When computing taxable income under the head “Profits and Gains of Business or Profession”, certain expenses or payments may not be deductible under specific circumstances. Section 40A of the Income Tax Act, 1961, provides a framework for disallowing expenses that do not meet the prescribed conditions. This article provides an in-depth analysis of Section 40A, its applicability, and the circumstances under which expenses may be disallowed.
Understanding Section 40A: An Overview
Section 40A overrides other provisions of the Act and restricts deductions of certain business expenses that may be excessive, unreasonable, or non-compliant with prescribed payment methods. The primary aim is to prevent tax evasion and ensure fair transactions.
Key Provisions of Section 40A
The following expenses are not allowed as deductions in specific circumstances:
Payments to Specified Persons – Section 40A(2)
Disallowance of excessive or unreasonable expenses paid to related parties.
Applicability:
If an assessee makes a payment to specified persons and the Assessing Officer (AO) finds the amount excessive or unreasonable, such an expense may be disallowed to the extent it exceeds a fair market value.
Who are Specified Persons?
Specified persons include:
- For individuals – Relatives of the assessee.
- For companies, firms, AOPs, or HUFs – Directors, partners, members, or their relatives.
- Entities having substantial interest (i.e., holding 20% or more of shares or profits).
Example:
A company pays an inflated consultancy fee to its director’s relative. If the AO finds it unreasonable, the excessive portion is disallowed as a deduction.
Cash Payments Exceeding ₹10,000 – Section 40A(3)
Disallowance of cash transactions exceeding ₹10,000 in a day.
Applicability:
If an assessee makes a payment in cash exceeding ₹10,000 to a single person in a day, it will not be allowed as a deduction. There is exception to this section in Rule 6DD.
Exceptions:
- If payments are made in areas with no banking facilities.
- Payments under business exigency.
- Payments made to transporters (limit raised to ₹35,000).
Example:
A business owner purchases raw materials and pays ₹12,000 in cash. Since the payment exceeds ₹10,000, the entire amount is disallowed as a deduction.
Cash Repayment of Earlier Deducted Expenses – Section 40A(3A)
If an allowance was earlier claimed for an expense (on accrual basis) and later paid in cash exceeding ₹10,000, the amount is added back to taxable income.
Example:
A company records an expense of ₹50,000 (on credit) in Year 1 and claims a deduction. In Year 2, it pays ₹25,000 in cash. ₹25,000 is added to taxable income in Year 2.
Provision for Gratuity – Section 40A(7)
Only actual payments towards an approved gratuity fund are allowed.
Disallowance:
- Provisions made for gratuity are not deductible unless paid to an approved gratuity fund.
- Direct gratuity payments in the same financial year are allowed.
Example:
A company sets aside ₹5 lakh for future gratuity obligations. Since it is only a provision and not an actual payment, it is disallowed.
Payments to Unapproved Employee Welfare Funds – Section 40A(9)
Contributions to funds or trusts not approved by law are disallowed.
Applicability:
Payments to welfare funds, societies, or trusts are not deductible unless specifically allowed under Section 36.
Example:
If a company donates to an unapproved employee welfare fund, the payment is not allowed as a deduction.
Marked-to-Market Losses – Section 40A(13)
Only recognized and allowable losses under Section 36(1)(xviii) can be deducted.
Applicability:
Unrealized or expected losses from changes in the market value of assets are not deductible.
Example:
A business records an estimated loss due to currency fluctuations but has not actually incurred it. Such a loss is not deductible.
Conclusion
Section 40A of the Income Tax Act ensures that businesses claim only genuine and reasonable expenses while computing taxable profits. To avoid disallowances:
- Ensure transactions with related parties are at fair market value.
- Prefer digital transactions over cash payments above ₹10,000.
- Make gratuity and welfare payments to approved funds.
- Avoid claiming provisions and unrealized losses.
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