The Cost-Step-Up Cap on Amalgamation: The Sixth Proviso to Section 32(1) and Explanation 7 to Section 43(1)

Suppose that Alpha Limited, a manufacturer, merges into Beta Limited under a court or tribunal sanctioned scheme. Alpha’s plant and machinery stand in its own books at a written down value of Rs. 40 crore, but the valuers engaged for the scheme report that the same plant is worth Rs. 150 crore. Beta issues its shares to Alpha’s shareholders, records the plant at Rs. 150 crore, and in its first return after the merger claims depreciation on that figure. The Assessing Officer allows depreciation on Rs. 40 crore. Who is right? The Act has answered this question, and answered it the same way, since 1967. Under Explanation 7 to section 43(1), the amalgamated company inherits the transferor’s tax cost; it does not acquire a new and larger one merely because a scheme has intervened. This article explains where that rule comes from, which provisions carry it, what it does and does not reach, and how it has been restated in the Income-tax Act, 2025, in force from 1 April 2026.

Actual Cost and Written Down Value: The Basis of Depreciation on Amalgamation

Depreciation under section 32 of the Income-tax Act, 1961 is not computed on what an asset is worth but on a statutory figure. In the year an asset enters the books that figure is the “actual cost” defined in section 43(1); thereafter it is the “written down value” of the block of assets defined in section 43(6). A “block of assets” is simply a bundle of assets of the same class carrying the same rate of depreciation, depreciated collectively rather than asset by asset since 1 April 1988. Control those two figures and you control the deduction. That is precisely what the legislature did.

Explanation 7 to Section 43(1): Carry-Forward of Actual Cost on Amalgamation

Before 1967 an amalgamation was, for tax purposes, an ordinary transfer. If the transferor received more for its plant than the plant’s written down value, section 41(2) as it then stood taxed the excess, up to the depreciation it had already enjoyed, as business income. That charge was a real deterrent to mergers, and the Finance (No. 2) Act, 1967 removed it. The same statute introduced the definition of “amalgamation” (then section 2(1A), renumbered section 2(1B) with effect from 1 April 1989), the capital gains exemption in section 47(vi), and the cost carry-over for shareholders in sections 49(1)(iii)(e) and 49(2).

The relief was not free. The Memorandum to the Finance (No. 2) Bill, 1967, and CBDT Circular No. 5-P dated 9 October 1967 both explain the quid pro quo in terms: because no profit would be computed under section 41(2) in the amalgamating company’s hands, the actual cost and the written down value of the assets transferred “will be taken, in the assessment of the amalgamated company, to be the same as in the case of the amalgamating company”, and the depreciation already granted to the transferor would count against the aggregate. The transferor escapes the balancing charge; in exchange, the transferee gets no fresh depreciation base. The two limbs of that bargain are Explanation 7 to section 43(1) – “the actual cost of the transferred capital asset to the amalgamated company shall be taken to be the same as it would have been if the amalgamating company had continued to hold the capital asset for the purposes of its own business” – and what was then Explanation 2A to section 43(6), now Explanation 2 to section 43(6)(c) after the block regime was introduced by the Taxation Laws (Amendment and Miscellaneous Provisions) Act, 1986 with effect from 1 April 1988.

The design is deliberately fictional. Explanation 7 does not ask what Beta paid; it asks a counterfactual – what would the cost have been had Alpha never merged at all? The scheme, the share swap and the valuation report are, for this purpose, invisible.

Depreciation in the Year of Amalgamation: The Sixth Proviso to Section 32(1)

The 1967 provisions fix the base. They say nothing about the year of the merger itself, when two assessees have each held the same assets for part of the year. That gap was closed nearly thirty years later. The Finance (No. 2) Act, 1996, with effect from 1 April 1997, inserted a proviso to section 32(1) providing that the aggregate depreciation allowable to the predecessor and the successor, or to the amalgamating and the amalgamated company, or to the demerged and the resulting company, “shall not exceed in any previous year the deduction calculated at the prescribed rates as if the succession or the amalgamation or the demerger… had not taken place”, and that it shall be apportioned between them “in the ratio of the number of days for which the assets were used by them”.

A word of caution on nomenclature, because it trips up citations. That provision was the fourth proviso when inserted, the fifth from 1 April 1999, and the sixth only since 1 April 2016; it was substituted in its present, demerger-inclusive form by the Finance Act, 1999. Most reported decisions therefore call the identical rule the fifth proviso, and the Act itself uses no ordinal at all.

