Budget 2021: No Goodwill Depreciation – Impact On M&ABloombergQuintOpinion
Picture an India Inc. boardroom discussion, taking place pre Feb.1, 2021, on a $1 billion business buyout. The business buyout may create $500 million of intangible assets, including an approximate goodwill of $400 million.
Will this goodwill be tax deductible? Yes, there is a legal basis for it to be so and, hence, it will give a potential benefit of approximately $100 million.
How does it impact the post-acquisition internal rate of return?
Should the company factor the present value of the benefit in the bid price?
Should the company consider a business purchase or merger option for acquisition and will it impact the claim of depreciation on goodwill?
In just a span of a day, Feb. 1, the answers to all these questions undergo a significant change, due to the changes proposed in the Finance Bill, 2021.
Treatment So Far
To provide perspective, Indian income tax laws prescribe the class of tangible and intangible assets that are permitted to be depreciated. The categories of tax-depreciable intangible assets are defined to mean know-how, patents, copyrights, trademarks, licences, franchises, or ‘any other business or commercial rights of similar nature’.
The language and scope of intangible assets do not explicitly deal with the issue of classification of ‘goodwill’ as an intangible asset and there has been much controversy on whether ‘goodwill’ qualifies as an ‘any other business or commercial rights of similar nature’ and accordingly, eligible for depreciation.
There are several decisions of high courts and the Income Tax Appellate Tribunals, often conflicting, on the classification of goodwill as an intangible asset, which added to the controversy. The Supreme Court in 2012 held that the phrase ‘any other business or commercial rights of similar nature’ includes goodwill and accordingly, provided the legal basis for a claim of depreciation on goodwill. The apex court did not delve into the issue on whether the entire amount recorded as goodwill is eligible for depreciation or not.
In line with the earlier favorable judicial decisions, corporates have been legitimately classifying the amount recognised as ‘goodwill’ as an intangible asset, eligible for depreciation (25% p.a. on a written down value basis) in computing profits under tax laws and thereby leading to a lower tax outflow.
This is one of many examples, where India Inc., before February 1, had factored in the benefit of such tax deduction in various intra-group and third-party M&A transactions.
The Changes Proposed
Against this backdrop, Finance Bill 2021 has proposed that ‘goodwill of a business or profession’ is not a depreciable asset, and, accordingly, the amount recognised as goodwill will not be eligible for depreciation in any situation.
This change has been proposed with effect from April 1, 2020, and, thus will apply to the current financial year as well as to goodwill acquired or recognized in earlier financial years since April 1, 1998!
Finance Bill 2021 further proposes that the price paid for the acquisition of goodwill will continue as a non-depreciable capital asset for the buyer and the cost base will be available in computing capital gains arising on the subsequent sale of the acquired business or goodwill.
The Bill does not make any distinction in relation to the treatment of goodwill recognised pursuant to ‘tax neutral’ business reorganisations such as mergers or demergers vis à vis goodwill recognised pursuant to business purchases, being fully ‘taxable transactions’. The memorandum accompanying the Finance Bill 2021 acknowledges that depreciation on goodwill in case of business purchase could be a ‘valid claim’.
In relation to goodwill recognised pursuant to tax neutral business reorganisations such as mergers or demergers, even post the ruling of the Supreme Court, the matter was being litigated by tax authorities given the interpretation of certain provisions of tax laws that may restrict such step-up. However, denying the benefit of depreciation on goodwill recognised in case of a business purchase is unfair as the seller will pay applicable taxes on the deal consideration.
The changes proposed by Finance Bill 2021, though applicable from April 1, 2020, appear to be retrospective in nature, given the way the provisions carrying out the amendments are worded. In the absence of any ‘grandfathering’ provisions, depreciation may not be available even for ‘goodwill’ recognised in M&A transactions undertaken prior to April 1, 2020.
Also, as these amendments are aimed at overruling the judgments that gave a legal basis to the claim of depreciation, one would have to wait and see the position tax authorities take with respect to the earlier claims of depreciation, pending finality, and whether these amendments bring closure to such open litigations.
For M&A transactions already consummated, the deal IRRs considered by India Inc. would undergo a significant change, as these IRRs would have assumed the tax benefit on goodwill.
This change will also have an impact of increasing India Inc. tax outflows, lowering the earnings per share on account of a possible write-off of tax assets and possible impairment of goodwill recorded in the financials. Similarly, for M&A negotiations presently underway, buyers will need to factor in the impact of these changes in finalising the bid price.
Another point to be considered is whether this restriction could also have unintended ramifications on depreciation claim on other classes of intangible assets such as customer relationships, dealer network, workforce etc., as these may be argued to be part of the goodwill of the business.
Going forward, the importance of purchase price allocation studies will increase manifold with the emphasis to ensure that valuation of both the tangible and the six categories of the specified intangible assets, if any, acquired are supported by appropriate documentation, as in case of any valuation dispute, the amount may get categorised as non-depreciable goodwill.
Companies will need to quickly move to the drawing board to assess the possible ramifications of these changes including on transactions undertaken during the present financial year. They will need to wait for the final amendments to be approved and see whether any carveouts are created for third-party un-related business purchase transactions as well as ‘grandfathering’ of transactions undertaken before February 1, 2021.
Lokesh Malik is Partner – M&A and PE Tax, KPMG in India.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.