1.35 Query
Valuation of goodwill. 1.Following is the balance sheet of a partnership firm.
Profit for the last 3 years is as under: -
2. According to the querist, in the present case, goodwill is computed as per the generally accepted principle, which is as under: -
Rs. Average profit (1,50,000/3) 50,000 Less: Interest on capital 12,000 Salary to partners 18,000
30,000 Super Profit 20,000
Goodwill is valued, say, at two years purchase: Rs. 40,000
After calculating the amount of goodwill at Rs. 40,000, provision for taxation is made as under:
Rs. Goodwill 40,000 Less: Provision for taxation say 30% from purchaser’s point of view 12,000 ______ Goodwill 28,000
3.The querist has sought the opinion of the Expert Advisory Committee as to whether provision for taxation is to be made while calculating goodwill. In other words, whether Rs. 12,000 (assumed as tax), is to be deducted from value of goodwill as suggested in para 2 above.
4.The querist has also expressed his view that, on the following grounds, provision for taxation cannot be deducted while valuing goodwill:
(a) In the case cited in paras 1 and 2 above, only purchaser’s tax liability for valuation of goodwill has been considered. Similarly, seller is also liable for capital gains tax. The capital gains are to be computed as per section 45 of the Income-tax Act, 1961, and the income is to be included in the seller’s income. So the theory of taxation in computation of goodwill has been considered only from purchaser’s point of view. The liability of taxation of seller has not been considered. So this concept is not correct to that extent.
(b) The legal authorities have not accepted the view that provision for taxation is to be deducted from valuation of goodwill. The Income-tax Appellate Tribunal in C.G.T. vs. K.P.S.U. Duraiswamy, as reported on page 149 of Taxation, May 1974, has not accepted this view.
(c) Various authors, such as Pickles, Batliboi, Shukla and Grewal, and Chaturvedi, have computed goodwill and not accepted the theory of taxation. They have not made any provision for taxation.
(d) Goodwill is totally independent of provision for taxation. Taxation depends upon the status of each person’s tax structure. Some tax entities are totally exempt from taxation. Some have to pay lesser taxes. Therefore, goodwill figure of the same concern and under same situation is different from different purchasers’ point of view.
5.The querist has also pointed out that the commentary on valuation of goodwill contained in the book, ‘Three New Taxes’, by Sampath Iyengar, at page nos. 1104 and 1108, is as under:
“Page 1104
……. .9(iii) Since the purchaser of the business goodwill pays for it in the hope of “recovering” it within a reasonable period by earning super-profits after he steps into the shoes of the seller, it is very vital for him to consider the burden of progressive taxes on Incomes and Wealth. Suppose, there are no such taxes, then he can get back his cost of goodwill much more quickly, than if the super profits earned by him are depleted by the taxes imposable thereon. What is more, the higher the rates of taxes, the longer is the period during which he can hope to recover his investment in goodwill. This means that either the super profits should be suitably cut down before applying the purchase factor, or the factor itself should lean on the very low side, other things being equal: See 3.12 post………...”
“Page 1108
3.12 Re. taxation factor, discussed in 3.9(iii) ante, the view taken by us is confirmed by the opinion expressed by Shri S.R. Mittal, B. Com., F.C.A., A.C.I.S. (London), A.C.S. in his article “Goodwill and its Computation” Published in Sec. II of ‘Taxation’, September 1974.
Relevant extracts form this article are given below:
“The theory of goodwill was initiated when there were no direct taxes or even if the taxes were there, these were very nominal. However, in present days the rates of direct taxes have gone up very high, as high as 97.75 per cent of one’s income. The super profits mean retainable super profits after paying off all possible liabilities connected with the earning. For determining one’s earning for the purpose of Income-tax Act, for good reasons the liability of Income-tax is not allowed. For determining the super-profitability i.e., retainable profits of a person, income-tax liability is also an important cash outgoing and as such should be an allowable deduction out of super profitability but this is being denied by the Department as well as judiciary. In one of my cases I argued this point very strongly but unfortunately Tribunal refused to allow me that tax liability on the ground that there was no case-law on the subject. In another I.T.A.T. case, C.G.T. vs. K.P.S.U. Duraiswamy reported on page 149 of Taxation, May 1974, this point was pleaded by the learned Counsel but the Hon’ble Tribunal did not accept the contention.
Realising the importance of the subject and the injustice that is being presently done to assesses, I personally feel that detailed working on the subject should not be postponed. However, the Institute of Chartered Accountants of India is the sole body to work and have dialogue with the Government of India because in dispute on the matters of goodwill the expert opinion of the Institute is generally appreciated by the Government………….”
5.According to the querist this was only form the point of view of tax liability that tax planners are developing this concept without any base. From purely commercial point of view, and as per generally accepted accountancy principles, goodwill is to be calculated without deducting the provision for taxation.
Opinion January 23, 1990 1.The Committee has considered the question of valuation of goodwill purely form accounting angle and has assumed that in the present case the valuation is for the purpose of transfer of business.
2.The Committee notes that there are different ways of computation of super-profits for the purpose of valuation of good will depending upon the facts and circumstances of each case. For instance, the terms agreed to in this regard by the buyer and the seller may be that the value of the goodwill be computed as certain number of years of purchase of super-profits based on the number of years in which a business of similar kind would be able to earn the same. Another manner of computing the goodwill may be based on the present value of super-profits for a number of years. Accordingly, the opinion of the Committee is not based on the figures and the method given by the querist. The opinion of the Committee is on the limited question of adjustment of average profits with the provision for taxation from the buyer’s point of view for the purpose of arriving at the value of goodwill as per the ‘super profits method’.
3.The Committee further notes that super profits method of computation of goodwill is based on the estimated worth to the buyer of the future earning capacity of the business, the risk of the discontinuance or diminution in such future profits being duly considered.a “A prospective purchaser will be vitally concerned with the question of possible future taxation liability. It is clear that a purchaser of goodwill expects to recoup what he has paid for it out of the future profits. In such case, should future profits be likely to be reduced materially by taxation, then he will not be disposed to pay any large amount of goodwill, other things being equal.b”
4.The Committee further notes that P.D. Leake, in his book “Commercial Goodwill”,c has also stated: “The fact that the purchaser of goodwill takes upon himself the burden of future income-tax on the whole of the future profits- a share of which he is paying to the vendor in advance –should always be fully allowed for in computing the value of the goodwill”.
5.The Committee notes that Yorsten and Smyth, while discussing computation of the normal annual profit under the ‘Purchase of Super Profits’ method of valuation of goodwill, state that “The matter of taxation referred to earlier may also require to be considered form the purchaser’s point of view.”d
6. On the basis of the above, the Committee is of the opinion that value of goodwill from the accounting angle should be computed by first arriving at average annual profit on the basis of pre-tax annual profits of the vendor. The average annual profit so arrived at should then be adjusted, inter alia, with the provision for taxation from the buyer’s point of view for the purpose of computation of super profits, based on which the value of goodwill would be obtained. ___________________________________
a William Pickles, ‘Advanced Accounting’, 3rd Edition (1960) p. 622. b R. Keith Yorston and E. Bryan Smyth, ‘Advanced Accounting’ (Volume 2) (1964) p. 469 c4th Edition, (1948), p. 35 dIbid, p. 477
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