Drafting of agreements for purchase of undertakings : A lesson from supreme courts judgment in CIT v. Hooghly Mills Co. Ltd.

[Mrs. Uma Kothari]

Purchase of undertakings - We find several cases in which a business is taken over from the previous owner by a new owner.  The acquisition is called as take over of a business and the purchase is on the basis of a going concern. 

Taking over of assets and liabilities

Usually in case of take over of a business, assets and liabilities of the business are taken over by acquirer.  Sometimes, there may be some assets or liabilities, which are retained by the transferor.  However, there is a mix of assets and liabilities, both of which are being taken over by the buyer / acquirer / transferee.

Acquisition pricing

Sometimes the business is acquired for a lump sum consideration without any allocation of value to various assets and liabilities. The parties agree for lump sum consideration.  In such case the consideration is called as a consideration for sale of the business of 'slum sale basis'. Though there may be internal calculations by both the parties for working out the consideration and negotiation of net price payable. 

Allocated value

Sometimes the seller and the buyer allocates value of various assets transferred as well as various liabilities transferred to the acquirer.  In such case the net consideration is worked out and that is paid by the acquirer to the seller.

Broad valuation

Sometimes in stead of valuing each and every asset or class of asset, broad valuation is made for the assets of the undertaking and there from the estimated liabilities of the running business is deducted and the acquirer pays the net consideration. This can be transacted in two ways- by payment of net consideration or by way of full payment for assets acquired and receiving back from the transferee, the amount of liability.  An example -

(a) slum sale - a sugar mill of 3000 TCD capacity is sold with all its assets and also liabilities for a net consideration of Rs.30 crores.

(b) The sugar mill is valued as follows:-

a)  Value of fixed assets including land, building plant and machinery, Furniture & Fixtures, roads and bridges	20   crores
b)   Current assets of the sugar mill	15 crores
Less - Current liabilities	5 crores
Net current assets	10 Crores
Total	30 Crores
c) Allocation of value to various assets
Land	2 crores
Buildings	5 crores
Roads & Bridges	1 crore
Plant & Machinery	11 crores
Furniture & Fixture and vehicles	1 crores
Net current assets	10 crores

In case of slum sale the acquirer can allocate the value of assets at a reasonable basis.  However, when specific valuation is made for various assets in the agreements then it may be difficult to reallocate the same.  Therefore, it can be said that in case of a slum sale, the buyer has a discretion to make a reasonable estimate for various assets.

Intangible assets an important assets:

In case of any running business of manufacturing unit  like a jute mill, sugar mill, tea estate, textile mills, engineering unit,  etc. many intangible assets like manufacturing process information, technical data base of manufacturing processes, data base of plant and machinery, trade brands, trade names, product logos, product packing designs, designs and patterns, data base of assets- technical specifications and  history, data base about employees,  commercial information about suppliers, service providers, customers, and also various licenses like factory licence, industrial licence, trade licenses, storage licenses, etc. are also acquired along with human resources- who can deal with various business aspects. These assets are created over a period of time and they are very vital for running the business in future. With acquisition of such assets the acquirer is enabled to carry business from the first day itself. These assets are very important and an allocation of value for such assets is required to be made.

Capital gains arising on sale of such assets may not be taxable as the date and cost of acquisition and improvement cannot be ascertained. Sale value minus zero will be equal to capital value and there would be no element of profit or gains, furthermore taking nil as cost of acquisition and cost of improvement, cost cannot be inflated with CII, therefore computation of LTCG fails. Hence following B.C.Srinivas Setty's case 128 ITR 294 (SC) capital gain cannot be computed. There is no other provision except S. 45(1) in which such gain can be brought under taxable category under the head 'capital gains'.

Liability taken over but not mentioned as a consideration:

If a liability is taken over as a part of consideration of the acquisition of the unit, then such liability ( including some additional liability which may be found later on) can be considered as part of 'actual cost' of assets taken over. However, in case valuation of assets is made separately and in addition to the value paid by the acquirer, for assets, the acquirer also takes over the liability then it may be difficult to allocate the amount of such liabilities towards other assets taken over for which specific valuation has already been made in the agreement.

Case of Hooghly Mills (2006) 157 Taxman 347 (SC):

The case of Hooghly Mills - In case of Hooghly Mills the agreement provided for a specific amount as consideration for the assets taken over as follows:-

The amount of consideration agreed to be paid by the purchaser t the vendor shall be apportioned amongst the following heads:

	(Rs. in lakhs)
(A) Land	5
(B) Buildings, structures, godowns sheds and all other constructions and properties of immovable nature at the said premises	35
(C) Plant, machinery and other movables	160
	200

     thus the consideration for various assets was specifically fixed in the agreement.

