Imagine two long-established companies deciding to merge. The stronger company absorbs the weaker one under a scheme of amalgamation sanctioned by the High Court, and in exchange issues its own shares to the shareholders of the company that disappears. When the accountants sit down to record the transaction, they find that the price effectively paid — the value of the shares issued — is larger than the net worth of the assets and liabilities actually taken over. That difference does not vanish; it has to be parked somewhere on the balance sheet. Accountants have a name for it: goodwill. It represents the premium a buyer pays for reputation, customer relationships, distribution networks, brand loyalty and the simple fact that an established business is worth more than the sum of its tangible parts.

The question that has occupied the Indian tax system for the better part of two decades is deceptively simple: can a company claim depreciation on goodwill recognised in its books following an amalgamation, in the same way it would on a factory building or a patent? The answer has moved through three distinct phases, and knowing which phase a given year falls into is essential, because the law that governs an amalgamation in 2004 is not the law that governs one in 2024.

Section 32(1)(ii): Depreciation on Intangible Assets

Depreciation is governed by section 32 of the Income-tax Act, 1961. For most of the Act’s life, depreciation was confined to tangible assets — buildings, machinery, plant and furniture. That changed with the Finance (No. 2) Act, 1998, which, with effect from assessment year 1999-2000, extended depreciation to a defined class of intangible assets under section 32(1)(ii). (An “assessment year” is the year in which the previous year’s income is taxed; assessment year 1999-2000 corresponds to income earned in the financial year 1998-99.)

What counts as an intangible asset is spelt out in Explanation 3 to section 32(1). It defines “asset” to mean an intangible asset “being know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature.” The list is closed at the front but open at the back: after naming six specific intangibles, it adds the residual phrase in clause (b) — “any other business or commercial rights of similar nature.” The entire controversy about goodwill turns on whether it can be squeezed into that residual clause, because goodwill is conspicuously not named among the six.

The Pre-2012 Debate: Is Goodwill “of Similar Nature”?

Before the Supreme Court intervened, the position was genuinely contestable, and both sides had respectable arguments.

The Revenue’s case rested on a canon of interpretation called ejusdem generis — literally, “of the same kind.” Where a general phrase follows a list of specific items, the general phrase is read as limited to things of the same genus as those items. Know-how, patents, copyrights, trademarks, licences and franchises, the Department argued, are all rights that can be separately identified, separately owned and separately transferred. Goodwill, by contrast, is inseparable from the business itself; it cannot be sold on its own without selling the undertaking. On that view goodwill was not “of similar nature” to the named intangibles and fell outside Explanation 3(b) altogether. The Revenue frequently added a second objection rooted in accounting: goodwill arising on amalgamation is often merely a balancing figure — the plug that makes the two sides of the entry agree — and a book-keeping residue should not attract a real deduction.

The assessee’s case was that the residual clause was deliberately worded broadly. Goodwill is unquestionably a “commercial right” — it is the very asset that gives a business its earning capacity above the value of its net tangible assets. When a company acquires that earning capacity by paying a premium in an amalgamation, it has paid real consideration for a real commercial advantage, and there is no principled reason to treat it differently from a franchise or a licence, both of which are equally bound up with the goodwill of the business they attach to. On this reading the phrase “of similar nature” describes the commercial character of the right, not a narrow structural test of separability.

Smifs Securities: Supreme Court Ruling on Depreciation of Goodwill (2012)

The debate was resolved by the Supreme Court in CIT v. Smifs Securities Ltd., [2012] 348 ITR 302 (SC) (also reported at [2012] 24 taxmann.com 222 and 210 Taxman 428), decided on 22 August 2012 by a Bench of Chief Justice S. H. Kapadia and Justice Madan B. Lokur. The facts were the classic amalgamation scenario described at the outset: YSN Shares & Securities merged into Smifs, the consideration exceeded the net assets taken over, the excess was recorded as goodwill, and the company claimed depreciation of roughly ₹54 lakh on it for assessment year 2003-04. The Assessing Officer disallowed the claim on the ground that goodwill did not fall within Explanation 3 to section 32(1).

