(First Published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/intangibles-conundrum-amortise-or-not)
Background
Consider a case where a company (“Company A”) intends to acquire the business of another company (“Company B”) through a cash neutral and a tax neutral transaction. In such a scenario, various corporate structuring routes through an “amalgamation” or a “demerger” through a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 could be explored. The basic mechanics of such a structuring route could either be as under:
- Amalgamation of Company B into Company A, where all the assets and liabilities of Company B are vested upon with Company A, lock, stock, and barrel, including the entire business, contracts, employees, legal proceedings, intangibles, technical know-how, brands, etc. In consideration of the said amalgamation, Company A would issue its shares to the shareholders of Company B; or
- Demerger of an identified “undertaking” (i.e., business of Company B) to Company A, where the identified assets and liabilities, including the business, contracts, employees, legal proceedings, intangibles, technical know how, brands, etc. of that particular undertaking would vest upon Company A. In consideration of the same, Company A would issue its shares to the shareholders of Company B.
Accounting Implications under IndAS
Assuming that Company A and Company B are unrelated parties, and therefore, both the companies are not controlled ultimately by the same set of shareholders before and after the said business combination, and assuming that Company A follows IndAS accounting, which would be so if Company A is listed, or if the net assets of Company A are in excess of INR 250 Cr, then Company A would be required to account for the said business combination as per “Acquisition Method” of accounting prescribed under IndAS 103 : Business Combinations.
The said standard provides for recognition of assets and liabilities of the transferor company (i.e., Company B) at fair value, recognition of the consideration issued at fair value, and recordal of the difference between the fair value of consideration issued and the fair value of net assets recorded as residual goodwill.
One important aspect in Acquisition Method of accounting is that even previously unrecognised intangible assets in the books of Company B could be recorded as an intangible asset in the books of Company A, and therefore, the amount of residual goodwill would only be recorded after recognising such previously unrecognised intangibles. IndAS 103 provides a guidance with respect to the same. The acquirer (i.e., Company A) shall recognise, separately from goodwill, the identifiable intangible assets acquired in a business combination, if the said intangible assets either the separability criterion or the contractual-legal criterion.
The separability criterion means that an acquired intangible asset is capable of being separated or divided from the acquiree and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, even if the entity does not have the intention to sell it. The contractual-legal criterion may arise from licenses, contracts, or other types of agreements, and is identifiable even if it does not meet the separability criterion.
In the context of the above, while the obvious intangible assets that would meet the criterion of separability or ownership would be brands, trademarks, etc., a question arises whether certain other intangible assets could be recognised as an intangible asset or not.
For example, an acquirer entity may be able to recognise customer lists, essentially a database, which are acquired in a business combination, as an intangible asset, provided its fair value can be reliably measured based on the future economic value the acquirer will derive from it. The ability to sell the list or to exchange it provides evidence that it is separable from the goodwill arising on acquisition.
Conversely, any sign-on payment to top employees may not be recognised as an intangible asset and should be expensed out since the same has not established a right to future benefit over which the acquirer has control, given that the employees may leave during the contract period, and use their skills elsewhere. An intangible asset in this regard could have been recognised if there was an enforceable contract with an embedded non-compete clause, enabling the entity to recover the sign-on payment in the event the employee leaves and depriving the competitors from use of the said employees.
Another example of the recognition of an intangible asset on acquisition would be if the transferor entity has established a substantial repute for itself but has not registered or recognised any brand name in its books. On merger, the transferee entity also pays for such right to use the transferor’s brand and reputation with customers and suppliers, and could be capitalised in the merged entity, barring others to use the same brand.
IndAS 103 thus elucidates that intangible assets may be recognised at fair value in the books of the transferee even if it was not recognised by the transferor.
Interplay with Amortisation under the Income-tax Act, 1961 (“Act”)
While one may recognise the intangibles under IndAS 103 as a part of business combination, the key question is whether the same is eligible for amortisation under section 32 of the Act. Before going into the merits in favour of amortisation of such intangible assets under section 32 of Act, it is imperative to note that in the case of U.P. State Industrial Development Corporation[1], the Supreme Court had emphasized on the well-accepted proposition that for the purposes of ascertaining profits and gains, the ordinary principles of commercial accounting should be applied, so long as they do not conflict with any express provision of the relevant statute. The said principle was again retreated by the Supreme Court in the case of Woodward Governor[2] wherein it held that profits for income-tax purpose are to be computed in accordance with ordinary principles of commercial accounting, unless such principles stand superseded or modified by legislative enactments.
In other words, it can be said that accounting treatment of any transaction is relevant only to the extent they are not in conflict with the express provisions of the Act. In case of a business combination, therefore, where the Act does not provide for any guidance on recordal of intangibles pursuant to a merger or demerger, the accounting principles enshrined in IndAS 103 (or under purchase method of accounting under AS 14) should prevail.
Position post Amendment to Section 32 vis-à-vis Smifs Securities Case
In the case of Smifs Securities Ltd[3], the Supreme Court had held that ‘goodwill’ is an intangible asset eligible for depreciation under the provisions of section 32 of the Act. In this case ‘goodwill’ had arisen as a result of amalgamation of two companies.