Two consequences follow. The first is arithmetical: a merger cannot manufacture a second year’s depreciation out of a single year. The second is temporal. In Padmini Products (P.) Ltd. v. Deputy CIT (Karnataka High Court, ITA No. 154 of 2014, decided 5 October 2020), a firm’s business was succeeded to by a company and the revenue sought to use the proviso to deny depreciation in later years as well. The Court held that the proviso “in any case will apply only in the year of succession and not in subsequent years”, and separately that Explanation 3 to section 43(1) cannot be invoked without a recorded satisfaction and the prior approval the section requires. The reasoning is difficult to fault on the language, though readers should check the status of the special leave petitions said to have been filed against that judgment before treating it as settled.

An Asymmetry worth Noticing: Amalgamation and Demerger are not Drafted Alike

When the Finance Act, 1999 extended the scheme to demergers with effect from 1 April 2000, it drafted Explanation 7A to section 43(1) in almost the same words as Explanation 7 and then added something Explanation 7 has never had: “Provided that such actual cost shall not exceed the written down value of such capital asset in the hands of the demerged company.” The same Act inserted Explanations 2A and 2B to section 43(6) for the block side. For amalgamations there is no equivalent express ceiling in section 43(1) itself; the ceiling arises indirectly, from the counterfactual in Explanation 7 read with Explanation 2 to section 43(6). For most assets that produces the same answer. The gap matters only for an asset that had no cost, and therefore no written down value, in the transferor’s hands at all – which is exactly where the litigation has settled.

Where the Argument Actually Happens: Goodwill Arising on Amalgamation

Take the merger consideration and subtract the fair value of the net assets taken over. Where the consideration is larger, accounting under the purchase method requires the difference to be carried as goodwill. Until the Finance Act, 2021, goodwill was capable of being a depreciable intangible: in CIT v. Smifs Securities Ltd. [2012] 348 ITR 302 (SC), decided on 22 August 2012, the Supreme Court held that “goodwill” is an asset within Explanation 3(b) to section 32(1). The question that then divided the tribunals was whether Explanation 7 reduces the cost of that goodwill to nil.

The revenue’s argument is faithful to the text. Explanation 7 requires the transferee’s cost to be measured as though the transferor had continued to hold the asset. If goodwill did not appear in the amalgamating company’s balance sheet, then on that counterfactual its cost is nil, and depreciation on a self-created figure is depreciation on nothing. That, in substance, is what the Bangalore Tribunal accepted in United Breweries Ltd. v. ACIT [2016] 76 taxmann.com 103, ITA No. 722/Bang/2014, disallowing goodwill of about Rs. 62 crore recorded on absorbing a wholly owned subsidiary, and holding that Smifs, which decided only that goodwill is an intangible asset, did not answer the separate question of quantification.

The assessee’s answer is equally textual. Explanation 7 operates on “any capital asset… transferred by the amalgamating company”. Goodwill of the kind recorded in a merger is not transferred; it comes into existence for the first time on the merger, as the residue of a valuation exercise, and it frequently reflects synergies belonging to the combined enterprise rather than anything the transferor held. On that view Explanation 7 has no subject matter to operate on, and a deeming fiction cannot be stretched beyond the case it names. Support is drawn from CIT v. B.C. Srinivasa Setty [1981] 128 ITR 294 (SC), where the Supreme Court held that self-generated goodwill has no ascertainable cost, and from the observation that where Parliament wanted a nil cost for goodwill it said so expressly, in section 55(2)(a), and said nothing of the kind in section 43.

High Court authority is thin, and narrower than it is often made to sound. In Pr. CIT v. Zydus Wellness Ltd. [2017] 87 taxmann.com 82, the Gujarat High Court dismissed the revenue’s appeal against depreciation on goodwill arising on amalgamation. But the ratio has two limbs – a procedural holding that a claim made by revised computation is not shut out for want of a revised return, and a merits holding expressly conditioned on the record, that there was “no material referred to by the Assessing Officer to hold that the claim of depreciation was fictitious”. Read fairly, Zydus tells the revenue what it must do, not that it can never succeed.

