Goodwill Amortization: Indian Tax Authorities’ Remaining Coffin Nail?

The latest change will have far-reaching consequences

The entry of goodwill in the accounts due to the acquisition or reorganization of businesses and their depreciation has been a long-debated issue under Indian Income Tax Law.

While many judgments were in favor of the right to write-off, there were still differences of opinion between the courts on some points. While taxpayers were all prepared to argue in the highest courts, the Treasury Department made certain changes to the 2021 budget to completely end such claims.

What is goodwill?

Although goodwill is not a term defined in Indian tax laws, common dictionaries describe it as a company’s established reputation seen as a quantifiable asset.

Interestingly, Lord Macnagthen in Inland Revenue Commissioners v. Muller Co’s margarine [1901] AC 217 found that goodwill is very easy to describe but very difficult to define. Lord Macnagthen described it as the benefit or advantage of a company’s name, reputation and association. He also stated that the goodwill does not have a separate existence and must be linked to the business.

Therefore, with every company acquisition, the buyer also acquires the goodwill associated with this business as a standard. Usually goodwill created over a certain period of time is not recorded as an asset in the books of the seller.

When assessing the transaction and negotiating the consideration, the parties take into account not only the market value of the tangible and intangible assets already recorded in the seller’s books, but also the goodwill associated with this transaction. Therefore, any premium paid by the buyer to the seller in excess of the reported net worth of the business, that is, the value of all other assets minus liabilities, is often recorded as goodwill on the buyer’s books.

Since the going concern acquisition itself can take various forms, such as slump sale, merger or demerger, the treatment of goodwill on the buyer’s books will also vary depending on several factors, including those that apply Laws and accounting standards.

Former depreciation law

Indian Income Tax Act provides for the depreciation of various tangible and intangible assets owned and used by the taxpayer for business purposes (see Section 32 of the Indian Income Tax Act 1961).

In the past, intangible assets were large enough to cover any know-how, patents, copyrights, trademarks, licenses, franchises or other business or commercial rights of a similar nature. Although goodwill was not specifically mentioned as one of the intangible assets, courts in India had ruled that goodwill falls under the expression “any other business or commercial right of a similar nature” using the principle of ejusdem generis (see CIT v. Smifs Securities Limited [2012] 348 ITR 302 (SC)).

Regardless of this, it is controversial whether there has been an acquisition of goodwill and whether the buyer is entitled to record goodwill in his business books in a certain situation / transaction. The way in which the company’s other assets and liabilities were valued also had a direct impact on the amount of goodwill and was often disputed by the tax department.

When dealing with goodwill in the event of an internal reorganization of business operations within a group of companies, in which there is essentially no transfer of ownership to a third party, the courts are divided.

The question was even more controversial in the case of a transfer of business in the context of a tax-neutral merger or division, as some provisions oblige the acquiring company to book the assets with the same value as they appeared in the books of the transferor, and also to exclude the claim Depreciation by the purchaser goes beyond what the seller could have asked for.

Recent amendment to exclude goodwill

While disputes were pending in higher courts on a variety of issues related to the right to amortization of goodwill, the government recently tabled a major amendment to explicitly remove “goodwill” from the scope of intangible assets excluded, on which a depreciation can be claimed (see § 8 Finance Act 2021).

The Tax Department’s memorandum to explain the aforementioned change specifically states that although the Supreme Court has classified goodwill as a depreciable asset, it may not be justified to treat goodwill as a depreciable asset, as the case may be As a business is run, goodwill can actually see an increase in value. The memorandum also states that the amortization of the goodwill of companies that were acquired by way of a tax-neutral merger / spin-off, etc., contradicts other legal provisions.

Against this background, the tax department has tried to resolve many controversies in one fell swoop by excluding goodwill from the group of depreciable intangible assets. Although the change is expected to come into force on April 1, 2021 (assessment year 2021–2022), it will also affect recent transactions in which goodwill was booked and written off for tax purposes.

Pursuant to this change, a new regulation has also been notified that provides for the recalculation of the amortized starting value of the block of intangible assets, which consists of any goodwill (see Rule 8AC of the Income Tax Rules 1962). Apart from the loss of possible future write-off claims on the goodwill, the rule provides that the taxpayer has to pay taxes on the excesses asserted in the past on this goodwill as short-term capital gains under certain circumstances.

Keep it up

The latest change will have far-reaching implications for future corporate acquisitions and restructuring, as one of the key factors in the valuation was potential tax savings from amortization claims on large goodwill recognized in such transactions.

Although the change is technically prospective, its impact even on transactions with significant goodwill over the past few years must be assessed. It cannot be ruled out that the tax authorities will question the valuation of the mechanism for assigning a higher value to goodwill (indirect reduction in the cost of other depreciable assets).

Since only the goodwill has been excluded, the possibility of identifying and recording other valuable intangible assets such as know-how, patents, trademarks, etc. at the time of acquisition and the possibility of amortizing them can be carefully examined.

With Vasudevan

Managing Partner, Lakshmikumaran & Sridharan

Karanjot Singh Khurana

Main shareholders, Lakshmikumaran & Sridharan

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