The difference between the consideration for amalgamation and the net book value of assets of the amalgamating company was regarded as ‘goodwill’ and depreciation was claimed thereon. The taxpayer argued that the extra consideration was paid towards the reputation which the amalgamating company was enjoying in order to retain its existing clientele. The Supreme Court did not deliberate on the issue of the amount of goodwill, which was previously not recognised in the books of the transferor company, since it can be considered as “cost of acquisition” within the meaning of section 43(6) or section 49 of the Act. Given that the cost of goodwill in the hands of the previous owner was NIL, such “inflated” cost recorded in the books of the transferee company, being the difference between consideration paid and net assets acquired, could be considered as a cost base for the purposes of recognising goodwill and claiming amortisation under section 32 of the Act.
Be that as it may, the provisions of section 32 of the Act have since been amended, and now section 32 provides that goodwill shall not be considered as an asset eligible for amortisation. Consequently key question to be analysed is whether other intangible assets such as brands, technical know-how, customer lists, etc. which are recognised in accordance with the principles of section 32 could be eligible for amortisation under section 32 of the Act.
Analysis of “Cost to the Previous Owner” under section 43(6)
Section 43(6) provides, inter alia, that the written down value of block of assets taken over by the successor entity (i.e., Company A) shall the same as it would have been in the hands of the transferor company (i.e., Company B). Therefore, a question arises as to when the written down value or the cost of intangibles was NIL in the hands of Company B, whether the recording the same at fair value by Company A could result in juxtaposing a NIL value with the fair value, and therefore, whether a claim of amortisation, subject to discussion on section 32 of the Act hereinafter, could be feasible?
In this context, in the recent case of Eltek SGS Pvt Ltd[4], the Delhi High Court observed that the transferee company in the process of amalgamation had acquired a capital right, because of which the market worth of the assessee stood increased, and such capital right, being an intangible, could be calculated as the difference between the cost of assets and amount paid in consideration.
In the case of Bodal Chemical Limited[5], the transferee company had contended that notwithstanding the fact that intangible assets had not previously been recorded in the books of the transferor company, the transferee company had indeed “discharged” consideration in the form of issuance of shares, and therefore, the value of shares issued should be considered as cost of acquisition of the said intangibles, both under section 43(1) or section 43(6) of the Act, and the Ahmedabad ITAT had admitted the claim of depreciation with respect to the same.
Having established that irrespective of the fact that the cost of acquisition of intangibles in the hands of the transferor company is NIL, but since the transferee company has discharged consideration as a result of an amalgamation / demerger, cost of goodwill can be established. It would now be pertinent to analyse the last part of the puzzle to this conundrum – whether mere recording of intangible assets by the transferee company would constitute as an “ownership” in the hands of the transferee company?
“Ownership” under section 32 of the Act
Section 32 allows an owner of assets, including intangible assets other than goodwill, to claim depreciation, where assets are used for the purpose of business or profession. The term ‘owned’ must be assigned a wider meaning. Any person exercising title over a property with ability to exclude others from using such property or enjoy its usufruct in their own right can be said to be the owner of such property[6]. In the same manner, one can be called as an ‘owner’ of an intangible asset, if they can restrict another person from using such intangible, such as brand, or can transfer the intangible to another person, such as customer lists. Here, the criteria of contractual right or separability established under IndAS 103 can also useful in establishing such ownership.
In the case of Daikin Shri Ram Aircon (P.) Ltd.[7], the company purchased a manufacturing business, which gave the company such exclusive business rights. Given that the said rights are valuable, and akin to license and within the meaning of an intangible asset, the company is the owner of such intangible assets by virtue of the agreement to purchase the business, being brand name, logo and trademarks, even in absence of their registration. The consideration paid to the transferor includes the intent to purchase such intangible assets.
In the case of SKS Micro Finance Ltd[8], the company entered into a memorandum of understanding to acquire the entire business of the transferor. It was observed that the consideration paid included payment made to acquire the customer base of the transferor, thereby acquiring intangible assets being business and commercial rights of similar nature. The company owns / possesses the rights to access such customers and have been acquired for a consideration, hence the company owns such intangible asset and could claim depreciation on the same.
In Conclusion
A business acquisition does not involve acquisition of merely the net assets of the transferor, but also gives the transferee access to exclusive rights that the transferor enjoyed, whether or not such rights had been capitalised in the books of the transferor. This proves as a major incentive of a third-party acquisition, giving the transferee access to intangible assets as a result of the acquisition. While the fact that the acquisition through merger or demerger may itself be tax neutral, it does not belie the fact that consideration would be discharged by the acquirer in the form of issuance of shares, and such consideration would represent consideration discharged towards acquiring intangible assets. Given that, such consideration would inevitably be backed by a valuation, since it would be a transaction between unrelated parties, and given that the acquirer would be able to reap future economic benefits from acquisition of the said intangibles as a part of business combination, subject to the contractual-legal control or separability criterion, the acquirer should be able to claim amortisation under section 32 of the Act.
[1] CIT v. U.P. State Industrial Development Corpn. [TS-14-SC-1997]
[2] CIT v. Woodward Governor India (P.) Ltd. [TS-40-SC-2009]
[3] CIT v. Smifs Securities Ltd..[TS-639-SC-2012]
[5] [TS-8665-ITAT-2019(AHMEDABAD)-O]
[6] Supreme Court in the case of Mysore Minerals Ltd v CIT [TS-18-SC-1999-O]