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Jeezan Riyaz
National Law Institute University, Bhopal
Abstract
Depreciation on goodwill has been in contention of late for the lawmakers and accountants. For an M&A transaction under normal circumstances, “many companies would end up buying companies for more than what the actual book value of the company is on its financial statements”, knowing that the balance payment can be recovered by depreciating goodwill and by lowering tax. However, the Finance Bill, 2021 has proposed significant changes in M&A circuit. As per the proposals contained in FB 2021, ‘goodwill’ is not considered to be a part of block of assets and hence is not eligible for depreciation. This research blog further tries to analyze the after-effects of the said amendment in light of M&A transactions and how tax departments will use this law to curtail certain transactions retrospectively. The main aim of the amendment has been on improving the tax administrative regime and paving way for foreign investors by encouraging a trustworthy system and easing of certain technicalities.
I. Introduction
Goodwill“is the value of things that cannot be directly measured, it’s an intangible asset which adds value to the company e.g. reputation. In accounting terms, it’s the difference between consideration paid and the total net value of the assets. Normally the companies after evaluating their balance sheet, carry forward the assets including goodwill, and therefore claim depreciation on goodwill in order to save themselves from paying more tax as would have been the case if goodwill was not allowed to be depreciated. It is argued that the companies claimed depreciation on goodwill to reduce tax liability and benefit out of a tax-neutral transaction. But the Union Budget, 2021 ended Corporate India’s “age-old practice on tax accounting and depreciation of”goodwill”.
II. An analysis of various rulings related to claim for depreciation on goodwill
The“Supreme Court of India held that the goodwill is an intangible asset and falls within the domain of any other business or commercial right of similar nature (such as patents, know-how’s, copyrights, licenses, trademarks, etc.) and thus can be depreciated.[1] But the Bangalore tribunal ruled against the findings of the Supreme court by stating that the SC based their decision on the mere fact that goodwill is an intangible asset and therefore can be depreciated. Section 32(1) of the Income-tax Act, 1961 states depreciation of goodwill on amalgamation cannot be greater than the depreciation that was allowable to the amalgamating company provided that amalgamation did not take place.[2] Normally goodwill is a self-generated asset and is not recognized in account books, it’s only when any buyer recognizes its value and pays consideration for the same, it can be depreciated but goodwill in itself not being depreciated, therefore in common parlance, depreciation should not be allowed to the amalgamated company as well. The main consideration put forth by the tribunal was the basis of “the principle that tax advantage cannot be derived out of a tax neutral transaction.” There has also has been debate regarding claim of depreciation on self-generated assets acquired via merger, demerger, succession, and upon conversion from firm to a company. The ruling of Karnataka HC in this matter was that goodwill can be depreciated even on conversion as there is a transfer of shares from a firm to a company and therefore both of them being different entities thus allowing claim for depreciation on goodwill provided it passes the anti-abuse provisions to ensure that intangible assets have commercial value and accordingly can be”depreciated.[3]
III. Amendments proposed by the Financial Budget
Section 2(11) normally defines the block of assets, but after the amendment it has excluded goodwill from the category of block of assets and accordingly will not be depreciated.[4]
Under normal circumstances, Article 32(1) provides for depreciation on intangible assets wherein the assesse must be the owner of the asset and the asset must be used for business purposes in an accounting year. The amendment has excluded goodwill from the category of assets and therefore cannot be depreciated therein.[5]
Section 50 lays down various provisions for the computation of capital gains. If an assesse sells a capital asset that forms part of the block of assets on which depreciation is allowed, the income therein is referred to as capital gains. In cases where goodwill forms part of the block of assets, the question of it being depreciated will be notified in due course of time.[6]
Section 55 has been amended to ensure that if an assesse claims depreciation on goodwill before the assessment year 2021-22, then the cost of such purchase of goodwill via acquisition will be reduced by such amount of depreciation claimed. If the goodwill is acquired from the previous owner, the cost of such goodwill will be equal to the purchase price paid for it, and in all other cases the cost will be nil.[7]
IV. International Standards for accounting of goodwill
In US, as per the GAAP & IFRS, goodwill is never depreciated because it is believed to have an indefinite life wherein its value can never be depreciated or amortized.[8] It is believed that companies via an acquisition deal normally would benefit by paying lower tax as goodwill was depreciated earlier and therefore to avoid tax benefits the said approach was approved in the US. In Italy, under the Italian Civil Code, goodwill is recognized under block of assets and can be depreciated only under exceptional circumstances where its useful life cannot be ascertained or estimated.[9] Therefore in Italy, goodwill is depreciated over a period of ten years at max.