The Court held, in favour of the assessee, that goodwill is an asset within Explanation 3(b). Turning the Revenue’s own canon against it, the Court reasoned that a reading of the words “any other business or commercial rights of similar nature” in clause (b) shows that goodwill would fall within that expression — and that “the principle of ejusdem generis would strictly apply while interpreting the said expression.” In other words, applied honestly, the genus of the named intangibles is “business or commercial rights,” and goodwill belongs squarely to that genus. The Court concluded that goodwill is an asset under Explanation 3(b) and that depreciation on goodwill is allowable under section 32.

Two features of the judgment are frequently overlooked and deserve emphasis, because they explain why Smifs did not end all litigation. First, the Court recorded a caveat of fact. The Assessing Officer had also found, as a matter of fact, that “no amount was actually paid on account of goodwill”; but the Commissioner (Appeals) and the Tribunal had found the opposite — that the difference between the consideration and the net assets did constitute goodwill and that a capital right had genuinely been acquired — and the Revenue had not appealed that factual finding to the High Court. The Supreme Court therefore left the finding of fact undisturbed. The legal proposition (goodwill is a depreciable asset) was thus decided against a factual backdrop the Revenue had not contested. Second, the same order held that a stock exchange membership card is a depreciable asset, following Techno Shares & Stocks Ltd. v. CIT, [2010] 327 ITR 323 (SC) — a useful reminder that the residual clause has always been read to accommodate commercial rights that are not obviously “property.”

After Smifs: Consolidation and the Questions Left Open

High Courts across the country applied Smifs without hesitation. In the Gujarat High Court, PCIT v. Zydus Wellness Ltd., [2017] 87 taxmann.com 82 (Guj), decided on 3 October 2017 by Justices Akil Kureshi and Biren Vaishnav, is representative. The Revenue there challenged depreciation of some ₹7.19 crore on goodwill recognised on amalgamation, arguing that it was “only a book entry” with no goodwill in the commercial sense. The Court held that Smifs “would squarely apply,” and that the Assessing Officer had pointed to no material to show the claim was fictitious; a bare assertion that an intangible acquired on amalgamation cannot be depreciated was, the Court said, directly opposed to Smifs. The Bombay High Court had reached a similar result in CIT v. Pruthvi Brokers & Shareholders (P.) Ltd., [2012] 349 ITR 336 (Bom).

Yet Smifs did not answer two harder questions, and it is here that the Revenue continued to litigate successfully in appropriate cases. The first is whether goodwill genuinely exists at all on the facts, as opposed to being an accounting plug — precisely the factual enquiry the Supreme Court had left open in its own caveat. The second is how much goodwill may be recognised where the asset comes across in an amalgamation. This is not left to the parties’ valuation. Explanation 7 to section 43(1), read with the sixth proviso to section 32(1), caps the cost of assets transferred in an amalgamation at the written-down value in the hands of the amalgamating company and requires depreciation to be apportioned as if the amalgamation had not taken place. The Department’s recurring argument was that a company cannot manufacture a fresh, depreciable goodwill simply by paying a premium over book value in a court-sanctioned scheme, when the underlying assets carry their historical cost across the merger.

Lurking behind all of this is a deeper doctrinal tension with CIT v. B. C. Srinivasa Setty, [1981] 128 ITR 294 (SC). That case, decided in the capital-gains context, held that self-generated goodwill has no ascertainable “cost of acquisition,” so the computation machinery of section 48 fails and its transfer cannot be taxed. The principle cuts both ways in the depreciation debate. If self-generated goodwill has no cost, can it be depreciated? Smifs answers this by confining itself to acquired goodwill — goodwill for which a measurable premium was actually paid on amalgamation — leaving self-generated goodwill, which never enters the books at a cost, outside the depreciation net for want of an actual cost to write down.

Finance Act 2021: Removal of Goodwill from Depreciable Assets

For nearly a decade after Smifs, acquired goodwill was depreciable. Parliament then intervened decisively. The Finance Act, 2021, with effect from assessment year 2021-22, removed goodwill of a business or profession from the depreciation regime altogether. It did so on three fronts at once: it amended the definition of “block of assets” in section 2(11) to exclude goodwill; it inserted a proviso to section 32(1)(ii) stating that goodwill of a business or profession shall not be an asset eligible for depreciation; and it amended section 55(2)(a) to prescribe how the cost of acquisition of goodwill is to be determined for capital-gains purposes. The Memorandum explaining the Bill was candid that the object was to reverse the effect of Smifs.

