The Hindu Business Line : Depreciation on intangibles in M&A

With India Inc actively pursuing mergers and acquisitions route for their expansions, and valuations reaching dizzying heights, the consequent availability of tax deductions on goodwill and other intangible assets has become a sore point.

The income-tax law way back in 2000 had made considerable amendments dealing with business reorganisations which made `M&A' tax neutral, however, scope of some of these provisions need to be revisited especially the issue of depreciation on cost of intangibles, since it has a significant tax impact .

Legislative history

The Government had made a case for substituting several provisions under the Income Tax Act, 1961 (`the Act') and rolled them into the revised Section 32 with a concept of depreciation on intangibles.

Definition of `block of assets' was amended vide the Finance Act (No. 2) 1998 to include `intangible assets' and correspondingly Section 32 was amended to allow depreciation on intangible assets. Sections 35A and 35AB which earlier provided for amortisation of expenditure on patent rights, copyrights and know-how over a period of six years was also amended and such expenditure was to be treated as intangible assets eligible for depreciation.

The Government has rationalised tax laws and introduced provisions to allow expenses on merger as tax deductible, which were not permitted earlier. There has clearly been a strategic shift in the Government's attitude towards M&A provisions, however, there is still a case to review the provisions relating to slump sale, merger / demerger that strictly do not satisfy the conditions under the Act, in which case tax concessions would not be available.

The Supreme Court in a landmark judgment involving BC Srinivasa Setty 128 ITR 294 ruled that it is not possible to evaluate the cost of goodwill, as it is a self-generated asset. To overcome this judicial interpretation, Section 55(2)(a) was amended by the Finance Act, 1987, to state that the cost of acquisition in case of goodwill would be the purchase price and in case of self-generated goodwill it will be nil. Thus purchased goodwill is now specifically recognised as a capital asset. M&A transactions usually results in the transferee company paying a consideration higher than the value of the assets taken over, which is accounted as `Goodwill'. A moot point from an income-tax perspective is whether such goodwill, being an `intangible asset', would be eligible for tax depreciation.

The term `intangible assets' as per the Act does not categorically include goodwill. Hence, the issue is whether goodwill can be considered as a business or a commercial right in the nature of patent, copyright, trademarks, licence, franchises etc. It cannot be denied that certain inherent rights may be attached with goodwill when a business is purchased, like an established customer base, vendor relationship, established skilled workforce, etc.

Though the goodwill may represent different intangible rights or benefits, it still represents an asset acquired by the company, and hence should be allowed to be amortised. Without such amortisation, it would have a distortion as it would result in tax on notional income. Accounting Standard 26 on `Intangible Assets' allows amortisation for books purposes.

Views of Indian Courts

Ahmedabad Tribunal in Bharatbhai J. Vyas v. ITO 97 ITD 248 held that depreciation is allowable only in respect of intangible assets specified in the provisions of the Act and depreciation on goodwill is not allowable as it is not covered under those specified assets.

Recently in Delhi ITAT's ruling involving Guruji Entertainment Network 108 TTJ 180, the assessee, engaged in the business of production and telecasting of serials, acquired a firm with all rights and liabilities including copyrights, business & commercial rights of its stock of serials.

The company based on an independent valuation, capitalised the intangibles and claimed depreciation thereon which was disallowed by the Revenue on the grounds that the assessee acquired goodwill from the other firm which is not depreciable.

However, the ITAT held that intangible assets in the nature of copyright, trademark, patent, licences etc. are depreciable and since assessee acquired copyright and related commercial and business interests, the same is depreciable. Thus, the assessee was entitled to depreciation on the cost representing the value of intangible assets except goodwill. Even though transferor companies could take advantage of the above ruling to allocate part of the purchase consideration towards business or commercial rights, this position is a subject matter of huge controversy, since it has not got the affirmation from higher judicial authorities.

Treatment across borders

Deductible

UK: Tax treatment of goodwill and other intangible assets and aligned closely with their accounting treatment. Amortisation of goodwill and intangible assets acquired after April 2002, is tax deductible.

US: Purchased intangibles, including goodwill, going concern value, patents, copyrights and non-compete fee may be amortised over 15 years and claimed as tax deductions.

Germany: For tax purposes, goodwill has to be depreciated over a 15-year period. All other assets are depreciable in line with the published depreciation rates.

Switzerland: The tax depreciation is usually either 40 per cent p.a. for five years on a declining balance basis (the balance being claimable in the last year), or 20 per cent p.a. on a straight line basis.

Not deductible

Hong Kong: Goodwill should not be amortised, instead it shall be subject to annual impairment test. Goodwill impairment loss is not deductible for tax purpose.

Singapore: Goodwill written off or amortised is not deductible for tax purposes on the basis that it is capital in nature.

Australia: Goodwill paid for business as a going concern can neither be deducted nor amortised for tax purposes. However, few payments giving rise to intangible assets may be amortised and deducted for tax purposes

In countries such as the US, the UK, Switzerland and the Netherlands, goodwill is allowed to be amortised over a specified period for tax purposes.

Since business acquisitions are imperative for growth of business in the days to come, allowability of depreciation on goodwill will only integrate the Indian tax laws with international practices. The tax authorities should take a cue from the accounting norms which have been amended specifically for the same purpose.

Depreciation on non-compete fees

Another type of payment which is becoming increasingly common in acquisition deals is that of non-compete fee which is generally paid to ward off competition. Though there is a clear provision for taxability of the said fees in the hands of recipient, there is an ambiguity on the tax deduction of the same in the hands of the payer.

There are plethoras of judgments that have held that sums paid as compensation towards non-compete results in enduring benefit and therefore cannot be allowed as revenue expenditure. In this scenario, the assessee's contention is that the non-compete fee should be allowed to be written off over a number of years in the form of tax depreciation.

However, Courts in India have, on several occasion, disallowed the claim of depreciation on the grounds that non-compete fee cannot be construed as an asset which the assessee could use like royalty, franchise etc. for its business. It is a payment made to ward off the competitor for specified number of years and it only confers a right to sue in case of a breach.

There is a case for a simpler regime which either allows the non compete fee payment as revenue expenditure or allows depreciation on the same based on duration of the non compete period.

Under the present taxation regime, the cost that a company incurs in acquiring another company in the form of goodwill becomes a non-deductible cost from an income tax perspective, if it cannot be relatable to any business or commercial right. Further, there is no explicit provision for claiming deduction on non-compete fees.

In the absence of allowing corresponding deduction for high value intangibles, assessees are being forced to pay higher tax. It is in contradiction to the views of major accounting bodies, which have now permitted amortisation of such expenses in computing book profits.

To encourage M & A deals, it is suggested that the Government should clarify and explicitly state the position so that unnecessary litigation can be avoided.

(The authors are Bangalore-based Chartered Accountants)

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