Defining “Goodwill” and it’s tax treatment

Studies on goodwill have dated as far back as the late 1800’s and have remained a topic of argument and debate to present day.

Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business.

As per IFRS, Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.

Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so.

From the SARS Guide to Capital Gains Tax, Goodwill also include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations.

Intangible assets include goodwill, debts, patents, copyrights, trade marks, designs and mineral rights.

Examples of identifiable assets that are goodwill include a company’s brand name, customer relationships, artistic intangible assets, and any patents or proprietary technology. The goodwill amounts to the excess of the “purchase consideration” (the money paid to purchase the asset or business) over and above the total value of the assets and liabilities.

Goodwill is often not purchased, but is self-generated by the business.

The goodwill of a business is a single asset, separate and distinct from the other assets of the business. It does not attach to the identifiable assets of the business. On the other hand, goodwill has no existence independently of the conduct of a business and cannot be severed from the business that created it.

A few reason are given below why you would value Goodwill.

Business or professional practice merger.
Business or professional practice separation.
Solvency test.
Insolvency test.
Inter-company transfer price.
Bankruptcy and reorganisation.
Business enterprise valuation.
Ownership allocation litigation.

Factors Affecting the Goodwill value:

The profitability of company is past and expected profit in future will affect value of Goodwill;
Capital Employed to earn profit;
The yield from business as expected by investors;
The longevity of existence of business concern;
Market share of products of entity;
Quality of services rendered;
The edge of concern over its competition in the market;
Relationship between management and staffs;
Location of business enterprises;
Brand position and efforts taken to establish brand of the concern,
Technical innovation, modern technology, patents,etc.
Tax Planning;
Relationship with Government, local bodies;

When a taxpayer sells a distinct and separate business and the goodwill attaching to that business was not separately valued at the valuation date, SARS accepts that certain difficulties may arise.

If only one business is being carried on and a part of it is disposed of, it is a question of fact whether a discrete business, to which goodwill attaches, has been disposed of.

This question is determined having regard to all the facts and circumstances, including whether:

sufficient relevant assets are sold to enable the purchaser to continue with the business, the assets sold are accompanied or carry with them the legal right, privilege or entitlement to conduct the business, and what is sold is sold as a self-contained business.

If part of a business is disposed of, an important consideration is whether the effect of the transaction is to put the purchaser in possession of a going concern, the activities of which the purchaser could carry on without interruption.

In the SARS Comprehensive Guide to Capital Gains Tax (Issue 4), part of the determination of the base cost of an asset is done by using the time-apportionment base cost formula. If the goodwill/asset was valued at 1 October 2001, that value will represent the base cost of the goodwill. In cases where the valuation was not done, the time-apportionment base cost formula will be applicable.

The use of time-apportionment for determining the valuation date value of self-generated goodwill may be possible in appropriate circumstances.

The time-apportionment base cost method is one of four methods that may be used for determining the valuation date values of assets acquired before valuation date; the other three being:

the market-value method (paras 29 and 31),
the weighted-average method [para 32(3A)] and
the ‘20% of proceeds’ method (para 26).

Under the time-apportionment method the growth or decline that occurred before 1 October 2001 is added to or subtracted from the pre-CGT expenditure to arrive at the time-apportionment base cost, which constitutes the valuation date value (VDV). The expenditure incurred after the valuation date is added to the time-apportionment base cost to arrive at the base cost under para 25.

The time-apportionment base cost method involves two types of apportionment, namely, time apportionment (applicable in all circumstances), and expenditure apportionment (applicable when expenditure is incurred on or after valuation date).

What costs should be allocated to self-generated goodwill in the time-apportionment and proceeds formulae?

Much of the expenditure contributing to goodwill (for example, salaries and wages and advertising costs) will have been allowed against income and will be excluded from base cost.

Costs relating to other identifiable assets (for example, an advertising sign of a capital nature or the cost of a building) should be allocated to those assets, rather than to goodwill. While these other assets may contribute to the existence and value of goodwill, they are considered to be separate from goodwill which is taken as an asset in its own right.

Goodwill may comprise different elements or arise from different sources, for example, a person, monopoly, site or name, it is treated as one asset inseparable from the business.

However, a word of caution needs to noted in cases in which there is no pre-valuation date expenditure. The entire capital gain will be subject to CGT if there is even the slightest amount of qualifying post-valuation date expenditure because of the effect of the proceeds formula.

