, to the claim of depreciation on Goodwill, the acquirer of business had to be cognizant of the type of assets transferred and the manner of allocating the purchase price.</p><p>However, the introduction of the new Indian Accounting Standards (Ind AS) made the task of the Tax Officer seemingly more difficult while mounting a challenge to the claim of depreciation on goodwill acquired during the transfer of business. Ind AS 103 specifies that only common control business combinations will be accounted for using the ‘pooling of interest method’ such that the assets and liabilities of the combining entities are reflected at their carrying/book value and any difference will be adjusted against the capital reserve. In other words, no goodwill is recorded for common control business combinations. However, in all other cases of business combinations, it is accounted for by using the acquisition method which is based on fair value accounting i.e., the acquirer records the assets and liabilities at their respective ‘fair values’ in its books. This implies that the acquiring business can record ‘goodwill’ in its books as an asset where there is a difference between the consideration paid (either in the form of cash, shares or liabilities assumed) and the fair value of the assets and liabilities acquired.</p><p>Given this emerging position and the burgeoning claims of depreciation on goodwill of acquired businesses, the Finance Ministry, assumingly on the recommendations of the Income Tax Department, introduced suitable amendments to the ITA under the Finance Bill 2021 so as to put a permanent halt to the trend of claiming depreciation on large sums allocated to Goodwill by Companies that had acquired businesses in the preceding financial years and thereby mobilise more tax revenue or plug the apparent tax leakage commencing from the current financial year onwards.</p><p>Most importantly, from the perspective of treating depreciation claimed post 1st April, 2020, on the net WDV of Goodwill in the books of accounts as a STCG, an amendment was introduced under Section 50 of the ITA. It is pertinent to note here that the provisions of Section 50 deal with the tax treatment for the surplus on sale of a depreciable business asset as a STCG.</p><p>Section 50 of the ITA was amended by the Finance Act, 2021 to introduce a new proviso as under:</p><p>“Provided that in a case where the goodwill of a business or profession forms part of a block of asset for the assessment year beginning on the 1st day of April, 2020 and depreciation thereon has been obtained by the assessee under the Act, the written down value of that block of asset and short term capital gain, if any, shall be determined in such manner as may be prescribed.”</p><p>From a plain reading of the above provision, it is evident that an attempt has been made to treat the net goodwill removed from the block of assets (intangibles) to STCG by deeming it as a transfer in FY 2020-21. Further, vide Notification No. 77/2021 dated 7th July 2021, a new rule (Rule 8AC) was introduced in the Rules that provides the methodology for computation of STCG on the block of intangible assets comprising of goodwill whereon depreciation had been availed in the FY 2020-21. The said rule states that where the value of net goodwill removed from the block is in excess of the opening WDV as on April 1, 2020, such excess will now be offered to tax as STCG.</p><p><strong>Why it could be bad in law to treat net goodwill removed from the block as STCG? </strong></p><p>There could be two reasons for mounting a legal challenge to the amendments brought about in Section 50 and Section 55 of the ITA. So far as Section 50 is concerned, it deals with “computation of capital gains in case of depreciable assets” whereas Section 55(2)(a) deals with “Determination of Cost of Acquisition’ of an intangible asset. Typically, under the ITA, profits or gains arising from transfer of a capital asset are called “Capital Gains” and are charged to tax under the head “Capital Gains”.</p><p>It is pertinent to note that the amended Section 50 introduces a deeming provision whereby net WDV of Goodwill as on 1st April 2020 is deemed to be capital gain in the hands of the acquirer of the business and liable to be taxed as STCG just as other depreciable assets. Thus, what is being taxed under Section 50 is merely the net goodwill and not the net sale consideration of the intangible asset sold in the previous year, given that goodwill is no longer to be considered as a depreciable asset w.e.f. 1st April 2020. This militates against the salutary principle of computing capital gain under the ITA on the occurrence of a transfer of a depreciable capital asset in the previous year relevant to the year under assessment.</p><p>Secondly, the proviso inserted in Section 55(2)(a) seeks to reduce the purchase price of goodwill to the extent of the amount of depreciation claimed thereon in the period prior to 1st April 2020. This implies that while the statute (ITA) no longer recognises Goodwill as an asset for the purpose of claiming depreciation, it, however, seeks to reduce the purchase price of acquired goodwill to the extent of depreciation already claimed up to 1st April 2020 under the clause which provides for determination of cost of acquisition of depreciable assets. Thus, while the recent amendment to Section 55 recognizes deduction of depreciation from the purchase price of Goodwill, however, the deeming provision of taxing net goodwill removed from the block of assets prior to 1st April 2020 creates a dichotomy that is inconsistent and hence bad in law.</p><p>These two provisions (Proviso to Section 50 and Proviso to Section 55(2)(a)) clearly appear to have been introduced in the statute to merely deny the assessees, their legitimate right to claim depreciation on goodwill. Taxing the net goodwill removed from the block of intangibles prior to 1st April, 2020 by the acquirer of a business as his capital gain in the financial year commencing from 1st April 2020 appears to have been introduced in haste without finding the need for cogent legal basis.</p><p>Hence, a view could be adopted that subjecting net value of goodwill removed from the block of intangible assets on 1st April 2020 to tax as short-term capital gain is bad in law and a legal challenge, if mounted against these provisions, may survive.</p>