Technical proprietary information and pre-qualification rights obtained by assessee cannot be treated as goodwill and assessee is entitled to depreciation on these two items of intangible assets

4. But the Assessing Officer disallowed this claim, for all the four assessment years under appeal, on the reasoning that the intangible assets would partake the character of ‘goodwill’ which is not eligible for depreciation under section 32(1 )(ii) of the Act. The Assessing Officer treated the consideration amounts as having been paid for ‘goodwill’ as against claimed as a consideration for intangible assets. He has ignored the contention of the assessee that the transfer of business was based on the business-valuation-report given by M/s. Ernst & Young Pvt. Ltd., and as per this report, the transferor possessed pre-qualification rights and technical proprietary information at the value estimated and that the parties have agreed to consider this amount as a value for transfer. The assessee further substantiated its claim by stating that M/s. Best & Crompton Engineering Ltd. was having vast experience, and also track record of Electrical and Projects Contracting Division, and the transfer took place was along with the skilled employees besides the entitlement to quote for any tender by virtue of the technical expertise they had gathered over the years. It was further contended that the pre-qualification right is a commercial right acquired from M/s. Best & Crompton Engineering Ltd. which could not be equated with ‘goodwill’, at all. It was submitted that sections 32 and 55 clearly distinguish between a goodwill and commercial rights, brand value and tenancy rights. To further clarify its claim the assessee stated that any goodwill which Best & Crompton Engineering Ltd. could be stated to have, it was submitted that this company was making losses in contract business and hence, there could be no goodwill for the Electrical & Projects Contracting Division which was transferred to the assessee. It was contended that the experience of Best & Crompton Engineering Ltd. for the last ten years was the main criteria for quoting of tenders and that as per clause 2.4 of the business transfer agreement, Best & Crompton Engineering Ltd., bound itself to facilitate the assessee for quoting of the jobs and as per the agreement, pre-qualification rights were transferred to the assessee; and as per clause 3.22 of the sale agreement, the assessee agreed to pay the transferor royalty for permitting to use its name which has been termed as ‘goodwill’ in the agreement computed at the rate of 0.5 per cent of the annual turnover. But there was no goodwill in view of the losses incurred by Best & Crompton Engineering Ltd. Regarding technical proprietary information, it was contended that it shall include design reports, manuals, know-how, technical information, formulas and efficiency improvement techniques as are developed and/or used by Best & Crompton Engineering Ltd., over the years, which are owned by them on the date of transfer relating to projects division. As per the asses see, above information was taken over in the form of books, manuals, technical drawings and designs, presentations, old tender documents and other related materials and therefore, depreciation was eligible as these information would amount to technical information. In the alternative, it was pleaded that, at worst, the assessee was entitled to deduction on account of technical know-how @ 1/6 every year as per section 35AB of the Act. From the records, the Assessing Officer found that except for the diversion of Rs. 9,13,00,000 by M/s. May Springs Investments Ltd., there was no actual payment to the holding company as the balance amount was partly adjusted against the value of equity shares to be allotted to the holding company and partly by treating it as a loan to the assessee company. By treating both the entities as separate for income-tax purposes, the Assessing Officer examined only the nature of payment and finally he concluded that this payment was towards goodwill only. He, therefore, disallowed depreciation on pre-qualification rights as well as on technical know-how as claimed by the assessee. Aggrieved, the assessee preferred appeal for all the four years before the ld. CIT(A), who has passed a common order for all the four years because the question to be settled in all the four years is exactly identical. After considering the submissions of the assessee and the Department, he has given a finding that the assessee is entitled to depreciation on both the items. Now, the Revenue is in appeal and we extract below the grounds taken by the Revenue for assessment year 2002-03, which would also reflect the grounds taken in other years:

“1. The order of the learned CIT(A) is contrary to law and facts and circumstances of the case.

2.1 The learned CIT(A) erred in directing the Assessing Officer to allow depreciation on pre-qualification rights and technical know-how.

2.2 The learned CIT(A) failed to note that there is no basis for the valuation of the above assets by M/s. Ernst & Young (P.) Ltd. Except for the diversion of Rs. 9.31 crore received from M/s. Springs Investments Ltd., there is virtually no actual payment to the holding company. The balance amount has been partly adjusted against the value of equity share allotted to the holding company and partly by treating the same as loan to the assessee­company.

2.3 The learned CIT(A) ought to have seen that the above transaction was only a financial transaction and the entire transaction was a paper transaction in order to avail depreciation benefits.

3. For these and other grounds that may be adduced at the time of hearing, it is prayed that the order of the ld. CIT(A) may be set aside and that of the Assessing Officer restored.”

