Depreciation on goodwill: Final nail on the coffin by the Indian tax authorities?
S Vasudevan and Karanjot Singh Khurana of Lakshmikumaran & Sridharan explain why changes to the recording of goodwill will have far-reaching consequences on business acquisitions and reorganisations.
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.
Interestingly, Lord Macnagthen in Inland Revenue Commissioners v. Muller Co’s Margarin  AC 217 observed 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.
Therefore, 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.
However, 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.
As 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 depreciation
Indian 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).
Earlier, 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  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 department.
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
While 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).
The 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.
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.
Considering 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.
Executive partner, Lakshmikumaran & Sridharan
Karanjot Singh Khurana
Principal associate, Lakshmikumaran & Sridharan