Expenses on development or purchase of such intangibles, are either capitalized, or are expensed out in the profit and loss account, depending on the facts of each case. Regarding, customer lists, the Canadian Supreme Court in the case of Gifford v. The Queen (Can. No. 29416, 3/4/04) has held that purchase of a client list represents a payment on account of capital. In respect of non-compete payments there remains a controversy as to whether such payments should be regarded as deductible expenses, or as payments on capital account. Payments for employee contracts, unexecuted vender/customer contracts, arguably, could be regarded as revenue payments. In support, reference can be drawn to the case of the Andhra Pradesh High Court in Venkata Reddy v. CIT (43 ITR 100), or that of the Bombay High Court in the case of CIT v. Desmet (138 ITR 382).
Where such intangibles are capitalised, the Income Tax Act, 1961 (the Act) expressly provides for depreciation allowance. Depreciation is allowed on know-how, patents, copyrights, trade-marks, licences, franchises and any other business or commercial rights of similar nature. However, there is no express provision for depreciation in respect of other widely known intangible assets, such as, goodwill, non-compete rights, customer lists, employees contracts, vendor/customer contracts, distributorship rights, service process flows, knowledge databases, brands, to name a few.
The key issue in respect of depreciation of such unspecified intangible assets, mentioned above, is whether they can be regarded as business or commercial rights of a nature similar to know-how, patents, etc. The Supreme Court in Nat Steel v. CCE (1988 AIR 631) has held that the expression similar means corresponding to or resembling to in many respects.
As an example, let us examine the nature of goodwill. The Supreme Court in the case of Khushal Shah v. Khorshed Boatwalla (AIR1970SC1147) has held that goodwill of a business is an intangible asset being the whole advantage of the reputation and connections formed with the customers together with the circumstances that make the connection durable. Further, the Madras High Court in Rathnams case (71 ITR 433) has referred to Lawsons Law of property, which observes that goodwill is the right to enjoy all the advantages of an established trade connection.
However, intangible assets, such as, goodwill, non-compete, etc. may lack specific legal enforceability. Further, the Madras High Court in CIT v. Raffiuddin (242 ITR 57) has observed that goodwill is inseparable from business. It may not be possible to acquire goodwill on a standalone basis, separate from the business, unlike know-how, patents, etc.
Nonetheless, it may be pertinent to note that the Calcutta High Court in Bird and Co. (108 ITR 253) has observed that depreciation in the value of goodwill had to be taken into account either as business expenditure or purely as a capital loss. It is now well accepted that the amounts capitalised as goodwill, etc. have to be amortised in the books of accounts over a period of time, to reflect true and fair profits. Hence, applying the ratio of the Supreme Courts decision in the case of CIT v. Alps Theatre (65 ITR 377), one may argue that amortization/depreciation on amounts paid towards goodwill, etc is not only a legitimate but a necessary charge for arriving at the assessable profits.
To avoid litigation, the CBDT may consider expressly clarifying that depreciation would be available on all intangible assets. In the meantime, in the absence of direct judicial precedents, in case of purchase of a business for a lump-sum consideration, it may be advisable to attribute the consideration separately to all identifiable intangible assets, which are expressly mentioned in the list of depreciable assets. Further, at the time of any business re-organisation, one will also have to consider the intangible assets, to optimize the tax benefits.
The authors are senior tax professionals with Ernst & Young