Secondly, at what point before the valuation date is the goodwill created? This information is needed to determine ‘N’ in the time-apportionment formula (number of years or part of such years before valuation date).

The following extract from the United Kingdom Inland Revenue and Customs Capital Gains Manual sets out when self-generated goodwill is acquired:

‘Where an asset was not acquired but was created by the person making the disposal, for example goodwill, the date of acquisition is the date the asset was created. The date the asset was created is determined as a question of fact on the basis of the evidence available.’

Calculating Goodwill

According to IFRS 3, “Business Combinations,” Goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired.

The general formula to calculate goodwill under IFRS is:

Goodwill=(C+NCI+FV)−NA

where:

C=Consideration transferred
NCI=Amount of non-controlling interest
FV=Fair value of previous equity interests
NA=Net identifiable assets

Non-Controlling Interests in the Goodwill Calculation

The method to calculate goodwill is straightforward however an issue arises in measuring one of the variables. The amount of non-controlling interest (NCI) plays a significant role in the goodwill-calculation formula. A non-controlling interest is a minority ownership position in a company whereby the position is not substantial enough to exercise control over the company.

Under IFRS 3, there are two methods for measuring non-controlling interest:

Fair value or full goodwill method
Non-controlling interest’s proportionate share of the acquiree’s net identifiable assets

Part-disposal of goodwill

The goodwill of a business is a single asset, separate and distinct from the other assets of the business. It does not attach to the identifiable assets of the business. Goodwill has no existence independently of the conduct of a business and cannot be severed from the business that created it.

Logically, goodwill as a general rule cannot be partly disposed of. It is accepted that it is possible to own and operate separate and distinct businesses, each with its own goodwill.

When a taxpayer sells a distinct and separate business and the goodwill attaching to that business was not separately valued at the valuation date, SARS accepts that certain difficulties may arise.

The following approach will be adopted:

If only one business is being carried on and a part of it is disposed of, it is a question of fact whether a discrete business, to which goodwill attaches, has been disposed of.

This question is determined having regard to all the facts and circumstances, including whether:

sufficient relevant assets are sold to enable the purchaser to continue with the business, the assets sold are accompanied or carry with them the legal right, privilege or entitlement to conduct the business, and what is sold is sold as a self-contained business.

If part of a business is disposed of, an important consideration is whether the effect of the transaction is to put the purchaser in possession of a going concern, the activities of which the purchaser could carry on without interruption.

The disposal of pre-valuation date goodwill

Paragraph 33 of the Eighth Schedule of the Income Tax Act provides for the apportionment of the base cost of an asset when there is a part-disposal of that asset. In applying paragraph 33, the following should be noted:

The discrete business disposed of must have been in existence in its present form on 1 October 2001. In other words, one cannot allocate a portion of the goodwill in existence on 1 October 2001 to the disposal of a business that commenced after that date. This requirement means that one cannot allocate a portion of the goodwill in existence on 1 October 2001 to the disposal of a group of assets that did not, in themselves, constitute a discrete business on 1 October 2001, even though the assets were assets of the business on that date.

Annual revaluation

Management is responsible for revaluation of goodwill every year and to determine if an impairment is required. If the fair market value goes below historical cost (what goodwill was purchased for), an impairment must be recorded to bring it down to its fair market value. However, an increase in the fair market value would not be accounted for in the financial statements.

Revaluation does not mean only an upward revision in the book values of the asset. It can also mean a downward revision (impairment) in the book values of the assets. Any downward revision in the book values of the assets is immediately written off to the Profit & Loss account. Under IFRS, an asset is considered to be impaired (and is thus written down) if its carrying amount is greater than its recoverable amount. The recoverable amount is the greater of the asset’s value in use (present value of future values) or net realizable value.

Indicators of goodwill impairment according to the IAS 36 Standard as a minimum include:

External information that show observable indications that an asset’s value has declined abnormally in the period. Significant changes taking place in the year or near future with an adverse effect on the entity A decline in market interest rates or rates of return on assets and when the carrying amount of the net assets of an entity is more than its market capitalisation (IASB,2008d)

Amortisation

Under IFRS, Goodwill is never amortised (distribution of loan repayments into multiple cash flow installments). For accounting purposes self-generated goodwill is not reflected in the financial statements of an entity.

Author Craig Tonkin

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