5. We have considered the rival submissions. The main plea taken by the ld.DR is that the ‘goodwill’ defines as ‘privilege of trading as the successor to a well established business’. It is a value of all available attributes relating to a business enterprise such as customers attitudes, superior products, pleasing surroundings, desirable location, time factor, management, good name and reputation in business. As per the ld.DR, the Assessing Officer was correct in holding that the valuation report given by M/s. Ernst & Young Pvt. Ltd. cannot be made a basis for valuing pre-qualification rights and technical know-how. On the other hand, the ld.AR has relied on the lengthy written submission filed before ld. CIT(A) which has been extracted in his order verbatim as well as he has submitted oral submissions controverting the allegation of the Assessing Officer. We have examined the entire details including the written submission filed before the ld. CIT(A) which is apart of the appellate order as well as the paper book filed before us. The sole question involved is as to whether the pre-qualification rights and technical proprietary information could be treated as intangible assets eligible for depreciation under section 32 or these tantamount to ‘goodwill’ which will not admit any depreciation under the Income-tax Act, 1961. In our considered opinion, after going through the business transfer agreements entered into between the parties clause by clause, we can safely conclude that by no stretch of imagination, the pre-qualification rights and technical proprietary information can be treated as ‘goodwill’. These have to be treated as ‘intangible assets’. The valuation report given by the reputed Chartered Accountant’s firm, a copy of which was placed before the Assessing Officer, cannot be lightly brushed aside and in our opinion, the Assessing Officer has erred in observing that the valuation of pre-qualification rights and technical know-how cannot be valuated as has been done. In fact, a commercial/business right is acquired by application and development of technical knowledge and experience in a chosen field of activity. The common examples for such rights are software/manufacturing process, patents,trademarks etc. It is the exclusive property of a person who is entitled to enjoy or to transfer at its will, it cannot be seen or in other words, is not tangible but its value for a particular business may be indispensable. On the contrary, a ‘goodwill’ of a business is a reputation which a company enjoys with its customers in its chosen field of activity. A goodwill enables the company to give more business and profits than its competitor. Thus, it is an intangible asset of a subjective nature which is exclusively available to that particular entity. The common examples of goodwill are locational advantage, image of the proprietor/directors etc. It is true that both commercial rights as well as goodwill can be classified as ‘intangible asset’. But the distinguishable feature of the two is that the commercial rights whether the business runs profitably or not, it never diminishes or gets distinguished; but in case of goodwill, the business gets diminished or even gets distinguished in proportionate to the existing status of the ‘goodwill’. In the given case, the holding company has been incurring losses for a number of years. The pre-qualification rights which was created over a period of time continued because of which it could bid or quote for tenders. Although there was continuous losses being suffered, yet, there being no goodwill, the business did not get distinguished. The undisputed facts of this case can be detailed as under:

(i)   The assessee is a wholly owned subsidiary of Best & Crompton Engineering Ltd., which was carved out of the project division of the holding company as per business transfer agreement for a consideration of Rs. 34.85 crores;

(ii)   The break-up of project consideration includes the cost of technical proprietary information at Rs. 10 crores and value of commercial/pre-qualification rights at Rs. 12,65,42,944 on which the Assessing Officer did not allow depreciation;

(iii)    The consideration for which the project division was to be transferred to the company was determined based on the business valuation report of M/s. Ernst & Young Pvt. Ltd. which was submitted before the Assessing Officer along with letter dated 2 1-1-2005;

(iv)    The assessee adopted the same value as per the valuation report given by M/s. Ernst & Young Pvt. Ltd. in respect of technical proprietory information and pre-qualification rights;

(v)   As per the business transfer agreement, the pre-qualification rights and technical proprietary information are defined and further the same were transferred to the assessee;

(vi)    The pre-qualification rights include skills and expertise of the employees, transfer of the commercial rights or eligibility entitlement to quote for tender in the areas of business by virtue of having executed the works of similar nature and capacity;

(vii) The pre-qualification right was valued on the basis of 5 per cent of the total sale value for the last five years of the project division of Best & Crompton Engineering Ltd. on the total sales (contract);

(viii)As per section 32(1 )(ii) introduced by the Finance Act, 1998 depreciation is allowable on intangible assets like know-how, patents, copyrights, trademarks, licence or franchise or any other business or commercial rights of similar nature.

6. With reference to the above admitted facts, it is not true that there is no basis for valuation of the intangible assets which are pre-qualification rights and technical proprietary information. There are numerous methods for valuation of business and the one such method which has been adopted by M/s. Ernst & Young Pvt. Ltd. and it is evident in the report itself, which has dealt the issues extensively to arrive at the business valuation. We cannot attach much importance to the routine disclaimer appended to the report in question because normally every valuation report, being an estimation, contains such a disclaimer to avoid future litigation. A business valuation is definitely different from an audit report. The hiving off of the projects division was done with an intention to carry on the business of projects division in a better and efficient manner. Seemingly because the manufacturing units of Best & Crompton Engineering Ltd. was not profitable and there were major problems which could affect the operations of the projects division, in our considered opinion, Explanation 2 and 2A appended to section 43(6) of the Act is not applicable in the given case as the pre-qualification rights and technical proprietary information were not forming part of the block of assets of the holding company namely Best & Crompton Engineering Ltd. No need to mention that hiving off of the Projects Division is a demerger and it does not amount to demerger in the given case. The assessee­company could carry on business only on acquisition of pre-qualification rights, so, it can be safely epilogued that it is not simply a book entry, more particularly, because the customers of the company are Indian Railways, PSUs, like Power Grid Corporation, NTPC Ltd., and International Companies, to whom the business purchase agreement was submitted to prove the pre-qualification rights and this was the basis for awarding of tenders to the assessee when it had no qualification to bid on its own for tenders. The entire consideration of Rs. 34.85 crores for hiving off the Projects Division by the holding company was discharged by allotment of shares for Rs. 20 crores and the balance of Rs. 14.85 crores was unsecured loans which was paid by the assessee and the balance as on 31-3-2002 was only Rs. 1,03,11,000 as is evident from the audited accounts dated 30-6-200 1 and loan funds – Schedule 2 of the audited accounts as on 3 1-3-2002. The mode of discharge for purchase consideration and the details of amount discharged were submitted by the assessee vide letter dated 21-3 -2005 as under:

7. Therefore, the cumulative effect from these facts is that the transfer of pre-qualification rights and technical proprietary information by the holding company was on account of genuine commercial considerations done, at arms length, based on the business valuation report, given by a reputed firm of Chartered Accountants and without which the assessee would not have been in a position to carry on the business and also to secure further business. In our opinion, this transaction cannot tantamount to only a paper transaction or sham transaction as there is no such evidence on record. Consequently, we do not find any error in the appellate order and we confirm the findings of the ld. CIT(A).

8. In the result, all the appeals filed by the revenue stand dismissed.