What are the tax implications of sale of goodwill on the seller? An early decision of the Supreme Court viewed the provisions of the Income Tax Act, 1961 strictly and held that sale of goodwill cannot result in any capital gains since it being a self-generated asset, its cost of acquisition and improvement cannot be worked out (CIT vs BC Srinivasa Setty 128 ITR 284). For many years, therefore, this principle held sway. In fact, this decision promoted several other decisions whereby other self generated assets such as route permits, tenancyrights, etc. were also held to be outside the purview of capital gains. However, in 1988, to bring profits arising from sale of goodwill into the tax net, an amendment was made to the Act whereby it was provided the cost of self generated goodwill will be deemed to be nil. Thus, the decision of the Supreme Court had been neutralised to this extent.

However, often, one sees in practice, that the tax department attempts to use provisions relating to tax one type of income to tax a related but untaxable income. The artificial provision deeming the cost to be nil extends only to goodwill and certain other assets such as route permits, etc. An attempt is often made, however, to treat sale of other self generated assets as sale of goodwill to levy tax. An interesting recent case, in which the assessee lost, brings this issue to the forefront.

In this case (ITO vs Prabhatkumar Agarwal (1999) 69 ITD 224 (Ind.)), the assessee had sold a dealership of kerosene of the Indian Oil Corporation to a third party for acertain sum. Under the dealership agreement, the assessee was prohibited from transferring the dealership to any third party. Apparently, to circumvent this restriction, the assessee sold the rights of the firm name to the third party. Further, he agreed that he or his family members will neither use that firm name for any business nor will claim any rights towards the dealership. The assessee claimed that this was a sale of a self generated asset and hence there could be no taxable capital gains. However, the assessing officer claimed that the sale of dealership amounted to sale of goodwill which was covered by the amendment. In view of this, he held that the cost of acquisition of the asset was nil and the whole amount received was taxable capital gains.

This matter went to the tribunal, who, it is respectfully submitted, incorrectly, held that the sale of the dealership was sale of goodwill resulting in taxable gains. The tribunal observed, "On consideration of the various definitions of goodwill in theaforesaid legal dictionaries, it has become abundantly clear that the goodwill is an intangible benefit attached to the business which can be subject to transfer from one person to another. In a transfer of goodwill, certain benefits and advantages attached to the business are being transferred through a covenant and the purchaser can enforce the covenant for the protection of his business. If we examine transfer of a kerosene dealership in the instant case in the light of the definitions of goodwill illustrated in the legal dictionaries, we will find that by transfer of dealership of kerosene oil, the assessee had transferred certain benefits and advantages attached to the name of the firm in favour of the purchaser for a consideration of Rs 4 lakh by executing a document whereby the assessee has surrendered its all rights with regard to the said business with a specific undertaking that neither the assessee nor his family members would run any business under the name of M/s RR Agarwal."

Based on thissuperficial comparison to goodwill, the Tribunal held that it amount to transfer of goodwill.

The author respectfully submits that one needs to look at the substance of each transaction clearly evident by the circumstances to decide the matter. For goodwill to exist, it has to be clearly be shown that because of the reputation or similar characteristics, customers are drawn whereby the owner gets disproportionate profits. In fact, the more the amount of such profits, the higher the amount of the goodwill. Thus, in a given case, to ascertain whether there is transfer of goodwill or not, one has to see what was really transferred and how much of the sale proceeds related to compensate for loss of recurring extra profits (called "super-profits" in accounting jargon). In this case, it seems that the assessee has sought to circumvent the restriction placed by his principal on transfer of dealership by transferring his name itself whereby dealership was transferred. In substance, therefore, there was a meretransfer of dealership rights which was recognised by the tribunal itself. However, dealership rights are similar to licenses or other rights and have nothing to do with goodwill. It is true that the assessee restrictions were placed on the dealer over the use of the firm name but this is clearly to prevent him to indirectly claim ownership over the dealership rights. Thus, clearly, the sale of dealership rights cannot be said to be sale of goodwill resulting in taxable gains. At best, one could bifurcate the sale proceeds and allocate a portion to goodwill, if one feels that some part really related to the transfer of benefits arising from continuing business flowing in.

To conclude, business restructuring is carried out in transactions which are complex and one needs to look at them through the eyes of a businessman. An approach where only some superficial traits are focussed on merely to levy tax may place undue restrictions over such transactions which, as recent amendments show, are being encouraged byLegislature.

The author is a Mumbai-based chartered accountant