Depreciation on goodwill: Ultimate nail on the coffin by the Indian tax authorities?

The latest amendment will have far-reaching consequences

Recording of goodwill in the books
of accounts pursuant to acquisition or reorganisation of business and claim of
depreciation on it has been a long-debated issue under the Indian Income Tax Law.

While many of the rulings were in
favour of claim of depreciation, there were still differences of opinion among
the courts on certain issues. While the taxpayers were all geared up to battle
it out before the highest courts, the tax department has brought in certain
amendments in the 2021 budget to put an end to such claims altogether.

What is goodwill?

Though goodwill is not a term
defined in the Indian tax laws, common dictionaries describe it as the established reputation of a
business regarded as a quantifiable asset.

Lord Macnagthen in Inland Revenue
Commissioners v. Muller Co’s
Margarin (1901) AC 217observed
that goodwill is very easy to describe, but very difficult to define. Lord
Macnagthen described it as the benefit or advantage of the good name,
reputation and connection of a business. He also noted that goodwill has no
independent existence and it must be attached to the business.

whenever a business is acquired, the buyer also by default acquires the
goodwill associated with such business. Usually, goodwill which is
self-generated over a period of time is not recorded as an asset in the books
of accounts of the seller.

while valuing the business and negotiating the consideration, the parties not
only take into account the market value of the tangible and intangible assets
already recorded in the books of the seller, but also that of the goodwill
associated with the said business. Thus, any premium paid by the buyer to
seller over and above the recorded net worth of the business, i.e. value of all
other assets minus liabilities, is often recorded as goodwill in the books of
the buyer.    

the acquisition of business as a going concern itself may take different forms
like slump sale, merger/ amalgamation or demerger, the treatment of goodwill in
the books of the buyer also varies depending on multiple factors including applicable
laws and accounting standards.

Earlier law on

Income Tax Law provides for depreciation on various tangible and intangible
assets, which are owned and used by the taxpayer for the purposes of business (see
section 32 of the Indian Income Tax Act, 1961).

the scope of intangible assets was wide enough to cover any know-how, patents,
copyrights, trademarks, licences, franchises or any other business or
commercial rights of similar nature. Even though goodwill was not expressly
mentioned as one of the intangible assets, courts in India had held that
goodwill will fall under the expression “any other business or commercial right
of a similar nature” by applying the principle of ejusdem generis (see CIT v. Smifs Securities Limited (2012) 348 ITR 302 (SC)).

Inspite of
the above, whether goodwill can be said to have been acquired and whether the
buyer is entitled to record goodwill in its books of accounts in a particular
situation/transaction has been a subject matter of debate. Also, the manner in
which the other assets and liabilities of the business were valued had a direct
bearing on the quantum of goodwill and was often disputed by the tax

The opinion
of the courts has been divided on treatment of goodwill in case of internal reorganisation
of business within a group of companies, where in essence there is no transfer
of ownership to a third party.

The issue
has been even more contentious in case of transfer of business under a tax
neutral amalgamation or demerger, as some provisions require the transferee
company to record the assets at the same value as they were appearing in the
books of the transferor and also bar claim of depreciation by the transferee in
excess of what could have been claimed by the transferor.

Recent amendment to
exclude goodwill

disputes were still pending before higher courts on a multitude of issues
relating to claim of depreciation on goodwill, the government has recently
brought in a significant amendment to expressly exclude ‘goodwill of a business
or profession’ from the scope of intangible assets on which depreciation can be
claimed (see Section 8 of the Finance Act 2021).

memorandum issued by the tax department to explain the said amendment expressly
states that though the Supreme Court had held goodwill to be a depreciable
asset, it may not be justified to treat goodwill as a depreciable asset as
depending on how a business is run, goodwill may actually see appreciation in
its value. The memorandum also states that allowing depreciation on goodwill of
businesses acquired by way of tax neutral amalgamation/demerger, etc. will be
contrary to other statutory provisions.

In this
background, by excluding goodwill from the scope of intangible assets eligible
for depreciation, the tax department has sought to put many controversies to
rest in one stroke. Though the amendment is said to be prospectively coming
into effect from April 1 2021 (assessment year 2021–2022), it will also impact
any transactions undertaken in the recent past wherein goodwill was recorded in
the books and on which depreciation was claimed for tax purposes.

Pursuant to
this amendment, a new rule also has been notified which provides for the manner
in which the opening written down value of the block of intangible assets
comprising of any goodwill is to be recomputed (see rule 8AC of the Income Tax
Rules 1962). Apart from the loss of potential depreciation claim on goodwill
going forward, the rule requires the taxpayers to pay taxes on excess
depreciation claimed in the past on such goodwill by deeming the same as short-term
capital gains in certain circumstances.

Way forward

The latest
amendment will have far-reaching consequences on business acquisitions and
reorganisations going forward, as potential tax savings arising out of claim of
depreciation on huge amounts of goodwill recorded during such transactions has
been one of the important factors impacting valuation.

Though the
amendment is technically prospective, its impact even on the transactions
undertaken in the past years involving substantial amount of goodwill will have
to be evaluated. The possibility of tax authorities questioning the valuation
of mechanism in an attempt to attribute higher value to goodwill (indirectly
reducing the cost of other depreciable assets) cannot be ruled out.

what has been excluded is only goodwill, the possibility of identifying and
recording other valuable intangible assets like know-how, patents, trademarks,
etc. at the time of acquisitions and the possibility of claim of depreciation
on the same may be carefully evaluated.

S Vasudevan

Executive partner, Lakshmikumaran & Sridharan


Karanjot Singh Khurana

Principal associate, Lakshmikumaran & Sridharan

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