With the Finance Act of 2021, the dust has settled on the longstanding legal disputes and the judicial debate about whether the amortization of goodwill is deductible when calculating taxable corporate profits – the conclusion is negative.
Previously, the Supreme Court ruled in the case of Smifs Securities Ltd. on the permissibility of goodwill amortization as “other business or commercial rights of a similar nature” and therefore brought it to the meaning of intangible assets in Section 32 of the Income Tax Act of 1961. However, the matter was later contested. The Tax Act has now been amended to the effect that the goodwill (including the existing goodwill) of a company or profession is not considered a depreciable asset and a write-off on the goodwill of a company or profession is not permitted as a tax deduction . In the case of goodwill from an acquired business (acquired goodwill), the purchase price of the goodwill (adjusted for previously claimed depreciation) continues to be regarded as the acquisition cost for calculating the capital gains from the sale of the underlying business.
In making its decision, the central government stated in its memorandum which explains the provisions of the Finance Act of 2021 that goodwill is generally not a depreciable asset and in fact depends on how business goes. Goodwill can experience an increase in value or, alternatively, no decrease in value. Accordingly, there may be no justification for amortizing goodwill in the manner that amortization is required for other intangible assets or machinery and equipment.
It is interesting to note that global accounting standards, both the International Accounting Standards Board and the Financial Accounting Standards Board, in their recent proposals continue to consider whether goodwill is a wasteful asset and therefore must be written off or has an indefinite term as a result not amortized, but only depreciated if there is a loss in value of the related business. However, with the Finance Act of 2021 in India we closed that debate, at least from a tax point of view, that goodwill should not be written off.
Now let’s see how this can affect companies preparing their annual financial statements on March 31, 2021, and what stakeholders can expect from companies with tax-deductible goodwill.
The effects of this change could be material and likely have a negative impact on net income, cash flow and net worth, as follows:
The first three points are easier to decipher. Let’s try to understand the fourth point in detail. This is important and can potentially decrease the reported net income and net worth of certain companies.
According to IndAS, the goodwill of a company is not amortized for financial reporting purposes, but is checked for impairment at least once a year. If the fair value (or value in use) of the transaction in which such goodwill is contained falls below the reported carrying amount, an impairment loss is recognized in profit or loss. Prior to this amendment to the Finance Act of 2021, certain companies may have claimed tax benefits from the amortization of goodwill acquired, which in turn would have resulted in the recognition of a deferred tax liability.
Put simply, a deferred tax liability would have been recognized for the amount by which the book base of the goodwill exceeds the tax base – that is, for the portion of the goodwill that was used for tax purposes and caused a lower current tax expense.
After the amendment of the tax law, the loss of such a tax label on the value of the goodwill could lead to an additional deferred tax expense and an additional deferred tax liability, since tax depreciation on the goodwill is probably no longer possible, as the tax base for the acquired goodwill is expected to be restored through use is zero. Such a deferred tax expense would be recognized immediately in the income statement, which would lead to a decrease in net income and net assets.
The effects of the tax law change are explained using an example:
A company purchased a company on April 1, 2019 and recorded Rs 5,000 in goodwill which is tax deductible at 20% and the tax rate is 25%.
As noted below, due to the change in tax law during the year ended March 31, 2021, the company will recognize additional deferred tax expenses and liabilities of Rs 1,000.
In light of the foregoing, companies should carefully consider the impact of this change in tax law and their assessment of the expected nature of the recovery of goodwill (whether through use or sale) and adequately explain the financial implications of this change in their financial statements and results. This is sure to have an impact on valuation and related considerations in the future that will affect future corporate restructurings, mergers and acquisitions.
Sumit Seth is a Chartered Accountant and Partner at Price Waterhouse.
The views expressed here are those of the author and do not necessarily reflect the views of BloombergQuint or its editors.