Strategic acquisition of a target by an acquirer by paying the seller more than the company’s book net worth is fairly common in Mergers & Acquisitions (M&A) deals. The purchase price is generally based on the fair market value of assets/business. This typically occurs since the fair valuation of target factors in the value of the brand, or client base, or recurring revenue stream, which hitherto may not be recorded in the books by the target. The amount of the purchase price that exceeds the value of identified assets acquired is typically referred to as Goodwill.
In India, intangibles that qualify for depreciation under the Income-tax Act, 1961 (IT Act) are defined to include “know-how, patents, copyrights, trademarks, licenses, franchises and any other business or commercial rights of similar nature”. As “Goodwill” does not expressly find a mention in the list of intangible assets that qualify for depreciation, the claim of depreciation on goodwill has been a matter of debate for a considerable time with decisions on both sides of the spectrum.
The Supreme Court (SC), in its landmark decision of Smifs Securities Limited, put the debate to rest when it held that “Goodwill” is indeed an intangible asset in the nature of business or commercial right akin to other intangibles mentioned in the IT Act and should be eligible for depreciation as such. Following this SC decision, several subordinate courts/Income tax Appellate Tribunals (Tribunals) have extended relief in business acquisitions to tax payers by allowing depreciation claim on goodwill recorded in the books of the acquirer.
The Mumbai Tribunal recently had to deal with a similar issue of depreciation claim on goodwill in the case of Toyo Engineering India Ltd. (Toyo). In this case, Casablancas Gannon Engineering Limited (“CGEL”), a wholly owned subsidiary of Toyo, amalgamated with Toyo through a Court approved process. CGEL was registered as a company engaged in the business of providing technical consultancy services and letting out property on hire. The Bombay High Court (HC) had approved the Scheme of Amalgamation wherein it was stated that no shares would be issued by Toyo pursuant to the Scheme, since it involved merger/amalgamation of wholly owned subsidiary with its parent and that the shares held by Toyo in CGEL will be cancelled.
It seems from the jurisprudence of this decision that Toyo had followed the purchase method of accounting to account for this merger. The difference between assets and liabilities taken over and cancellation of Toyo’s investment in CGEL resulted in a debit balance, which was transferred to the Goodwill account by Toyo. It was on this Goodwill created that Toyo claimed depreciation for income tax purposes.
In the course of Toyo’s assessment, while the assessing officer did not allow Toyo’s depreciation claim on the Goodwill, the CIT(A) was more forthcoming and offered relief to Toyo on this ground. The aggrieved Income tax authorities filed an appeal with the Tribunal. In the first round of litigation, the Tribunal held that the consideration in the form of cancellation of investments cannot be said to have been for purchase of assets at book value, when the fair value of assets is much higher. Going further into the accounting of the transaction, the Tribunal noted that Goodwill shown in the books of accounts of Toyo at the time of amalgamation was a mere book entry and in the absence of any specific valuation of assets, liabilities and goodwill taken over of CGEL, no portion of consideration could be apportioned toward the purchase of Goodwill and consequently no depreciation claim could arise. The Tribunal also noted that the Bombay HC had not discussed the issue of genuineness of Goodwill at the time of approval of the Scheme.
Undeterred by the decision of the Tribunal and supported by the decision of the SC in the case of Smifs Securities, Toyo approached the Bombay HC for relief. The Hon’ble HC restored the matter to the Tribunal for fresh decision on merits and in accordance with law in view of SC decision in case of Smifs Securities.
It was in this second round of hearing that the Tribunal agreed that the Bombay HC while approving the Scheme, had issued specific directions to take book value of assets and liabilities of CGEL as it appeared in the Balance Sheet and balance amount was to be transferred to Goodwill Account of Toyo. Therefore, the accounting treatment followed to account goodwill was in line with the order of the HC approving the Scheme. Hence, genuineness/valuation of goodwill cannot be doubted. In this regard, the Tribunal placed reliance on a landmark decision of the Bombay HC in the case of Sadanand Varde, which held that a Scheme of Amalgamation passed by a HC has a force of statute. The Tribunal then following the Apex Court judgement in the case of Smifs Securities ruled in favour of Toyo and allowed its depreciation claim on Goodwill.
There is a common theme under both the SC decision in case of Smifs Securities and Tribunal’s decision in the case of Toyo on allowability of depreciation on Goodwill arising pursuant to merger. While in case of Smifs Securities, Goodwill arose as a result of excess of consideration discharged by the amalgamated company over the net worth of the amalgamating company, in case of Toyo Goodwill arose as a result of cancellation of investment of amalgamating company over the net worth of the amalgamating company. It will also be interesting to note that while rendering the Smifs decision, the limited question before the SC was whether Goodwill constitutes a depreciable asset. The SC clearly specifies that Smifs Securities had acquired a capital right in the form of Goodwill in the process of amalgamation.
There is no denial of the fact that once a Scheme of Arrangement (including for amalgamations), which allows a particular manner of accounting is approved by a HC, such treatment cannot be brushed aside by income tax authorities. This will also be supported by the fact that a listed company is required to obtain a certificate from its auditor that the accounting treatment contained in the Scheme is in accordance with the accounting standards specified by the Central government. Furthermore, under the Companies Act, 2013, this requirement to obtain auditor’s certificate has been extended even to unlisted companies (though not notified as yet).
While on this point, it would also be worthwhile to note that the Central Board of Direct Taxes constituted a Committee in December 2010 to suggest tax accounting standards in order to bring to rest litigations created by differences in treatment in the tax books and in financial accounts. This Committee recommended that no separate tax accounting standard need be notified for mergers in view of the accounting standard issued by the Institute of Chartered Accountants and specific provisions already provided in the IT Act. However, the Committee did recommend that suitable amendments be made to the IT Act to provide certainty on the issue of allowability of depreciation on goodwill arising on merger.
With the positive decision of the SC in case of Smifs Securities and other Tribunal/HCs following the footsteps of the SC, a tax payer can explore the option of revisiting their past M&A deals and plan for their future deals to evaluate the possibility of claiming depreciation on such Goodwill. In fact, one can be certain that depreciation claim on Goodwill will feature as a point of discussion between acquirers and sellers in negotiating the deal value and the manner of structuring the deal, i.e., Business acquisition or Stock acquisition. This becomes relevant, since unlike a Business acquisition, which allows an acquirer to record Goodwill by allocating the purchase price over the fair value of assets acquired; in case of stock acquisition, an acquirer may not be able to record Goodwill in his books and enjoy the consequential tax benefits, unless certain restructuring steps are undertaken subsequently.
One would need to be mindful that a Scheme of Arrangement, which would involve recordal of Goodwill in the books of the Acquirer company, may invite increased scrutiny of the Regional Director (RD) while obtaining his no objection. This assumes increased importance now, considering the recent circular issued by the Ministry of Corporate Affairs, which provides that a RD has to obtain inputs from the Income Tax Department to ensure that the proposed Scheme of Arrangement has not been designed to defraud the Revenue and consequently being prejudicial to public interest.
The Modi Government has been advocating clearer laws to reduce the ambiguity regarding various issues, in order to promote ease of doing business in India. Furthermore, with the advent of this new Government, the markets have also been abuzz with a number of big ticket acquisitions hitting the headlines. It needs to be seen now whether this deduction of depreciation on goodwill available to an Acquirer in certain situations would continue or whether the upcoming budget would amend/clarify the law either positively or negatively. Considering the number of prospective M&A deals and the importance of this issue, further clarity would be much appreciated by the investor community.
(Tejas Mody, an Associate Director with the Transaction tax practise has also contributed to this Article)