The Hindu Business Line : Takeover of a going concern

In the Hooghly Mills case, the apex court held that no depreciation can be claimed in respect of gratuity liability even if it is regarded as capital expenditure.

Mergers and acquisitions are in. When companies are taken over as going concerns, extreme care is required in drafting the agreements. What is capital expenditure in one context may become revenue in another. Expenditure incurred in acquiring a running business will fall in the category of capital expenditure. Depreciation claims can be made for assets taken over. Not all capital expenditure will be eligible for depreciation.

This in spite of the fact that Section 32 of the Income-Tax Act, 1961 classifies assets into tangible and intangible and allows depreciation at 25 per cent even on the latter.

Still, certain types of capital expenditure may fall outside the ambit of the definition of assets entitled for depreciation.

Hooghly Mills case

In this case, Hooghly Mills Co. Ltd purchased an industrial undertaking by an agreement dated March 24, 1988. The amount of consideration agreed between the parties included Rs 5 lakh for land, Rs 35 lakh for building and Rs 1.60 crore for plant and machinery totalling in all Rs 2 crore.

The agreement mentioned that in addition to the Rs 2 crore, the accrued and future gratuity liability of the taken over workers payable under the Payment of Gratuity Act or otherwise including for the entire period of service with the vendor shall be on the purchaser's account and shall be met by the purchaser. The consideration for the sale, therefore, was not merely Rs 2 crore but it also included the accrued and future gratuity liability of the vendor. This amounted to Rs 3.5 crore.

Hooghly Mills claimed that it was entitled to depreciation under Section 32 of the Act on Rs 3.5 crore also. The Income-Tax department resisted this claim. According to the department, the entire expenditure of Rs 3.5 crore should be treated as revenue in nature in terms of Section 4 of the Payment of Gratuity Act.

The Kolkata High Court held that the liability of the employer to pay gratuity to the employees accrues as soon as the employee completes five years' continuous service at the rate of 15 days wages per year of completed service.

Employees whose service was continuing after the transfer of the undertaking were entitled to claim gratuity from the transferor on account of cessation of employment under him. The payment of gratuity to these employees till the date of transfer was deferred by reason of the terms of the agreement and the liability accrued till that date and payable by the transferor was taken over by Hooghly Mills Ltd. The liability thus became part of the total consideration for acquisition. It represented capital expenditure.

If the vendor company had paid those liabilities, it could have claimed the value thereof as cost of assets sold and, in that event, this amount would have been included in the cost of undertaking as consideration thereof. But this was taken over by Hooghly Mills and as such this was an adjustment of the amount payable as consideration. This cannot be excluded from the cost of consideration.

The Kolkata High Court ruled that the Rs 3.5 crore was to be distributed on different asset and depreciation should be allowed accordingly.

The I-T Department went to the Supreme Court in appeal. It is not clear why the Department took the stand before the Supreme Court that the Rs 3.5 crore should be treated as revenue expenditure. At any rate, objection was taken by the Department to the allowing of depreciation even on the Rs 3.5 crore.

Argument rejected

The Supreme Court rejected the argument about the Rs 3.5 crore being revenue expenditure. It held that the expenditure on taking over the gratuity liability is clearly a capital expenditure. But at the same time, no depreciation couldcan be granted on this amount. Mr Justice Markandey Katju of the Supreme Court explained that the gratuity liability did not fall in the category of knowhow, patents, copyrights, trademarks, licences, franchises or other business or commercial rights of similar nature categorised as intangible assets under Section 32.

No depreciation can, therefore, be claimed in respect of the gratuity liability even if it is regarded as capital expenditure. Depreciation cannot even be allowed on land, which is not mentioned in Section 32. The court pointed out that the agreement of sale separately mentioned the price of land, building and machinery.

The court also referred to the inclusive definition of the term "plant" in Section 43(3) of the Act. It said that even under this definition, the gratuity liability couldn't be brought in as plant. No depreciation can be granted on the gratuity liability taken over by Hooghly Mills Ltd (2006 206 CTR SC 301).

Would the result have been different if the take over agreement had merely fixed the gross price without apportioning the same among various types of assets and liabilities? In other words, if the agreement had merely stated that the industrial undertaking is taken over as a going concern with all assets and liabilities, probably there could have been arguments that depreciation should be allowed on the entire consideration.

(The author is a Chief Commissioner of Income-Tax.)

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