The recent tribunal trend runs the other way, and it runs on facts rather than on Explanation 7. In Invesco (India) (P.) Ltd. v. DCIT [2025] 176 taxmann.com 784 (Hyderabad), and again in Aptara Technologies (P.) Ltd. v. DCIT [2026] 183 taxmann.com 571 (Pune), decided on 17 February 2026, tribunals disallowed goodwill recorded on the absorption of a fellow or wholly owned subsidiary. Aptara is instructive on method: the Assessing Officer had invoked Explanation 7, but the Tribunal decided the appeal without adjudicating that provision at all, holding on the facts that an intra-group rearrangement under common control, involving no payment beyond an issue of shares and followed by discontinuance of the transferor’s business, produced “merely a colourable transaction” and no intangible asset. Where the goodwill is genuine, paid for and supported by valuation, the Explanation 7 question remains open.

Explanation 3 to Section 43(1): Re-Determination of Actual Cost

Behind all of this stands a much older provision. Explanation 3 to section 43(1) permits the Assessing Officer, where assets were previously used by another person and he is satisfied that the main purpose of the transfer was the reduction of tax by claiming depreciation on an enhanced cost, to determine the actual cost himself. Two conditions are express and are frequently the assessee’s best point: the satisfaction must be recorded, and the determination requires the previous approval of the Joint Commissioner. The underlying principle predates the Explanation. In Guzdar Kajora Coal Mines Ltd. v. CIT [1972] 85 ITR 599, the Supreme Court held that where “a fictitious price has been put on the asset or there is fraud or collusion”, the authorities may refuse the price stated in the deed and ascertain the real cost, and on the facts carved goodwill out of a composite consideration. Explanation 3 is a scalpel with procedural safeguards, not a general licence to substitute the revenue’s valuation for the assessee’s.

Finance Act, 2021: The goodwill Question closes Prospectively

With effect from 1 April 2021, the Finance Act, 2021 (Act 13 of 2021) removed goodwill of a business or profession from the depreciable class altogether, by amending the definition of “block of assets” in section 2(11), clause (ii) of section 32(1) and Explanation 3 to section 32, the written down value machinery in sub-item (B) of item (ii) of sub-clause (c) of section 43(6), section 50 and section 55(2)(a). Rule 8AC of the Income-tax Rules, 1962, inserted by the Income-tax (19th Amendment) Rules, 2021 (Notification No. 77/2021 dated 7 July 2021), prescribes how goodwill already inside a block is stripped out and what short-term capital gain, if any, results. The tribunals have treated the change as prospective, so the Explanation 7 debate survives for earlier years – and for assets other than goodwill it survives outright.

The Position Period by Period

Explanation 7 to Section 43(1): Its Restatement under the Income-tax Act, 2025

The 2025 Act restates this scheme without changing it. Depreciation now sits in section 33, and the apportionment rule in section 33(5), which caps the aggregate deduction at what would have been allowable “as if the succession, amalgamation or demerger had not taken place” and allows it “on pro rata basis based on number of days for which assets were used”. “Actual cost” is computed under section 39, and the Explanations to the old section 43(1) have been recast as a Table in section 39(4): serial 1 carries the amalgamation rule in the same words as Explanation 7, serial 2 the demerger rule with its written down value cap now written inline, and serial 6 the holding and subsidiary rule. The Assessing Officer’s re-determination power, with the Joint Commissioner’s approval, appears in section 39(5) and (6). Written down value is section 41, with the amalgamation carry-over at section 41(2)(c) and the demerger provisions at sections 41(3) and (4).

Two drafting points are worth noting. Because the Explanations now sit in a Table, the demerger cap is visible immediately alongside the amalgamation entry that still does not carry one. And section 33(5) attaches both the cap and the pro rata allocation to the year of the reorganisation on the face of the provision, which is the point the Karnataka High Court had to reach by construction in Padmini Products. One further recent statute is often misdescribed: the Finance Act, 2025 did rationalise amalgamation provisions, but only by capping carried forward losses at the balance of the original eight years. It did not touch actual cost, written down value or the step-up cap.

What is Settled, and What is Not

Settled: an amalgamated company steps into the transferor’s tax cost and written down value; a valuation done for a scheme does not create a depreciation base; the year of merger yields one year’s depreciation, split by days; and the revenue may go behind a stated price, but only on a recorded satisfaction and with the approval the statute requires. Open, at least for years before 1 April 2021: whether Explanation 7 reaches an intangible that came into existence on the merger rather than being transferred through it. The recent decisions have avoided answering that by resolving the cases on genuineness instead – a sensible judicial economy, but one that leaves a real question of construction undecided.

