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Intangible Assets – Capitalisation of Technology Assets in India

Updated: Jul 2

In today's knowledge-driven economy, the true value of a company often lies not in its physical assets, but in its intellectual property, software, brand, and customer relationships. This dramatic shift is aptly captured by a staggering statistic: according to Ocean Tomo's Intangible Asset Market Value Study. In 1975, a whopping 83% of S&P 500 assets were classified as tangible. Today, that number has flipped, with tangible assets accounting for a mere 10%, while intangible assets reign supreme at 90%.[1]


Intangible assets are rapidly becoming the lifeblood of companies where information and innovation are king.[2]Similarly, the Indian business landscape is witnessing a surge in technology-driven innovation, leading to the growing importance of intangible assets. Though these assets do not have a physical form, many times they contribute significantly to a company's competitive advantage and ultimate profitability.


In almost all tech startups, a substantial amount of time and effort in the initial years goes into developing an intangible asset that is expected to generate revenue, cost savings, or enhancement of other assets in the future. However, costs incurred in developing intangible assets are entirely expensed to the Profit and Loss account whereas benefits of the development cost are accrued to the start-up in the future years.


An asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow. An intangible asset is an identifiable non-monetary asset without physical substance.


This article delves into the fascinating world of intangible assets, exploring their recognition mechanisms and nuances in the capitalization of technology assets.


Image for Intangible Assets
Image 1: Intangible Assets

What are Intangible Assets?


Intangible assets are well defined by the Indian Accounting Standard (IndAS) 38 as assets that lack physical form but have the potential to generate future economic benefits.[3] Patents, Trademarks, Software, Goodwill, and Intellectual Property are all examples of intangible assets. According to IndAS 38, an asset needs to meet the following criteria to be categorized as an intangible asset, i.e.:


Recognition criteria to classify intangible assets according to IndAS 38
Image 2: Recognition criteria to classify intangible assets according to IndAS 38

It can be challenging to assess whether an intangible asset qualifies for recognition as it has to satisfy the following test laid down under IndAS 38:[4]


  1. Identifiable: An intangible asset is identifiable when it is separatable (i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or related contract)[5];  or arises from contractual or legal rights, regardless of whether those rights are transferable or separable from the entity or other rights and obligations[6].

  2. Reliability of measurement: The cost of the asset (whether to add to, replace part of, or service it)[7] can be reliably determined at the time of recognition. If the cost cannot be reliably measured, the asset cannot be recognized.[8] The purchase price or development costs should be documented, with the help of invoices and contracts.

  3. Control: The entity has the power to obtain future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. The capacity of an entity to control the future economic benefits from an intangible asset would normally stem from legal rights that are enforceable in a court of law.

  4. Future economic returns: The asset is expected to generate probable future economic benefits for the entity by way the of sale of products or services, cost savings, or other benefits by way of using the asset.[9]


Determining if future benefits are probable should rely on realistic and well-founded assumptions about the asset’s lifetime conditions.[10] However, for assets acquired separately or through mergers, the probability requirement is automatically met.[11]

Intangible assets can be bifurcated into two major heads; (i) Internally generated intangible assets, and (ii) Externally acquired intangible assets.

Many times it is difficult to assess whether an intangible asset qualifies for recognition because of the following issues:


  • Identifying whether and when there is an identifiable asset that will generate expected future economic benefits; and

  • Determination of the cost of the asset reliably as it is often difficult to distinguish whether the cost is incurred for maintaining or enhancing the internally generated intangible asset or for running day-to-day operations.


Thus, to simplify, whether an internally generated intangible asset qualifies for recognition, an entity is required to classify such an asset into two phases:


  1. Research phase: According to IndAS 38 terms, research is "original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding."[12] It's about venturing into the unknown, seeking fundamental discoveries or breakthroughs. Research costs are generally expensed as incurred, not capitalized, due to the high uncertainty and lack of identifiable future benefits.[13]

  2. Development Phase: Development takes research findings a step further, "applying research findings or other knowledge to a plan for the production of new or substantially improved materials, devices, processes, systems, or services."[14] It focuses on taking research concepts and transforming them into tangible applications. If specific criteria are met (identifiable, controllable, measurable, and future economic benefits), development costs can be capitalized as an intangible asset.


The Standard also prohibits an entity from subsequently reinstating as an intangible asset, at a later date, an expenditure that was originally charged to expense.[15]


Why capitalize on tech assets?


Capitalizing tech assets refers to the accounting treatment of recording these assets on the balance sheet, thereby spreading their cost over their useful life. This has several advantages:


  1. Enhanced financial reporting: a. Increases the asset base on the balance sheet: Capitalization provides a more accurate representation of a company's financial health, attracting investors and facilitating access to capital, particularly for technology-driven businesses. b. Accurate net worth in case of an exit: In case of an exit event for a company/founder, an intangible asset recognized on the balance sheet will assist in determining the net worth more accurately as the cost of the intangible asset will now also be considered. c. Enhanced transparency by way of the Matching concept: As per the “Matching Principle” of accounting, the company should recognize the expenses at the same time as the revenues they relate to. In tech-driven companies, costs involved in developing intangible assets are incurred in the initial years, however, revenue against the same is only realized once the asset is put to you and revenue gets generated.

