AUGUST 03, 2021

By Dr Shrikant Kamat

INDIA recently introduced some significant amendments to its Income Tax law (The Income Tax Act, 1961 or 'ITA') whereby, goodwill has been de-recognised as an intangible capital asset and any depreciation availed thereon upto 1st April, 2020, if more than the written down value of the block of intangible asset has to be offered to tax from hereon. Also, not only is availment of depreciation on goodwill prohibited with effect from 1st April, 2020, depreciation availed on acquired goodwill until that date is required to be deducted from the purchase price of that goodwill in the books of the acquirer of a business. These amendments have been introduced in the ITA at a time when large, medium and small businesses in India are just trying to regroup their resources after two terribly crippling waves of the coronavirus pandemic. Obviously, industry associations, tax experts and economists, all have vociferously expressed their displeasure at this new development and it is generally felt that mergers and acquisitions (M&A) activity in the country will be certainly dampened further. Let us understand why this recent amendment will impact M&A deals in India.

M&A activity is also the pulse of India's economic activity

Business enterprises, quite obviously look to maximize profits through M&A transactions and it has been proven statistically that more often than not, these do achieve this objective. But there is an economic perspective too that is attached to any M&A transaction. Mergers are intended to drive economies of scale, implying reduction in average costs and making production more efficient. With many small and mid-size potentially strong businesses having witnessed prolonged sluggishness over the past 2-3 years, their owners, vendors, bankers and employees keenly have been keenly looking forward to being acquired by some other enterprise to prevent an inevitable shutting down.

In this sense, a merger can also be seen as a transfer of resources. A transfer from one, lesser capable and profitable to the more independent, robust and profitable one. This allocation of resources and avoidance of the wastage of a certain amount of manpower, machinery, product line or even talent, is a highly economical transaction. When the target company is on the verge of failing and shutting down completely implying cent percent layoff of employees and pushing it towards liquidation, the acquirer in fact takes over the control of the target company and thus saves it from bankruptcy.

M&As in some sectors often lead to a drop in prices due to strengthening of competition and even higher productivity. Consumers certainly stand to benefit immensely in such a situation. After the second wave of the Covid-19 pandemic, India is witnessing a phase of unemployment that has never been seen before. M&A deals do have the potential to create more skilled employment.

Even though the Indian Economy is massive in its scale, certain sectors and industries such as textile, agriculture, education, clothing, technology and automobiles can certainly do better with more investments. When two firms of the same industry merge, or one of them acquires the other, it aids in a bigger investment in research and development, technology, machinery and distribution network (marketing as well as sales).

India accounts for more than 12% of announced deals in the Asia Pacific region so far upto the end of March 2021, the highest ratio since at least 1998. The country's tally has jumped 18% from a year ago to .3 billion, defying an 18% slide for the region, according to data compiled by Bloomberg. With half a billion internet users and growing, India is witnessing exciting M&A action in technology driven sectors such as e-commerce and content streaming to messaging and digital payments.

M&A activity in India has been buoyant from 2015 to 2020, with a steady pipeline of more than 4500 deals with an aggregate value of more than 0 billion, according to a study by one of the leading Investment Banking Company. M&A activity has witnessed an accelerated growth in 2018, 2019 & even in 2020 inspite of the heavy toll on industrial activity taken by the onset of Covid-19. One major reason has been availability of large number of distressed deals enabled by the corporate insolvency resolution process under the Insolvency and Bankruptcy Code (IBC).

Importance of Goodwill in M&As

	Purchase Price: INR 100 Crore
	Goodwill  represents the excess of purchase price over the fair market value of a company's net assets. If a business is simply a collection of assets, why would an acquirer pay more than the fair market value of that collection of assets? There are two good reasons for his doing so.

Firstly, the value of a business can be greater than the sum of the fair value of each of its individual assets. For example, a certain cola brand is valuable on its own, but is far more valuable when combined with its distribution system.

Secondly, synergies (cost savings) arise as a consequence of strategic deals. Hence, based on the present value of these savings, the buyer would not hesitate in paying a price that is more than the aggregate value of all the assets of that business.

Treatment of Goodwill for tax purposes in some OECD member countries

The United States

In the US, M&A transactions can be structured as either a  stock sale or an asset sale. The choice of the structure also determines goodwill's tax implications.

Any goodwill created in an acquisition structured as an asset sale is  tax deductible and amortizable over 15 years   along with other intangible assets that fall under Section 197. However, any goodwill created in an acquisition structured as a stock sale is  non tax deductible and non-amortizable.

Under GAAP ("book") accounting,  goodwill is not amortized  but rather  tested annually for impairment  regardless of whether the acquisition is an asset sale or stock sale. However, goodwill amortization is  permissible for private companies. The purpose of this accommodation is to reduce the costliness of annual impairment testing on private companies that lack the internal accounting resources needed to perform the tests. However, these companies would have to restate all of their financials if they decide to go public in the future.