In UK, similar approach is undertaken as that in the US and therefore goodwill cannot be amortized for the main reason that it has an indefinite life and its value doesn’t decrease so it cannot be treated like other intangible assets.[10] Goodwill only appears in the balance sheet when one company merges or acquires the other. In Canada, intangible assets are categorized in 2 main categories: intangible assets with a limited useful life and intangible assets with an unlimited and indefinite useful life and accordingly goodwill falls within the second category and therefore is depreciated.[11]
V. Impact related to budget
It’s“a no brainer that merger & acquisition transactions are set to become costlier as the budget announced that goodwill will no longer be depreciated and therefore no one can derive the tax advantage out of it. After the budget came out, goodwill all of a sudden lost its charm and now it will be extremely difficult to bargain between the sellers and buyers due to higher tax outflows, which will impact the business severely.
Not only this, the provision will apply retrospectively and would affect all such M&A transactions in the past as well wherein after an M&A deal, the goodwill was depreciated at a percentage that favored the acquirer immensely which no longer will be the rule now. Firms will be posed with the challenge of internal restructuring and would lead to a lot of litigation with regards the new change. Also the recent acquisition of Hindustan Unilever wherein they acquired Horlicks from GlaxoSmithKline PLC will have to go for proper internal restructuring as the prime consideration in this deal was depreciation on goodwill as Unilever expected around 1.3 billion euros of goodwill to be deductible for tax purposes.[12] The changes in the budget will have a very adverse impact on the buyers who have paid far more than the actual cost of the assets because the excess amount was paid for goodwill in order to avoid the tax liability. This proposal is a blow to internal group restructuring and strategic acquisitions. The budget has proposed to amend the Section 2(11) of the ITA[13], which defines block of assets, and Section 32 of the ITA to provide that neither should goodwill be included in the block of assets nor should it be considered as an asset to be depreciated under Section 32 of the ITA[14]. Not only this pending goodwill claims will also get affected and now M&A transactions will take place via traditional route,i.e. Purchase price considerations.
VI. Conclusion
So‘in my opinion I believe that in order to fix the equilibrium, the new change should apply only prospectively and not retrospectively, as it will unnecessarily lead to a lot of litigation and internal corporate restructuring. Moreover, all the transactions that had already taken place will put both the buyers and sellers at an unfair advantage of the new law, which didn’t exist when such M&A transactions took place. The new amendment has created an unambiguous arrangement wherein the seller is liable to pay tax on capital gains but the buyer is not allowed to claim depreciation on the capital gains, i.e. Goodwill. In nutshell, the M&A transactions will take a huge blow with respect to the new tax regime and disallowing’goodwill to be depreciated.
[1] CIT v. Smifs Securities Ltd., [252 CTR 233(SC)]. [2] Bangalore income tax appellate tribunal, I.T.A No. 722, 801 & 1065 Bang/2014, in the case of United Breweries Ltd. [3] Padmini Products Private Limited vs DCI (ITA No 154 of 2014. [4] The Income Tax Act, Act no. 43, § 2(11), 1961, (India). [5] The Income Tax Act, Act no. 43, § 32(1), 1961, (India). [6] The Income Tax Act, Act no. 43, § 50, 1961, (India). [7] The Income Tax Act, Act no. 43, § 55, 1961,(India). [8] Goodwill & Other Intangible assets (Issued 6/01), Summary of Statement no. 142. [9] Article 2426 (1), The Italian Civil Code by Royal decree no. 262 of 16 March 1942. [10] Finance (No 2) Act 2015 (F(No 2)A 2015. [11] Income Tax Act (R.S.C., 1985, C.1). [12] Sagar malviya, HUL acquires Horlicks from GSK for Rs 3,045 crore, The Economic Times. [13] The Income Tax Act, Act no. 43, § 2(11), 1961, (India). [14] Ibid, see footnote: 5.