Because taxpayers had legitimately claimed depreciation on goodwill for years before 2021, a transitional mechanism was necessary. The CBDT supplied it through Rule 8AC of the Income-tax Rules, 1962, notified by Notification No. 77/2021 dated 7 July 2021. Rule 8AC prescribes how the written-down value of the “intangible” block is to be reduced to strip out the goodwill component on which depreciation had already been allowed up to 31 March 2020, and how any resulting excess is to be brought to tax as a short-term capital gain under section 50. In plain terms: depreciation legitimately claimed in earlier years is not reopened, but the goodwill is carved out of the block going forward, and where the depreciation already granted exceeds what the revised block can absorb, the difference is taxed.

The transition has generated its own disputes, and again both positions are respectable. Taxpayers contend — and several Tribunals have accepted — that the 2021 amendment operates prospectively, so that depreciation lawfully claimed on goodwill for years up to and including assessment year 2020-21 cannot be disturbed, Smifs governing those years. The Revenue’s counter is narrower: it does not generally reopen past years, but it insists on strict application of the Rule 8AC computation at the point of transition, so that the accumulated benefit is squared off rather than carried forward indefinitely. The safest reading for any given year, therefore, is chronological: identify the assessment year, and apply the law as it stood then.

The Position at a Glance, by Period

The following table states the depreciation position for acquired goodwill by time period. It is a summary only; the governing statute and the leading authority are cited in each row.

Frequently Asked Questions

Sources & Citations

• Income-tax Act, 1961 — section 32(1)(ii) and Explanation 3 (intangible assets), inserted by the Finance (No. 2) Act, 1998, w.e.f. assessment year 1999-2000; sixth proviso to section 32(1) and Explanation 7 to section 43(1) (amalgamation cost cap).
• CIT v. Smifs Securities Ltd., [2012] 348 ITR 302 (SC) = [2012] 24 taxmann.com 222 = [2012] 210 Taxman 428 = [2012] 252 CTR 233 (SC), decided 22 August 2012 (Kapadia CJI and Lokur J).
• Techno Shares & Stocks Ltd. v. CIT, [2010] 327 ITR 323 (SC) (stock exchange membership card as a depreciable asset).
• PCIT v. Zydus Wellness Ltd., [2017] 87 taxmann.com 82 (Gujarat), Tax Appeal No. 779 of 2017, decided 3 October 2017 (Akil Kureshi and Biren Vaishnav JJ).
• CIT v. Pruthvi Brokers & Shareholders (P.) Ltd., [2012] 349 ITR 336 (Bombay).
• CIT v. B. C. Srinivasa Setty, [1981] 128 ITR 294 (SC) (self-generated goodwill has no ascertainable cost of acquisition).
• Finance Act, 2021 — amendments to sections 2(11), 32(1)(ii) and 55(2)(a) of the Income-tax Act, 1961, w.e.f. assessment year 2021-22; Memorandum Explaining the Provisions of the Finance Bill, 2021.
• Rule 8AC, Income-tax Rules, 1962, inserted by the Income-tax (19th Amendment) Rules, 2021, CBDT Notification No. 77/2021 dated 7 July 2021 (computation of WDV and short-term capital gain under section 50 where depreciation on goodwill was obtained).

Related Reading

• Depreciation on Goodwill in Amalgamations: From Smifs Securities to the Finance Act, 2021
• Goodwill Removed from Depreciable Assets: The Finance Act 2021, Its Transition and Its Fallout
• Pooling of Interests vs Purchase Method: Can Goodwill Arise on Amalgamation?
• The Cost-Step-Up Cap on Amalgamation: The Sixth Proviso to Section 32(1) and Explanation 7 to Section 43(1)
• Bogus Purchases and Accommodation Entries: Burden of Proof and Commission-Rate Additions

© Bhatt & Joshi Associates. This article is for general information and academic discussion only; it is not legal advice and should not be relied upon without professional consultation on the specific facts.

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