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December 17, 2020

‘Goodwill’ generated in a newly commenced business could not be described as an “asset” under section 45 – SC

by CA Shivam Jaiswal in Income Tax

‘Goodwill’ generated in a newly commenced business could not be described as an “asset” under section 45 – SC

Capital gain is the profit one earns on the sale of an asset like stocks, bonds or real estate. It results in capital gain when the selling price of an asset exceeds its purchase price. It is the difference between the selling price (higher) and cost price (lower) of the asset. Capital loss arises when the cost price is higher than the selling price.

The sale of capital assets may lead to capital gains and these gains may attract tax under the Income Tax Act. Section 45 of Income Tax Act, 1961 provides that any profits or gains arising from the transfer of a capital asset effected in the previous year will be chargeable to income-tax under the head ‘Capital Gains’. Such capital gains will be deemed to be the income of the previous year in which the transfer took place.

Let us refer to the case of CIT v. B. C. Srinivasa Shetty (1981), where the issue under consideration was whether the transfer of goodwill to the newly constituted firm gave rise to capital gains under section 45 in the hands of transferor firm or not.

Facts of the Case:

  • The assessee, a registered firm, manufactured and sold agarbattis.
  • Clause (13) of the Instrument of Partnership showed that the goodwill of the firm was not valued and the valuation would be made on dissolution of the partnership.
  • Subsequently, the assessee firm was dissolved.
  • At the time of dissolution, the goodwill of the firm was valued at Rs. 1,50,000.
  • A new partnership by the same name was constituted and it took overall the assets, including the goodwill, and liabilities of the dissolved firm.
  • The Income-Tax Officer made an assessment on the dissolved firm but did not include any amount on account of the gain arising on transfer of the goodwill.

Order of Appellate Authorities and High Court (HC)

  • The Commissioner, being of the view that the assessment order was prejudicial to the Revenue, decided to invoke his revisional jurisdiction and setting aside the assessment order directed the Income-Tax Officer to make a fresh assessment after taking into account the capital gain arising on the sale of the goodwill.
  • In appeal before the Income Tax Appellate Tribunal, the assessee maintained that the sale did not attract tax on capital gains under section 45 of the Income-Tax Act, 1961.
  • By its judgment the High Court answered the question in the affirmative, holding that the value of the consideration received by the assessee for the transfer of its goodwill was not liable to capital gains tax under Section 45 of the Act

Observations of the Supreme Court (SC) on Goodwill

  • Goodwill denotes the benefit arising from connection and reputation.
  • Its value may fluctuate from one moment to another depending on changes in the reputation of the business.
  • It is affected by everything relating to the business, the personality and business rectitude of the owners, the nature and character of the business, its name and reputation, its location, its impact on the contemporary market, the prevailing socio-economic ecology, introduction to old customers and agreed absence of competition.
  • There can be no account in value of the factors producing it. It is also impossible to predicate the moment of its birth.
  • No business commenced for the first time possesses goodwill from the start.
  • It is generated as the business is carried on and may be augmented with the passage of time.

Observations of the Supreme Court (SC) on the issue of the present case

  • The asset must be one which fell within the contemplation of section 45. It must bear that quality which brings section 45 into play.
  • All transactions encompassed by section 45 must fall under the governance of its computation provisions.
  • A transaction to which those provisions cannot be applied must be regarded as never intended by section 45 to be the subject of the charge.
  • Thus, inference flows from the general arrangement of the provisions in the Act in which the charging section and the computation provisions together constitute an integrated code.
  • Ordinarily, the operation of the charging provision could be affected by the construction of a particular computation provision.
  • But the question here was whether it was possible to apply the computation provision at all if a certain interpretation is pressed on the charging provision.

Conclusion by Supreme Court (SC)

The Supreme Court held that:

  • The charging section and the computation provisions together constitute an integrated code.
  • When there is a case to which the computation provisions could not apply at all, it was evident that such a case was not intended to fall within the charging section.
  • All transactions encompassed by section 45 must fall under the governance of its computation provisions.
  • A transaction to which those provisions could not be applied must be regarded as never intended by section 45 to be the subject of the charge.
  • What was contemplated by section 48(ii) was an asset in the acquisition of which it was possible to envisage a cost. It must be an asset which possessed the inherent quality of being available on the expenditure of money to a person seeking to acquire it.
  • None of the provisions pertaining to the head “Capital gains” suggested that they include an asset in the acquisition of which no cost at all could be conceived.
  • When goodwill generated in a new business was sold and the consideration brought to tax, what was charged was the capital value of the asset and not any profit or gain.
  • Further, the date of acquisition of the asset was a material factor in applying the computation provisions pertaining to capital gain; but in the case of goodwill generated in a new business it was not possible to determine the date when it came into existence.
  • Having regard to the nature of goodwill, it would be impossible to determine its cost of acquisition.
  • Therefore, ‘goodwill’ generated in a newly commenced business could not be described as an “asset” within the terms of section 45 and the transfer of goodwill initially generated in a business did not give rise to a capital gain for the purposes of income-tax.

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