Tax department move to tax goodwill could expand in the next Budget

A somewhat overlooked amendment in the direct tax laws, flying in the face of established accounting standards, has bulged out the tax receipts in this fiscal and is keeping tax experts on tenterhooks for the next union government budget, due on February 1. 

The amendment is about the treatment of goodwill by a business. Over the past decade several multinational companies and Indian companies have used this route to reduce their tax liability spectacularly. The largest of them was Vedanta’s Rs 20,000 crore write down in 2015. Others included Vodafone, BP and Tata Steel. 

While the new tax is not retrospective in nature, it will impact foreign companies buying into Indian companies going ahead. It will impact domestic mergers and acquisitions too. Taxation of goodwill as a concept is gaining traction globally too. The US based Financial Accounting Standards Board (FASB) proposes to issue norms to restrict the tax advantages under goodwill in the New Year. 

The tax mechanism 

How does this happen? Let us say a local food business buys a franchise from a multinational chain to sell pizzas in a rich segment of a city. If the local business builds a reputation on that franchise and is then bought out by another company, the value of the pots and pans in its store may not be as significant as the reputation it has built up on the franchise. The pots and pans are its tangible assets, the franchise and reputation is its goodwill, an intangible asset. Obviously it is of far more value and is the reason why the local food business gets a seller. 

The income tax department has said in the last Budget 2021, that this intangible asset is something whose value never goes down, instead it rises. There is, in taxation language, no depreciation of the asset possible. But this has created a problem, because domestic and international accounting standards allow companies the option of depreciation or what is known as impairment of these assets. Most of these assets, as in this case, are goodwill, but it can also include trademarks, patents or copyrights, among others. 

Impact on M&As

The changed classification has huge significance for mergers and acquisitions (M&A), for the future. In calendar years 2020 and 2021 the number of M&A deals reached “an all time high”, according to a Business Standard report. Deals valued at above $75 million each, were 165, compared with 219 in the three preceding years. Most of these M&A were in digital, renewables, electric vehicles, consumer and fintech according to a report by consultancy firm, Bain & Company issued this month. While the report does not say so the overriding rationale of these deals was the intangible assets they provided. 

International M&As into India has moved the country to the global fifth spot for recorded foreign direct investment, in calendar year 2020, an Unctad report shows. Indian FDI touched $64 billion in a year when global FDI shrunk. M&As in the service sector has continued apace among domestic services companies too. Tata Group bought out 1mg and BigBasket. The services sector including the technology space is a large play for the treatment of goodwill. Tax set-offs for all types of accelerated depreciation under section 32 of the Income Tax act cost the department Rs 50,251.56 crore in FY20, so there is clearly an attraction to catch some of that. As the data shows the new tax liability will fall on the foreign companies buying into Indian companies. 

According to Vikas Vasal, Global Leader-Tax at Grant Thornton, “The challenge is not that goodwill has been prized out of the list of assets on which no depreciation can be claimed. There should be a list of which other similar assets will also not be available for impairment.” He said such a list will reduce the scope for litigation. Significantly, the tax department seems to have sensed the mood well. While tax professionals have made out a case for more dialogue with the income tax department on the changes, none have asked for a reversal. It does not figure in the ask made out by the industry chambers to the finance ministry in the run up to the union budget. 

The direct tax department position was made clear in the last union budget in the memorandum that accompanies the laying of the Finance Bill. “It has been decided to propose that goodwill of a business or profession will not be considered as a depreciable asset and there would not be any depreciation on goodwill of a business or profession in any situation.” In a case where goodwill is purchased by a company it shall be treated as capital gains, the memorandum added. Subsequently in July, the finance ministry issued detailed rules for the tax treatment of goodwill, for future deals, in the process setting aside a Supreme Court judgment which allowed for the deprecation of goodwill. 

While India is not alone in seeking to tax goodwill in line with the new global thinking, Shyamal Mukherjee, former country director, PriceWaterhouseCoopers said the thinking of the tax dept “is at odds with what the Accounting Standard(AS) on Goodwill accounting/amortization states”. While the department is clawing back goodwill, others like trademark, copyright and patents could face similar tax treatment too. 

Under the accounting standards, goodwill is a cost and like all such expenditures should qualify for a tax set off, he said. The tax department begs to differ.