Germany

German tax law allows a straight-line depreciation of goodwill over 15 years. For German GAAP purposes, however, the depreciation period of goodwill is generally 5 years.

Belgium

Belgian accounting and tax laws allow amortisation of goodwill arising at the occasion of an asset deal. For Belgian tax purposes, the amortisation period, which depends on the elements included in the goodwill, is a minimum of five years, and the straight-line method must be applied. However, such depreciation is not available for goodwill if mergers or de-mergers, among other things, follow the business continuity (going concern) principle from an accounting perspective.

Luxembourg

Under Luxembourg Tax Law, purchased goodwill may be depreciated. The tax authorities accept depreciation of goodwill over its useful life. A depreciation period between 5 and 10 years is generally accepted.

South Korea

Under the Korean Tax law, goodwill can be amortized straight-line over a period of 5 years within the prescribed limit provided that the amortization expenses have been also recognized for accounting purposes.

Australia

Under Australia's Tax legislation, acquired intangible assets such as goodwill, do not have taxable effective lives and cannot be depreciated. Inspite of repeatedly receiving a large number of representations from trade, the Australian Government however, considers it impractical to change the treatment of self-generated intangible assets (including goodwill). In the eyes of that Government, there is not a strong case to change the treatment of acquired goodwill and intangible assets as this would involve a substantial cost to revenue and it is not clear that it would have a significant impact on investment and innovation. ¹

It can be seen from the above examples of relevant provisions of the income tax statutes of many OECD member countries that most allow depreciation of acquired goodwill for tax purposes. So far as Australia is concerned, the Government did review the existing position and continued with the disallowance provision based on a view that such a position would not have any significant impact on the investment and innovation climate in the country.

What was the tax treatment regarding depreciation (amortisation) of goodwill in India, prior to the recent amendment?

The depreciation, under the ITA, for specified assets is computed on the basis of 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 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 block of asset for income tax purposes.

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 assets 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.

So far as depreciation on goodwill is concerned, the Income Tax Authorities had consistently maintained a position that since Goodwill is not specifically mentioned in the ITA under the Block of Intangible Assets, 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, and not on the cost of Goodwill as recorded in the books of amalgamated company. Tax Authorities also relied on Explanation 2 to section 43(6) of the ITA, which states that 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 actually allowed in relation to the said preceding previous year. Thus, in the eyes of the Tax Authority, 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.

Accordingly, a view consistently adopted by the Assessing Authorities was to disallow the claim of depreciation of the amalgamated company during its assessment on the ground that it cannot claim depreciation on the assets acquired under amalgamation in excess of the depreciation which would have been allowable to the amalgamating company.

The controversy on allowing depreciation on acquired goodwill raged until the the Hon'ble Supreme Court of India settled the position once for all in Smifs Securities Limited (CIT Vs. Smifs Securities - 2012-TIOL-53-SC-IT 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.

Until the recent amendment to the ITA, regarding the position on the admissibility of a claim of depreciation on acquired goodwill under the ITA, companies invariably followed the Smif Securities law (supra), and thus a large number of mergers, acquisitions, slump sales and share sales that have been undertaken since the Smifs Securities decision (supra) 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.

The Basis for admissibility of depreciation on Goodwill under the Indian Accounting Standards (Ind AS)

Until the Smifs Securities decision, The Income Tax Authorities in India had consistently relied upon 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, amalgamated companies allocate a separate amount to Goodwill merely to avail depreciation. However, Ind AS 103 radically diluted this view held by the Authorities over the past 5 years or so in as much as it mandates that no goodwill is to be recoded only for common control business combinations ². However, Ind AS 103 recognises that in all other cases of business combinations, goodwill can be 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. In other words, 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.

Government may want to rethink the amendments on depreciation of goodwill

We have seen above that even though Australia is one of the few countries that disallows amortisation of goodwill from a tax perspective, the Australian Government did review this position and satisfied itself that continuing with the position wouldn't have any impact on investments and innovation in that country. However, so far as the introduction of recent amendments in the ITA related to depreciation on goodwill are concerned, the Finance Ministry in India ought to have undertaken a review of the impact such amendments would have on the investment and innovation sentiment in the country, given that unlike Australia where the economy has matured and not growing at a fast pace, India on the other hand is witnessing a mushrooming of start-ups and queuing up of stressed businesses for buyers, while its economy is still expected to clock a growth in excess of 6 percent, despite the two waves of Covid-19. Until the findings of that study are revealed, the said amendments may be put on hold (deferred) and only once empirical evidence supports the contention that withdrawing the benefit of depreciation on goodwill won't have any significant impact on investments, should the new amendments be made effective. Unless this is done, the glow of the Indian market may fade away, somewhat, which India can ill afford at this time.

[The author is Counsel, Taxation & Commercial Laws and the views expressed are strictly personal.]

¹ "Intangible Asset Depreciation" at https://treasury.gov.au/national-innovation-and-science-agenda/intangible-asset-depreciation__trashed accessed on 1 st August, 2021

² "Common control business combination" means a business combination involving entities or businesses in which all the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory