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DEPRECIATION
OF GOODWILL
AUTHORED BY - TAMILSELVI D
INTRODUCTION
Goodwill
essentially represents a company's reputation and plays a crucial role when one
buys a business. It reflects not just the personal value of the company but
also its business value, including its assets, contacts, and goodwill itself.
Previously, goodwill was considered a depreciable asset, meaning it provided
economic benefits over multiple reporting periods. The Income Tax Act, 1961,
defines two types of assets tangible and intangible but does not explicitly
include goodwill in either category. Although the judiciary had recognized
goodwill as a depreciable asset, this status was short-lived. The 2021 Union
Budget clarified that goodwill is not a depreciable asset.
The
Union Budget 2021 amended the Income Tax Act, 1961, to prohibit depreciation on
the goodwill of a company. The Act disallows depreciation on self-generated
goodwill, and from 01 February 2021, no depreciation is permitted on the
exercise of goodwill related to ownership interests. Goodwill is explicitly
excluded from the 'extraordinary assets' category. However, deductions for
payments made for the acquisition of goodwill are legally permissible upon its
sale. This raises the question of whether depreciation is allowable on acquired
goodwill, which we will explore in detail.
CONCEPT
OF GOODWILL AND DEPRECIATION
GOODWILL
MEANING
Goodwill is an invisible force, hard to earn and takes years to build, but
once earned, its benefits can be reaped for years and generations. The importance of goodwill transcends the
limited scope of a business and actually permeates an individual's life.
In business terms, goodwill is the amount of
value that a company's reputation adds to its overall value. Goodwill is the sum total of what a business
has done in the past, what it is doing in the present, and what it plans for
the future. A company's reputation
primarily depends on its behavior with customers, society and the environment,
development of trust in its brand, transparency in its processes and ethical
behavior of the company. If a business
manages all these, it will automatically gain goodwill for the company or
brand.
Goodwill is the reputation of
a business. Goodwill is considered as an intangible asset for any organization
or business. Goodwill generally reflects the value of intangible assets such as
a strong brand name, good customer relationships and good employee relations. Goodwill
is calculated on the difference between the total value of the company and the
value of its net tangible assets.
VARIOUS
FEATURES OF GOODWILL
In a business context, "goodwill"[1]
refers to the intangible value of a company's reputation, brand name, customer
loyalty, and other factors that contribute to its overall positive perception
in the market. Goodwill is often associated with the excess of the purchase
price of a company over its net tangible assets when another company acquires
it. Here are some key features and aspects of goodwill:
Intangible Asset:
Goodwill is an intangible asset, meaning it does not have a physical existence
but represents the value of non-material elements of a business.
Brand Value:
One of the primary components of goodwill is a company's brand value. A strong
brand name, positive brand recognition, and customer loyalty can significantly
contribute to the goodwill of a company.
Customer Loyalty: Companies
with a loyal customer base tend to have higher goodwill. The positive
relationship with customers can lead to repeat business, referrals, and
increased sales.
Reputation: A
company's reputation in the market, among customers, suppliers, and other
stakeholders, can impact its goodwill. A positive reputation can attract more
business opportunities and support growth.
Employee Skills and Experience:
The skills, experience, and expertise of the employees can contribute to a
company's goodwill. Highly skilled and motivated employees can positively
influence the company's performance and reputation.
Favorable Supplier Relationships:
Goodwill can also be influenced by strong and favorable relationships with
suppliers, ensuring a steady supply of quality materials or services.
Patents and Intellectual Property: Owning
valuable patents or intellectual property can enhance a company's goodwill, as
it provides a competitive advantage and potential for future growth.
Customer Base and Market Share:
Companies with a large and diverse customer base or a significant market share
tend to have higher goodwill due to their established position in the market.
Market Presence:
The strength of a company's presence in various markets and geographic
locations can impact its goodwill.
Financial Performance: A
company's consistent and strong financial performance over time can contribute
to its goodwill, as it indicates stability and profitability.
Strategic Advantage:
Goodwill can arise from having a unique strategic advantage, such as
proprietary technology, exclusive licenses, or a dominant market position.
It's important to note that goodwill is
subject to impairment testing, and if there is a decline in the factors
contributing to goodwill, the company may need to write down its value on the
balance sheet. Additionally, the accounting treatment of goodwill varies based
on accounting standards, such as Generally Accepted Accounting Principles
(GAAP) or International Financial Reporting Standards (IFRS).
TYPES
OF GOODWILL
There are two distinct types of goodwill: acquired and inherent.[2]
1. PURCHASED GOODWILL
Purchased goodwill arises when a business concern is purchased for an
amount greater than the fair value of the separable acquired net assets. As a result, it is shown as an asset on the
balance sheet—a type of goodwill that is recognized in a company's accounts.
2.
INHERENT
GOODWILL
Inherent goodwill is the opposite of purchased goodwill and represents
the value of the business rather than the fair value of its separable net
assets. This type of goodwill is
internally generated and arises over time due to reputation, and can be
positive or negative.
Inherent goodwill is, of course, better to have. Best of all, it costs you nothing and you can
get a lot out of it. Intrinsic goodwill
takes a lot of time to build, however, certain factors have a major impact on
it.
DEPRECIATION
MEANING
Depreciation
refers to the accounting method used to allocate the cost of a tangible or
intangible asset over its useful life. Depreciation refers to how much an
asset's value has been used up. It allows companies to generate revenue from
assets they own by making payments over a period of time.
Since companies do not have to
fully account for assets in the year they are acquired, the immediate cost of
ownership is significantly reduced. Not accounting for depreciation can greatly
affect a company's profitability. Companies may depreciate long-term assets for
tax and accounting purposes.[3]
Depreciation
can be compared to depreciation, which accounts for the change in value of
intangible assets over time
Section 32 of the Income Tax Act 1961 talks about
depreciation.
Depreciation
means that over time, any asset deteriorates and loses its original value. Depreciation is when a purchased asset loses
its monetary value due to wear and tear, time and daily use.[4]
The monetary value of an asset decreases over time due to use, wear and
tear or obsolescence. This decrease is measured as depreciation.[5]
VARIOUS
FEATURES OF DEPRECIATION
Depreciation is an accounting method used to
allocate the cost of tangible assets over their useful life. This process
allows businesses to spread the cost of acquiring an asset over its expected
lifetime, matching the expense with the revenue generated from using the asset.
Here are some key features of depreciation:
Cost Allocation: Depreciation helps allocate the cost of an asset
over its useful life rather than expensing the entire cost in the year of
purchase. This is more representative of the asset's actual contribution to
revenue generation over time.
Non-Cash Expense: Depreciation is a non-cash expense, meaning no
actual cash outflow occurs when recording depreciation. It only affects the
book value of the asset and reduces the company's net income.
Useful Life: Assets have a limited useful life, which is the
estimated period they can be effectively utilized by the business. Depreciation
is calculated based on this useful life.
Residual Value: The residual value (also known as salvage value or
scrap value) is the estimated value of the asset at the end of its useful life.
It is subtracted from the original cost when calculating depreciation.
Depreciation Expense: This is the amount of depreciation recorded on the
company's income statement for a specific accounting period. It reflects the
portion of the asset's cost that has been allocated as an expense during that
period.
Accumulated Depreciation: This is the total depreciation expense recorded for
an asset since its acquisition. It is a contra-asset account and reduces the
asset's book value on the balance sheet.
Book Value: The book value of an asset is its original cost
minus its accumulated depreciation. It represents the asset's net carrying
value on the balance sheet.
Impacts on Taxes: Depreciation is often tax-deductible, allowing
businesses to lower their taxable income and reduce tax liabilities.
Depreciation Policies: Companies must choose a
consistent depreciation policy for each class of assets, adhering to generally
accepted accounting principles (GAAP) or international financial reporting
standards (IFRS).
Depreciation Schedule: A depreciation schedule
outlines the depreciation expense for each accounting period over an asset's
useful life.
Depreciation for Different Asset Classes:
Different types of assets (e.g., buildings, machinery, vehicles) have different
depreciation rates and useful lives, depending on their nature and expected
longevity.
Overall, depreciation plays a crucial role in
financial reporting, as it accurately reflects the wear and tear of assets and
their diminishing value over time. Properly accounting for depreciation is
essential for presenting a company's financial position accurately and making
informed business decisions.
TYPES
OF DEPRECIATION
There are four common methods of calculating depreciation for an asset,
each with its own advantages and disadvantages. Here's a brief overview of each
method:
1.
Straight
line depreciation: This method evenly spreads the cost of an
asset over its useful life, with the same amount of depreciation being recorded
each year. This is a simple and straightforward method, but it may not reflect
the actual decline in an asset's value over time.
2.
Units
of production depreciation: This method bases the depreciation on
how much the asset is used or produces. The more an asset is used, the more
depreciation is recorded. This method is useful for assets that wear out faster
with use, such as machinery or vehicles.
3.
Double
declining balance depreciation: This method records more
depreciation in the early years of an asset's life, and less in later years.
This reflects the fact that many assets lose value more quickly when they are
newer. However, this method can be more complex to calculate and may not be
suitable for all assets.
4.
Sum
of years' digits depreciation: This method also front-loads
more depreciation in the early years, but it uses a formula based on the number
of years in the asset's useful life to determine the rate of depreciation. This
method may be useful for assets that have a predictable pattern of decline in
value over time.
Ultimately,
the choice of depreciation method will depend on the nature of the asset, the
company's accounting policies, and other factors such as tax implications.[6]
DEPRECIATION OF GOOD WILL
Goodwill is easy to describe but
difficult to define. Goodwill is an intangible asset that represents the value
of a company's reputation, customer relationships, and other non-physical
assets. It consists of an established business apart from a new business any
excess of the net value of the asset taken in liquidation is called goodwill.[7]
Depreciation of goodwill is now disallowed but continues to apply to other
intangible assets such as trademark; copyright etc. section 32 of income tax
rules provides provisions relating it depreciation. [8]We
know that the value of machinery, land etc. may decrease over time and this
decrease is called depreciation. Goodwill was considered a depreciable asset
because it fell into the category of intangible assets and was believed to
depreciation over time like any other asset. But the Memorandum to the Finance
Bill, 2021 states that goodwill is not a depreciation asset as it can be
appreciated rather than depreciated. This phenomenon of depreciation helped a
tax payer to pay taxes but now with the new law, a Pandora of new rulings will
surely open. Unlike physical assets such as machinery or equipment, goodwill
does not have a definite useful life and is not subject to wear and tear. As a
result, goodwill cannot be depreciated using the traditional methods of
depreciation.
However, accounting standards require that companies test goodwill for
impairment at least annually or more frequently if certain events occur that
suggest that the fair value of the asset may be impaired. Impairment testing involves comparing the
carrying value of the goodwill (i.e., the amount recorded on the company's
balance sheet) to its fair value. If the carrying value exceeds the fair value,
an impairment loss must be recognized to reduce the carrying value to its fair
value. This impairment loss is reported as a non-operating expense in the
company's income statement.
In summary, while goodwill cannot be depreciated using traditional
methods, it is subject to impairment testing to ensure that its value on the
balance sheet is not overstated. If an impairment loss is recognized, it will
reduce the carrying value of the goodwill on the balance sheet and result in a
non-operating expense in the income statement.
COURT DECISION
The ambiguity about whether goodwill is depreciable led to the question
of whether it could be treated as "any other similar commercial or
business rights." In the early
1980s, the Supreme Court of India defined the term goodwill as follows:
Goodwill refers to the benefit arising from
association and reputation. A variety of
elements go into its manufacture, and its composition varies in different
trades and in different trades within the same trade, and one element may predominate
in one trade, while another may predominate in another. Its value may fluctuate from one moment to
another depending on changes in the reputation of the business. It is affected by the business, the
personality and business integrity of the owners, the nature and character of
the business, its name and reputation, its location, its impact on the
contemporary market, the prevailing socio-economic ecology, and introduction.
To older customers and acknowledged non-competition.[9]
The court did not address whether goodwill is
depreciable, which created much controversy, and was aggravated by conflicting
decisions rendered by various Indian courts and tribunals. Finally, in a judgment issued on August 22,
2012, the Supreme Court settled the issue, ruling that goodwill arising in a
joint venture fall within the ambit of the phrase "any other similar
commercial or business rights." An intangible asset is eligible for
depreciation as per Explanation 3(b) to section 32(1) of the Income Tax Act.
The Supreme Court decision held that taxpayers
were able to depreciate goodwill over a period of years, particularly in the
context of acquisition and/or restructuring transactions, thereby reducing
their taxable income and tax liabilities.
For about 10 years following the Supreme Court's decision, taxpayers
have been claiming depreciation of goodwill arising from business acquisitions
and other business reorganizations.
PROVISION
OF IT ACT DEALING WITH DEPRECIATION
The
Indian Income Tax Act, 1961 provides for the deduction of depreciation in
determining the taxable income of an assesses.
SECTION 32: DEPRECIATION
Section 32 of the IT Act lays down
the concept and procedure for depreciation.[10]
First, it classifies assets into two categories- tangible assets such as
buildings, machinery, plant or furniture and intangible assets such as
technical know-how, right, license etc.
In the case of tangible assets such as machinery, plant or furniture, depreciation
can be carried out by reducing the value of the asset if it exceeds a certain
value. It says that a car used for
tourism purposes and used outside India cannot be exempted. It also states that depreciation cannot be
allowed for new machinery in case of price reduction as per central government
norms. Section 32 of the Income Tax Act, 1961 deals with the provisions related
to the deduction of depreciation. Depreciation is a reduction in the value of
an asset over time due to wear and tear, obsolescence, or other factors. The
section provides for the calculation of depreciation on various assets used for
business or profession, such as buildings, plant and machinery, furniture,
vehicles, etc. Depreciation is allowed as a deduction from the income of the
taxpayer, which reduces the tax liability.
Section
32 of the Income Tax Act, 1961 deals with the provisions related to the
deduction of depreciation. Depreciation is a reduction in the value of an asset
over time due to wear and tear, obsolescence, or other factors. The section
provides for the calculation of depreciation on various assets used for
business or profession, such as buildings, plant and machinery, furniture,
vehicles, etc. Depreciation is allowed as a deduction from the income of the
taxpayer, which reduces the tax liability.
SECTION
45: CAPITAL GAINS
Section
45 of the Income Tax Act, 1961 deals with the provisions related to capital
gains. Capital gains arise when an asset is sold or transferred and the sale
price is higher than the cost of acquisition. The section provides for the
calculation of capital gains on various assets such as stocks, bonds, mutual
funds, real estate, etc. The capital gains are classified as long-term or
short-term, based on the holding period of the asset. The tax rate for
long-term capital gains is lower than that of short-term capital gains.[11]
SECTION 50: SPECIAL PROVISION FOR
COMPUTATION OF CAPITAL GAINS IN CASE OF DEPRECIABLE ASSETS
Section 50
of the Income Tax Act, 1961[12]
deals with the special provision for the computation of capital gains in case
of depreciable assets. Depreciable assets are those assets on which
depreciation is allowed as a deduction from the income of the taxpayer. The
section provides for the calculation of capital gains on the sale of such
assets, taking into account the depreciation claimed on the asset during the
period of ownership. The capital gains are calculated by reducing the cost of
acquisition of the asset by the amount of depreciation claimed on the asset.
The resulting amount is then taxed as capital gains.
RECENT
AMENDMENTS IN THE IT ACT REGARDING GOODWILL-AN ANALYSIS
The
decision to write off goodwill from depreciable assets has received a mixed
reaction from the tax community. Some of the fears (or we can say negative
side) of revision are-
This
will increase the tax burden. All recent contracts will have to be reviewed as
taxes will now be reversed as depreciation is no longer allowed. The memorandum
to the Finance Bill says that goodwill cannot be reduced but that is not true.
Goodwill can be impaired if a merger or acquisition goes wrong. There are of
course other instances where goodwill may be impaired. The proposal does not
differentiate between depreciation and amortization on wholesale in a merger
and acquisition agreement as goodwill has a different definition in the two
cases. The proposal would lead to double taxation, in which neither the buyer
nor the seller would benefit.
Depreciation
on goodwill is always an essential component in calculating the after-tax
returns of an acquisition proposal and can strongly influence the pay-back
calculations of every M&A deal and the associated negotiations in an
auction or offer price for an asset.
RECENT
AMENDMENTS
The most recent amendment to the provisions of depreciation under the
Income Tax Act was made by the Finance Act, 2021. The Finance Act, 2021 has
introduced certain changes to the provisions of depreciation under Section 32
of the Income Tax Act, which are as follows:
i.
Depreciation on goodwill: The Finance Act,
2021 has amended the definition of “block of assets” under Section 2(11) of the
Income Tax Act to include “goodwill of a business or profession” as a separate
block of assets. This means that the taxpayer can claim depreciation on the
goodwill of a business or profession separately, which was not allowed earlier.
ii.
Extension of time for claiming depreciation:
The Finance Act, 2021 has extended the time limit for claiming depreciation on
certain assets, such as buildings, plant and machinery, etc., from the previous
limit of 180 days to 270 days from the end of the financial year in which the
asset is put to use.
iii.
Increase in depreciation rate for motor
vehicles: The Finance Act, 2021 has increased the depreciation rate for motor
vehicles from 15% to 30% for vehicles purchased between April 1, 2020, and
March 31, 2021. This increase in depreciation rate is intended to provide
relief to the automobile industry, which has been impacted by the COVID-19
pandemic.
iv.
Introduction of new investment-linked
deduction: The Finance Act, 2021 has introduced a new investment-linked
deduction under Section 32AD of the Income Tax Act, which allows a deduction of
15% of the actual cost of new plant and machinery acquired and installed by a
taxpayer engaged in the manufacturing or production of any article or thing.
This deduction is available for investments made between October 1, 2020, and
March 31, 2023.
These
are the recent amendments made to the provisions of depreciation under the Income
Tax Act, 1961.
CIT v. Smifs Securities Ltd.[13]
In the amalgamation between YSN Shares and Smifs
Securities Ltd., the company incurred a bad debt and sought a depreciation
deduction of Rs. 54,85,430 for goodwill. Initially denied, the company
approached the Court, which ruled in its favor, allowing the deduction. The
Court recognized goodwill as an intangible asset eligible for depreciation,
applying the principle of 'ejusdem generis,' equating it with other business or
commercial rights of a similar nature.
Triune
Energy Services P. Ltd. v. DCIT[14]
The
assessing officer denied the deduction for goodwill. The assessee argued that
since the opposing party had goodwill, it should be deducted. The Delhi High
Court agreed, noting that goodwill, as an intangible asset, offers a
competitive advantage and various benefits when a business is acquired.
Bremko Brake India v. DCIT[15]
The income tax tribunal
ruled that acquiring a business includes acquiring intangible assets such as a
customer list and know-how, with goodwill being one of them, similar to
acquiring machinery and other tangible assets.
United Breweries v. ACIT[16]
The case differed in that
it did not directly support considering goodwill as a depreciable asset. The
ruling stated that an amalgamating company is not entitled to goodwill
depreciation if it is not claimed by the amalgamated company.
Pitney
Bowes India (P) Ltd. v. DDCIT[17]
The
company was denied a goodwill deduction as it had not previously claimed it
before the High Court and Supreme Court. The Court also rejected the
alternative plea to allocate the value of Government Authorizations/Approvals
(GAs) towards goodwill, as the taxpayer must adhere to the value assigned by an
independent evaluator.
CONCLUSION
Goodwill, once considered a
depreciable asset providing economic benefits over multiple reporting periods,
has undergone significant reclassification under the Income Tax Act, 1961
(Income Tax Act). The Act generally categorizes assets as either tangible or
intangible, with goodwill not explicitly included in either category.
Historically, the judiciary recognized goodwill as a depreciable asset, but
this status was short-lived. The 2021 budget clarified that goodwill is not a
depreciable asset.
Depreciation
on goodwill is crucial in calculating the post-tax return of an acquisition
proposal, significantly affecting pay-back calculations in M&A deals and
influencing bid or offer prices for assets. With the rise of pre-pack solutions
for stressed assets and Infrastructure Investment Trusts (InvITs) facilitating
the monetization of infrastructure like highways, airports, and railways, the
ability to depreciate goodwill could enhance returns for buyers. The government
might reconsider allowing depreciation on goodwill from business acquisitions,
potentially adjusting the depreciation rate to align with international
standards if necessary.
[1] Goodwill meaning - available at:
https://www.vedantu.com/commerce/goodwill / (visited on 05 May 2024)
[2] Goodwill types, available at: https://www.holded.com/blog/goodwill-meaning-features-types
(visited on 07 May 2024)
[3]What is depreciation- available
at: https://www.investopedia.com/terms/d/depreciation.asp
(visited on 08 May 2024)
[4]
Sec 139 of depreciation - available at: Income tax act,1961.
[5]Definition of depreciation- available
at : https://m.economictimes.com/definition/depreciation/amp
(visited on 08 May 2024)
[7] Depreciation of goodwill, available
at: https://taxguru.in/income-tax/depreciation-acquired-goodwill-allowable-provisions-income-tax-act-1961.html
[8]Depreciation relating provision – available
at: Income tax Act, 1961.
[9]Court decision, available at:
https://www.bdo.global/en-gb/microsites/tax-newsletters/corporate-tax-news/issue-59-july-2021/india-certain-goodwill-no-longer-eligible-for-depreciation#:~:text=Finance%20Act%2C%202021,-Finance%20Act%2C%202021&text=Effective%201%20April%202021%2C%20the,an%20asset%20for%20depreciation%20purposes
[10]Section 32 – available at: https://incometaxindia.gov.in/Acts/Finance%20Acts/1998/102120000000009269.htm#:~:text=(a)%20tangible%20assets%2C%20being,commercial%20rights%20of%20similar%20nature
(visited on 23 Feb 2023)
[11]Section 45-capital gain - available
at: Income tax department (visited on 23 Feb 2023)
[12]Section 50: Special provision for computation of
capital gains in case of depreciable assets –available at:
[13]CIT vs Smifs securities Ltd. - available at: https://itatonline.org/archives/cit-vs-smifs-securities-ltd-supreme-court-goodwill-is-an-intangible-asset-eligible-for-depreciation-us-32/#:~:text=Smifs%20Securities%20Ltd%20(Supreme%20Court),-Posted%20on%20August&text=Pursuant%20to%20an%20amalgamation%20of,goodwill%E2%80%9D%20and%20depreciation%20of%20Rs
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