Supreme Court in SIMF Securities case rules depreciation on goodwill permissible under Income Tax Act Freddy Daruwalla of Nasikwala Law Office provides brief analysis

On August 22, 2012 a Division Bench of the Chief Justice of India and Justice Madan B. Lokur passed judgment in CIT, Kolkata v SMIF Securities Ltd. The judgment, which has wide-ranging ramifications, deals with the valuation of “goodwill” and whether depreciation on the same can be claimed. Freddy Daruwalla, Partner at Nasikwala Law Office, provides a brief analysis of the judgment and what it means for future Purchase Price Allocations..On August 22, 2012 a Division Bench of the Chief Justice of India and Justice Madan B. Lokur passed judgment in CIT, Kolkata v SMIF Securities Ltd. The judgment, which has wide-ranging ramifications, deals with the valuation of “goodwill” and whether depreciation on the same can be claimed. Freddy Daruwalla, Partner at Nasikwala Law Office, provides a brief analysis of the judgment and what it means for future Purchase Price Allocations..Bar & Bench: So what has the Supreme Court held?.Freddy Daruwala: The Supreme Court in a Daniel judgement in the case of SMIF Securities (Commissioner of Income Tax, Kolkata v SMIF Securities SLP (Civil) No 35600 of 2009) has ruled that an assessee is entitled to claim depreciation on goodwill. In a very detailed ruling, the Bench comprising of the Chief Justice S.H. Kapadia and Justice Madan B Lokur, categorically decided on the question – “Whether goodwill is an asset within the meaning of Section 32 of the Income Tax Act, 1961, and whether depreciation on `goodwill’ is allowable under the said Section?” in the affirmative..B&B: What was the rationale adopted by the Court? .FD: The reasoning behind this decision lies in the wording of Explanation 3 to section 32(1) of the Income Tax Act 1961 (ITA) which defines an asset inter alia to “mean an intangible asset, being know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature“(emphasis supplied). Therefore the honourable apex court construed that goodwill by its very nature fell squarely within the legislative intent of Explanation 3 to section 32 (1) which clearly equated goodwill as a business or commercial right similar to patents, trademarks, copyrights, licences, franchises etc and consequently ruled that an assessee could not be denied depreciation on the same..B&B: What is your initial reaction to this ruling? .FD: This ruling is like a breath of fresh air as it brings much needed clarity on this issue which has led to profuse litigation between the IT Department and assessses in several judicial fora. Therefore an assessee, going by the ratio of the judgement will be entitled to depreciate goodwill on the basis of classifying it within the block of intangible assets..B&B: Do you foresee any other ramifications? .FD: This ruling also has a very positive effect in the sphere of Purchase Price Allocations (PPA) for an acquirer who has purchased assets on a slump sale basis (sale of an entire undertaking with assets and liabilities without individual allocations to the separate assets of such undertaking)..In the past, valuers, after deducting values of tangible assets and liabilities from slump sale consideration, were pressurised to allocate disproportionate amounts of the balance towards other intangible assets like trademarks, brands, copyrights etc. (defined in Explaination to sec 32(1) of the ITA) and leave miniscule amounts for goodwill..B&B: Why? .FD: The reason for this approach was that goodwill was earlier not entitled to depreciation (and consequent tax write offs on account of depreciation) like the other intangible assets specified in explanation 3 to section 32 (1) of the ITA. Such valuations were very often challenged by certain regulators like the Reserve Bank, SEBI and even in courts by minority dissenting shareholders, as well as by the income tax assessing officers (in assessments when depreciation was claimed on such inflated values of intangible assets)..Therefore this judgement, besides bringing in much needed clarity in tax law will also streamline and improve valuation practices and go a long way in reducing litigation. One only hopes that the new Finance Mister, Mr. Chidambaram, does not adopt the unhealthy practice of his predecessor in reversing the effect of this judgement with prospective or even worse, retrospective legislation.