  2. Income Tax benefits: a. Set-off and Carry Forward: Section 72 of the Income Tax Act, 1961 allows to carry forward business losses for eight consecutive assessment years.[16] However, the said restriction of eight consecutive assessment years shall not be applicable in case of unabsorbed depreciation[17] which can be carried forward for an indefinite period and can be set off against other income heads. Therefore, if the technology development cost is expensed to contribute to the business loss, the same may only be able to carry forward and set off the same for a period of eight consecutive years. However, if the technology development cost is capitalised, the depreciation charged on this technology asset shall be eligible for carry forward and set-off for an indefinite period. b. Computation of Capital Gains: In case of an exit event for the company or founder, the technology asset capitalized will be eligible to be reduced as cost of acquisition/cost improvement to be reduced from the net sale consideration payable which will, in turn, reduce the capital gains tax on the sale. However, if the technology development cost is expensed out, no cost shall be attributable to the intangible assets being transferred for reduction from the net sale consideration, leading to a higher capital gains tax payable.


Case Study


Case Study
Image 3: Case Study for Surya Power

Financial Reporting:


  • Accurate Financial Reporting: Surya Power will be able to provide a more accurate representation of a company's financial health as the cost incurred in developing "Prakash" will be capitalized to be set off against revenue in line with the "Matching Principle" of accounting rather than being expensed out to the profit and loss account to reflect increased losses.

  • Identifiable Asset Recognized: Further, as the development cost incurred on Prakash will be capitalized, Surya Power will be able to increase its asset base for easier access to capital, as well as accurately track and report investment in “Prakash” to investors and stakeholders showcasing its commitment to sustainable innovation and its potential to revolutionize rural energy access including potentially opening doors for government grants and subsidies for cleantech initiatives.


Tax Benefits:


  • Unabsorbed Depreciation carry-forward: Technology start-ups may not become revenue-generating immediately, as the initial years are invested in developing the underlying product. By merely capitalizing on the cost of technology development, Surya Power may carry forward the eligible unabsorbed depreciation if any on “Prakash" for an indefinite period or until Surya Power starts generating revenue.

  • Capital Gains Tax on the sale of Prakash: When Surya Power eventually sells Prakash, the carrying amount (cost net of depreciation) will be eligible reduced from the Net Sale Consideration for calculating the capital gain or loss on the sale. This potentially reduces tax liability for Surya Power as compared to if they had chosen to expense the costs incurred on developing Prakash.


Key takeaway:


Surya Power's case exemplifies how by change in the accounting practices, the cleantech startup was able to claim advantages such as tax benefits, unlock the potential of their intellectual property, boost financial performance, and contribute to impactful social change.


Conclusion


Capitalizing tech assets is becoming increasingly important for companies in the digital age. By merely following accounting best practices, start-ups may be able to unlock the benefits of accurate representation of performance, informed decision-making, and tax benefits. 

It is critical to note that before capitalizing on Technology Assets, an assessment should be done to identify and capitalize only those costs that are justifiable as development costs. The assessment should be made in consultation with the auditors and should be supported with adequate documentation and a basis for capitalization.  One cannot rule out the possibility of the Income Tax officer questioning the capitalization of tech cost and charge of depreciation as a means to reduce the income tax liability of the company in future years.


This article has been co-authored by Karan Dhingra, Corporate Team - Technology Product Coordinator, and Pratik Mehta, Manager, Transaction Advisory - Finance & Tax, with inputs and insights from Varun Rajda, Partner, Constellation Blu.

 

[1] Valuation Conundrum III: The Rise Of Intangible Assets, Outlook India; (Available at: https://www.outlookindia.com/website/story/business-news-valuation-conundrum-iii-the-rise-of-intangible-assets/397018)


[2] IP Finance Dialogue: Expanding Horizons on IP Finance and Valuation, WIPO; (Available at: https://www.wipo.int/sme/en/events/ip-finance-dialogue.html)


[3] Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[4] Para 21, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[5] Para 12(a), Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[6] Para 12(b), Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[7] Para 18, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[8] Para 21, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[9] Para 17, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[10] Para 22, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[11] Para 33, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[12] Para 8, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[13] Research & Development (R&D), Corporate Finance Institute; (Available at: https://corporatefinanceinstitute.com/resources/accounting/research-and-development-rd/#)


[14] Para 8, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)


[15] Para 71, Indian Accounting Standard (Ind AS) 38 – Intangible Assets; (Available at: https://www.mca.gov.in/Ministry/pdf/IndAS38_2019.pdf)



[17] Unabsorbed depreciation refers to the portion of depreciation expense exceeding a company's taxable income in a particular year. It can be utilized through set-off and carry-forward mechanisms under Sections 32 and 72 of the Income Tax Act, 1961.

 

Disclaimer: This article is provided for informational purposes only and does not constitute legal advice or an official legal opinion. The views expressed are those of the author and are based on the applicable law and facts available at the time of writing. The information has been prepared with due diligence and accuracy. Readers are advised to consult their own advisors, and refer relevant statutory provisions, latest judicial decisions, circulars, and clarifications before taking any action based on the information in this article. Alternative interpretations of the subject matter may exist. By utilizing this information, you agree that the author and Constellation Blu are not liable for the accuracy, authenticity, completeness, or any errors or omissions contained herein, nor for any actions taken based on this information.

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