In the same agreement it was also provided that  in addition to the consideration of Rs.200 lakh  , the accrued and future gratuity liability of the taken over workers, junior and senior officers, on their retirement or otherwise on termination of their services payable under the Payment of Gratuity Act or otherwise including for the entire period of service with the vendor shall be on the purchaser's account and shall be met by the purchaser.

Thus, the purchaser undertook to pay gratuity liability including for past services to the workers staff etc. whose service was considered as continuing service with the purchaser as new employer. However, there was nothing mentioned that such liability was taken over as a part of consideration to transfer the assets for which a specific valuation was agreed with the transferor.

The learned CIT(A) , Tribunal and the high court concurrently considered that  taking over of the liability was incidental to the take over of the business and therefore, the liability taken over can be spread over the vale of assets taken over and accordingly depreciation can be allowed. They relied on provisions of section 43(1) relating to the meaning of 'actual cost' of assets in the context of depreciation allowance under section 32. It is clear that they did not held that the gratuity liability was a depreciable assets. However, they considered gratuity liability as a part of consideration and actual cost of assets acquired and held it to forming 'capital expenditure' and capital cost of assets taken over to be allocated over various assets fro allowing depreciation allowance.

Decision of the Supreme Court:

However, on appeal by the revenue the Supreme Court held that as per agreement specific amount was mentioned as consideration for assets purchased. And liability for gratuity was taken over and estimated. Such liability was not taken over as a part of valuation of assets. However, it was not as a part of consideration for purchase of assets for which specific valuation was made and consideration was agreed. The court also held that gratuity liability would be revenue expenditure in hands of the vendor but in the hands of buyer of the undertaking it will be capital expenditure. Such capital expenditure is not for acquisition of any depreciable assets so it cannot be allocated as cost of assets acquired.

Gratuity liability as such is not an asset of any tangible or intangible nature as specified in section 32, therefore depreciation in respect of the same cannot be allowed.

What if the amount was not specified or kept consolidated?

     If there was no mention of the specific amount for various assets and net consideration was paid in addition to the liability taken over, it would have been possible to spread the amount of liability taken over as part of cost of assets taken over. The Supreme Court also considered this aspect and observed as follows:

        "Had it been a case where the agreement of sale mentioned the entire sale price without separately mentioning the value of the land, building or machinery, we would have remitted the matter to the Tribunal to calculate the separate value of the items mentioned in section 32 and grant depreciation only on these items.  However, in the present case, the agreement itself mentioned the value of the building, plant and machinery.  Hence it is not necessary to remit the matter to the Tribunal in this case."

Lesson from the judgment:

We learn a lesson from the judgment that any agreement should not be drafted in hurry and haste. There may be some factors affecting drafting style. For example, in this case for the purpose of stamp duty, it might have been considered proper to place a specific price in the agreement for immovable properties. It may be a case that deliberately value of immovable assets was kept at lower amount to reduce stamp duty liability. However, by doing so discretion of allocation of value was lost. The agreement is silent about intangible assets taken over or which came along with undertaking. In case of any running business of manufacturing unit like a jute, tea estate, textile mills, engineering unit etc. many intangible assets like trade brands, trade names, product logos, designs and patterns, data base of assets- technical specifications and history, data base about employees, commercial information about suppliers, service providers, customers etc. are also acquired along with human resources. With acquisition of such assets the acquirer is enabled to carry business from the first day itself. Therefore, it appears that an allocation of value for such assets was also required to be made.

It is true that no businessman shall accept a liability without corresponding advantage. In fact the buyer must have in mind these advantages, and that's why he agreed to take over liability of gratuity in addition to value for assets as mentioned in the agreement. However, in absence of mention of these assets it may be difficult to establish claim for deprecation on such intangible assets.

Therefore, it is advisable that in the agreement all assets and advantages obtained must be mentioned and the consideration can be mentioned in manner of slump price, so that in future there is scope of reallocation of amount on some reasonable basis and discretion can be exercised not only by the businessman but also by different officers and courts while dealing with different matters.    

Suppose in the case of Hooghly Mills, there was mention of all or specific assets and advantages (tangible and intangible assets) and liabilities taken over  and net consideration payable was fixed at  Rs. two crores, then  it was possible to allocate not only the amount of gratuity liability but also any other liability which may be found and  become payable in future for past business of transferor , as actual cost of assets acquired.