Frequently Asked Questions

Sources & Citations

• Income-tax Act, 1961: section 32(1) and the sixth proviso thereto (the fifth proviso before 1 April 2016; inserted as the fourth proviso by the Finance (No. 2) Act, 1996, w.e.f. 1 April 1997; substituted by the Finance Act, 1999, w.e.f. 1 April 2000); Explanation 3 to section 32(1).
• Income-tax Act, 1961: section 43(1), Explanation 3 (approval of the Joint Commissioner substituted by the Finance (No. 2) Act, 1998, w.e.f. 1 October 1998), Explanation 6 (Finance Act, 1965, w.e.f. 1 April 1965), Explanation 7 (Finance (No. 2) Act, 1967, w.e.f. 1 April 1967) and Explanation 7A (Finance Act, 1999, w.e.f. 1 April 2000).
• Income-tax Act, 1961: section 43(6)(c), Explanation 2 (substituted by the Taxation Laws (Amendment and Miscellaneous Provisions) Act, 1986, w.e.f. 1 April 1988; the predecessor Explanation 2A was inserted by the Finance (No. 2) Act, 1967, w.e.f. 1 April 1967), Explanations 2A and 2B (Finance Act, 1999, w.e.f. 1 April 2000).
• Income-tax Act, 1961: sections 2(1B), 47(vi), 47(vii), 49(1)(iii)(e), 49(2) and 41(2) as it stood before 1 April 1967.
• Memorandum to the Finance (No. 2) Bill, 1967, para 36, and CBDT Circular No. 5-P dated 9 October 1967 (both as extracted in the record in Aptara Technologies (P.) Ltd. v. DCIT, cited below).
• Finance Act, 2021 (Act 13 of 2021), w.e.f. 1 April 2021: sections 2(11), 2(42C), 32(1)(ii) and Explanation 3 to section 32, sub-item (B) of item (ii) of sub-clause (c) of section 43(6), section 50 and section 55(2)(a). Rule 8AC, Income-tax Rules, 1962, inserted by the Income-tax (19th Amendment) Rules, 2021, Notification No. 77/2021 dated 7 July 2021. The Explanation to section 50 was inserted by the Finance Act, 2022 with retrospective effect from 1 April 2021.
• Income-tax Act, 2025 (in force 1 April 2026): sections 33 and 33(5); section 39, including section 39(4) Table (serials 1, 2 and 6) and sections 39(5) and (6); section 41, including sections 41(2)(c), 41(3) and 41(4).
• Finance Act, 2025: section 72A(6B) and the amendment to section 72AA (carry-forward of losses on business reorganisation) – noted here only to distinguish it.
• CIT v. Smifs Securities Ltd. [2012] 348 ITR 302 (SC), Civil Appeal No. 5961 of 2012, decided 22 August 2012.
• CIT v. B.C. Srinivasa Setty [1981] 128 ITR 294 (SC), decided 18 February 1981.
• Guzdar Kajora Coal Mines Ltd. v. CIT [1972] 85 ITR 599 (SC), decided 31 July 1972.
• Padmini Products (P.) Ltd. v. Deputy CIT, Karnataka High Court, ITA No. 154 of 2014, decided 5 October 2020.
• Pr. CIT v. Zydus Wellness Ltd. [2017] 87 taxmann.com 82 (Gujarat).
• United Breweries Ltd. v. ACIT [2016] 76 taxmann.com 103 (Bangalore Tribunal), ITA No. 722/Bang/2014, assessment year 2007-08.
• Invesco (India) (P.) Ltd. v. DCIT [2025] 176 taxmann.com 784 (Hyderabad Tribunal).
• Aptara Technologies (P.) Ltd. v. DCIT [2026] 183 taxmann.com 571 (Pune Tribunal), ITA No. 63/PUN/2020, assessment year 2015-16, decided 17 February 2026.
• Technova Imaging Systems Ltd. v. DCIT, Bombay High Court, ITA No. 405 of 2003, decided 9 April 2025 (approval under section 72A is not a condition for an amalgamated company to work out written down value and claim depreciation).

Related Reading

• Depreciation on Goodwill in Amalgamations: From Smifs Securities to the Finance Act, 2021
• Is Goodwill an “Asset” for Depreciation? Smifs Securities and Explanation 3(b)
• Pooling of Interests vs Purchase Method: Can Goodwill Arise on Amalgamation?
• Goodwill Removed from Depreciable Assets: The Finance Act 2021, Its Transition and Its Fallout